IF YOU SPEND enough time at cocktail parties, you'll eventually run into someone boasting about his latest "bargain" stock or the hot company he managed to pick up "cheap." And as the ice melts in your glass, he'll probably ramble on about his superior stock-picking skills and all the winners he's found in the past.
Tedious? Guys like that are. But there's nothing boring about a good, cheap stock. More than anything else, learning to spot bargains is the essence of successful investing.
Many beginning investors make the mistake of thinking that a low stock price means the company is inexpensive. If, for instance, Microsoft is selling for $56.60 a share and IBM is selling for $95.60, then Microsoft must be the cheaper stock, right? Not necessarily. Those were real prices in early December 2000, and at the time, Microsoft's total market value was $302 billion, while IBM weighed in at $168 billion. The difference was that Microsoft had some five billion shares outstanding, while IBM had about one-third as many. Share price is total market value divided by shares outstanding. And since the number of shares is largely arbitrary, so is the stock price.
The crucial consideration is why the market thought Microsoft was worth $302 billion (even at a time when it's still waging a legal battle over violating federal antitrust laws) while it assigned IBM a value of just $168 billion. And that's a lot more complicated. Investors value stocks based on one question: If I put my money into this company, what are the chances I'll get a better return than if I invested in something else? It's a matter of risk vs. reward. The safest investment is a U.S. Treasury bond because its return is guaranteed by the "full faith and credit" of the federal government. (See our Bonds section for more on how these securities work.) A stock's value proposition starts there -- how much more will it return than a Treasury bond and at what risk?
When you buy a stock, your return is a stream of earnings over time -- which is hardly guaranteed. The more reliable that stream, however, and the more quickly it grows, the more investors will be willing to pay for it (see applet above). Your traditional electric utility has reliable earnings but utilities don't grow very fast, so they tend to be pretty sleepy stocks. Microsoft's earnings, on the other hand, are both steady and fast-growing, which is why there are more than a few secretaries in Redmond, Washington, who count their net worth in millions.
In order to evaluate companies against each other (and against themselves), investors long ago developed a measure called the price-to-earnings ratio, or P/E. It's derived by dividing a company's price per share by its earnings per share. If a company has a P/E ratio of 20:1, for instance, that means investors are paying $20 for every $1 of earnings. If the P/E is 18:1, they're only willing to pay $18 for that same $1 profit. Most people only use the top number when referring to a company's P/E, as in IBM has a P/E of 19. The ratio is also known as a stock's "multiple," as in Microsoft is trading at a multiple of 27 times earnings. Translation? Going back to our original example, investors are paying more these days for a slice of Microsoft's profits than IBM's.
A company's P/E fluctuates with investor perceptions about how quickly its earnings will grow in the future. That's why two companies with the exact same earnings per share over the past year may have different multiples. If Company A and Company B each earn $1 a share, but Company A is trading for $20 and Company B is trading for just $18, the market is making a judgment on their earnings prospects. Based on any number of factors -- company health, outside competition, better management, the economy, the outlook for the sector -- investors think Company A's earnings are better poised for growth. Consequently, they're willing to pay $2 more right now to lay claim to them.
OK, so we still haven't really answered the question -- what is a cheap stock? For that we have to look at a stock's behavior over time. Most established companies trade up and down in a range depending on how investors are weighing their earnings prospects. Sometimes disappointing news -- a lackluster quarterly-earnings report, for instance -- can depress the price for a period of time. Other times good news sparks a flood of investor interest.
This ebb and flow is reflected in the P/E, which can be compared both to a company's historical range and that of other companies in its industry. It can also be compared to the market as a whole. In late 2000, for instance, United Airlines was trading at about six times earnings projections, which looked cheap compared to the average of 20 for the S&P 500 index. But a little more research would tell you that airlines always trade at a discount to the broader market because their earnings are so cyclical. And United was having its own spate of labor and merger problems.
Southwest Airlines, on the other hand, was trading at around 23 times earnings projections, which made it look expensive. But among airlines Southwest has a strong record of consistency and top-notch management, so it usually trades higher. Faced with this evidence, you might conclude that United was a bargain if it could just solve some of its problems with its unions. Southwest might look fully valued, but ripe for the picking if its price falls temporarily.
The object of investing, obviously, is to buy low and sell high. And as you can see, that often means looking for stocks that are temporarily out of favor. If you buy stocks near the top of their range, the danger is they will reverse course and tumble downward. If you buy near the bottom -- or when the stock is cheap relative to its true potential -- you can enjoy the full ride back upward. (The catch, of course, is to do careful research so you can be confident the stock will, in fact, head north once again.) The art of investing is deciding when to strike -- and acting on that decision before everybody else does. We'll show you how in our Strategic Investing section.
