Okay lets continue on this topic.

Last week I was talking about how a stock price is determined and to summarize:
1. Supply and demand dictate the share price to some extent

So from this above point, you might feel that this rule would mean that the expensive of two similar stocks is the better choice right? This is where it might get a little confusing…

Well it should be noted, that simply comparing the share price of two similar companies does not determine which company is stronger. For instance, if you looked at two airline stocks, and one was $100 and another was $50, the more expensive stock does not necessarily mean it’s the stronger company.

Why? Well you need to look at the market capitalization (market cap) of a company. This is the shares outstanding multiplied by the current stock price. So going back to the airline example, if there were (to make it easy) 100 shares of the $100 stock, and 500 shares of the $50 stock, doing some simple math would show that the $50 stock has a stronger value.

by Ergo Martini

I know many investors look at a price of a stock and deem it too expensive or cheap and look for a similar company, this investment strategy needs to be thrown out the window. The demand of a company could be raising the price because of a perceived positive outlook of a stock. You need to look at why a stock price is at the level its at and why it could go up or down.

Now another strong reason for share prices is earnings. Earnings are what any shareholder is looking for and the only reason they are investing their time and money into a stock. Does a company have the ability to meet its earnings? Every three months (quarter), a company will post its earnings and also give guidance on the future.

These are important for an investor as poor outlook towards the future can make a stock fall in price, while the announcement of better outlook (growth) will raise a stock price.

Now when it comes to the earnings, these are usually scheduled in advance to be reported on a specific date/time. At that time, analysts already have calculated what should be announced. These are usually referred to “whisper numbers” in media slang.

An example is, if company “XYZ” is anticipated to post earnings of $0.25 cents/share (EPS), it must beat that in many instance for a stock to rally. A lot of times when a company just meets the expected price, it’s not good enough. Why? Its one of those mysteries that many accept.

Another indicator to look at is the P/E ratio. This is the price to earnings ratio and is referred to daily by the media when discussing a company and also is seen on charts when reading a stock quote.

The P/E ratio is calculated by getting the current market value of one share divided by the EPS (earnings per share). A high ratio shows that investors are buying the stock on hopes of better earnings in the future while a lower ratio can mean the opposite. To compare this ratio, you must calculate this for two similar stocks. P/E ratio should not be a single reason not to buy a stock, but its one of the levels to look at when doing research.

Going back to the EPS example of $0.25/share, we can calculate using a pretend stock price of $100/share that the ratio is: 100 (divided) 0.25 + ( the EPS of the previous 3 quarters) – this is to give a better gauge of the ratio. The number you get is the PE ratio or also can be referred to as the “multiple”.

This “multiple” is the number of times a shareholder is willing to pay for a stock compared to its earnings.

To clear something up quickly, a high PE ratio (multiple) is not always a good thing. A high ratio could mean that a stock be being over bought and could crash soon (like Google shares did from their ultra high price). This is why the raio should be looked at, but not be the sole reason to purchase a stock.

So these are some fundamentals you should read and look at when watching a stock. Next week I was look at more specific ways to read a market. But now now, being a huge day in football, I’m sure everyone wants to get to other things. Hope you all come back next Sunday!

Happy Investing!

Aman, MBA


Related posts:

  1. Simplified Sunday #2 – How to start off investing – Part 2
  2. Simplified Sunday #4 – How to start off investing – Part 4
  3. Simplified Sunday #5 – How to start off investing – Part 5