Sunday, October 14, 2007

Some Basic Information About Stocks

You may think it is very hard to try and put a price tag on a stock and it is even harder to tell which direction that stock should be going, but there is a basic underline way to determine how to price any stock out there.

The first and most important thing to consider is a stock's PE or Price To Earnings Ratio. Now sure that may sound complicated, but it's really not. All you do is take this price of any stock, let's say for instance Royal Bank Of Canada (ry) which is trading at $57.56 a share and divide it by it's earnings per share which is $4.19. ($57.56/$4.19 = 13.61 PE) It is just that simple, Royal Bank Of Canada has a 13.61 PE or Price To Earnings Ratio!

So, all we do is apply this same logic to future earnings. Let's say Royal Bank Of Canada earns $6.25 next year and the market is willing to pay the same multiple 13.61 for the stock it would be at $85.06 per share. ($6.25 EPS * 13.61 PE = $85.06)

Basically, if a stock can continue to grow it's earnings and the market is willing to pay the same multiple or more for the stock it will go up naturally. Now, if earnings decrease the price will generally go down and so may the multiple that the market is willing to pay for the stock which is a double whammy.

Another thing to consider is that the higher the multiple the more "expensive" the stock is.... that is investors are paying more for future growth. Sometimes this can really pay off if the earnings are growing quick enough, but stocks with a high multiple that missed their earnings estimates can get hammered. Take Akamai (akam) for example, their recent earnings missed just made their stock drop like a rock due to the fact that their multiple was already so high that any kind of a miss would be ugly and it certainly was if you look at the 3 month chart.

Therefore, in general the stocks with the lower multiples can be much safer, but sometimes it can be worth it to pay up for growth. It all depends on what kind of an investor you are and how much risk you are willing to take on.

One last thing, the multiplies can be a good measure of comparing similar stocks, for instance Google and Yahoo. Google (goog) trades at $637.39 and has a PE of 54.18 while Yahoo (yhoo) trades at $28.48 with a PE of 55.55. So technical Yahoo is more expensive than Google! Yes that's right, even though Google is a $637 stock it is still cheaper than Yahoo at 28 smackers! Amazing really, especially since Google is growing faster than Yahoo which is what the multiple is really based on.

So next time you are trying to hunt for a stock, make sure to keep the multiple in mind and don't be afraid to compare it to it's peers. Let me know if you have any questions or comments and good luck to everyone this earnings season!

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