And here is the LINK
university.smartmoney.com/departments/...dex.cfm?story=howmuch
Tedious? Guys like that are. But there's nothing boring about a good, cheap stock. More than anything else, learning to spot bargains is the essence of successful investing.
Many beginning investors make the mistake of thinking that a low stock price means the company is inexpensive. If, for instance, Microsoft is selling for $56.60 a share and IBM is selling for $95.60, then Microsoft must be the cheaper stock, right? Not necessarily. Those were real prices in early December 2000, and at the time, Microsoft's total market value was $302 billion, while IBM weighed in at $168 billion. The difference was that Microsoft had some five billion shares outstanding, while IBM had about one-third as many. Share price is total market value divided by shares outstanding. And since the number of shares is largely arbitrary, so is the stock price.
The crucial consideration is why the market thought Microsoft was worth $302 billion (even at a time when it's still waging a legal battle over violating federal antitrust laws) while it assigned IBM a value of just $168 billion. And that's a lot more complicated. Investors value stocks based on one question: If I put my money into this company, what are the chances I'll get a better return than if I invested in something else? It's a matter of risk vs. reward. The safest investment is a U.S. Treasury bond because its return is guaranteed by the "full faith and credit" of the federal government. (See our Bonds section for more on how these securities work.) A stock's value proposition starts there -- how much more will it return than a Treasury bond and at what risk?
When you buy a stock, your return is a stream of earnings over time -- which is hardly guaranteed. The more reliable that stream, however, and the more quickly it grows, the more investors will be willing to pay for it (see applet above). Your traditional electric utility has reliable earnings but utilities don't grow very fast, so they tend to be pretty sleepy stocks. Microsoft's earnings, on the other hand, are both steady and fast-growing, which is why there are more than a few secretaries in Redmond, Washington, who count their net worth in millions.
In order to evaluate companies against each other (and against themselves), investors long ago developed a measure called the price-to-earnings ratio, or P/E. It's derived by dividing a company's price per share by its earnings per share. If a company has a P/E ratio of 20:1, for instance, that means investors are paying $20 for every $1 of earnings. If the P/E is 18:1, they're only willing to pay $18 for that same $1 profit. Most people only use the top number when referring to a company's P/E, as in IBM has a P/E of 19. The ratio is also known as a stock's "multiple," as in Microsoft is trading at a multiple of 27 times earnings. Translation? Going back to our original example, investors are paying more these days for a slice of Microsoft's profits than IBM's.
A company's P/E fluctuates with investor perceptions about how quickly its earnings will grow in the future. That's why two companies with the exact same earnings per share over the past year may have different multiples. If Company A and Company B each earn $1 a share, but Company A is trading for $20 and Company B is trading for just $18, the market is making a judgment on their earnings prospects. Based on any number of factors -- company health, outside competition, better management, the economy, the outlook for the sector -- investors think Company A's earnings are better poised for growth. Consequently, they're willing to pay $2 more right now to lay claim to them.
OK, so we still haven't really answered the question -- what is a cheap stock? For that we have to look at a stock's behavior over time. Most established companies trade up and down in a range depending on how investors are weighing their earnings prospects. Sometimes disappointing news -- a lackluster quarterly-earnings report, for instance -- can depress the price for a period of time. Other times good news sparks a flood of investor interest.
This ebb and flow is reflected in the P/E, which can be compared both to a company's historical range and that of other companies in its industry. It can also be compared to the market as a whole. In late 2000, for instance, United Airlines was trading at about six times earnings projections, which looked cheap compared to the average of 20 for the S&P 500 index. But a little more research would tell you that airlines always trade at a discount to the broader market because their earnings are so cyclical. And United was having its own spate of labor and merger problems.
Southwest Airlines, on the other hand, was trading at around 23 times earnings projections, which made it look expensive. But among airlines Southwest has a strong record of consistency and top-notch management, so it usually trades higher. Faced with this evidence, you might conclude that United was a bargain if it could just solve some of its problems with its unions. Southwest might look fully valued, but ripe for the picking if its price falls temporarily.
The object of investing, obviously, is to buy low and sell high. And as you can see, that often means looking for stocks that are temporarily out of favor. If you buy stocks near the top of their range, the danger is they will reverse course and tumble downward. If you buy near the bottom -- or when the stock is cheap relative to its true potential -- you can enjoy the full ride back upward. (The catch, of course, is to do careful research so you can be confident the stock will, in fact, head north once again.) The art of investing is deciding when to strike -- and acting on that decision before everybody else does. We'll show you how in our Strategic Investing section.
And here is the LINK
university.smartmoney.com/departments/...dex.cfm?story=howmuch
