Investor Math Basics
After you've narrowed your focus to a handful of companies, continue your research efforts by reviewing a few factors for each company. Find out about each company's earnings per share, price/earnings ratio, book value, price volatility, dividends, number of shares outstanding, and total return. These factors will give you greater insight into the stocks.
While some of the numbers (like earnings per share) can be pulled straight from a corporation's annual report, others may require a little math on your part (like price/earnings ratio). Don't let the math stop you — it's all pretty straightforward and not terribly time-consuming. And the information you'll get from it is well worth the effort.
Earnings Per Share and Price/Earnings Ratio
Earnings per share (often abbreviated EPS) is the company's net income divided by the number of common shares outstanding. Simply, it is the portion of the company's profit (or net income) for each share of stock. A company's growth rate is often determined by how its earnings per share have changed over the years. Finding a company with a strong earning growth is advisable. You can find that by looking at a company's earnings per share over the past several years to see if it is growing on a consistent basis.
Reviewing a company's price-to-earnings (P/E) ratio is also an integral part of the stock selection process. P/E ratio is the stock price divided by the earnings per share, so the result tells you how much you'll be paying for one dollar of the company's earnings. Since stock prices reflect investor demand, this ratio tells you the price investors are currently willing to pay in proportion to the company's earnings. A P/E ratio of 20 means investors are willing to pay twenty times more for a stock than the stock's earnings per share. More important, though, is the relationship of one stock's P/E ratio to others in the same class. In most instances, you can find a company's P/E ratio, and those of its peers, in the newspaper or online.
To be entitled to dividends, you must actually own the shares on the record date, which is the day the Board of Directors declares a dividend. Compare the current dividend with the dividends paid over the past five years. Shrinking dividends may indicate plans for expansion; when a company's primary goal is growth, dividends may be small or nonexistent.
When investigating a particular stock, compare its P/E ratio with that of other companies in the same industry. Since every industry has its own unique qualities, you want to find out what the average P/E is for that sector. If a company has an exceptionally low P/E compared to others in its industry, find out why. For example, the company's growth could be stagnant or it could be burdened with excessive debt. Alternately, it could simply be undervalued — making it a great buy for value investors.
Book Value and Price Volatility
A company's book value per share is calculated by subtracting its liabilities from its assets, then dividing the result by the number of shares outstanding. Essentially, book value (which is also known as accounting value) shows the company's net worth. This can help you figure out whether the share price (the market value) makes sense compared with the company's actual intrinsic value. Many experts say that a good way to find value stocks is to look for companies whose stock price is less than double their book value.
Price volatility refers to how much the share price varies, usually calculated by looking at the difference between a stock's high and low prices over a set time period. This factor is important in determining the risk of an investment. You might not be as willing to pay a lot for a stock if you knew that its price had jumped up and down dramatically over the past few months. In stocks, the term that describes price volatility is beta, a quantitative measure of the variability when compared with the market as a whole. In most analysis, beta compares the changes in a stock's price against the S&P 500 stock index. For example, a stock with a beta of 2 moves twice as much as the S&P 500. That stock can be expected to rise in price by 40 percent if the S&P 500 rises by 20 percent or drop by 40 percent if the S&P 500 falls by 20 percent.
Dividends and Shares Outstanding
Dividends are payments to shareholders that are not based on the stock price but are made simply because the company has reaped healthy profits and chooses to reward shareholders. Depending on the company's profits, the board of directors will decide whether and how often to pay a dividend to shareholders. Dividends are usually most important to investors looking for income, and stocks that pay dividends are thus known as income stocks. Many companies pay dividends on a quarterly basis, and special one-time dividends may also be paid under certain circumstances.
The term shares outstanding refers to the number of shares a company has issued to the general public, including its employees. It's a good idea to start your investing career by looking at companies with at least 5 million shares outstanding. This indicates that the stock is heavily traded, which means there will be a ready market for it should you decide to sell your shares. At the same time, more shares outstanding can mean smaller dividends per shareholder (there's only so much money to go around, after all), so keep that in mind when you're looking for steady income.
Most investors in stocks tend to think about their gains and losses in terms of price changes, not dividends, whereas those who own bonds pay attention to interest yields and seldom focus on price changes. Both approaches are incomplete. Although dividend yields may be more important if you are seeking income, and price changes take center stage for growth stocks, the total return on any stock investment is extremely important. Knowing a stock's total return makes it possible for you to compare your stock investments with other types of investments, such as corporate or municipal bonds, treasuries, mutual funds, and unit investment trusts.
To calculate total returns, add the stock's price change (or subtract it if the price has gone down) and dividends for the past twelve months and then divide by the price at the beginning of the twelve-month period. For example, suppose you buy a stock at $45 per share and receive $1.50 in dividends for the next twelve-month period. At the end of the period, the stock is selling for $48 per share. Your calculations would look like this:
Price change: up $3.00 per share
$1.50 + $3.00 per share = $4.50
$4.50 divided by $45.00 = .10
Your total return is a 10 percent increase.
But suppose, instead, that the price had dropped to $44 per share by the end of the period. Then your calculation would look like this:
Price change: down $1.00 per share
$1.50 – $1.00 per share = $0.50
$0.50 divided by $45.00 = .011
Your total return is only a 1.1 percent increase.