The Dreaded PE Ratio

The amount of shares outstanding varies from business to business.  One company might have 1 million shares outstanding, while the next, 1 billion.  Not only that, the float size can change at any time, depending on the company's actions.  They might sell more shares into the market to raise money, or decide to buy back shares to shrink the float, and increase Earnings Per Share (EPS).  Sometimes companies do "splits" and "reverse-splits" which restructure the float, and share structure.

The amount of shares outstanding, is simply the amount of pieces a business has been broken into.  In the example above, the billion dollar company has been split into a billion pieces.  That's 1000 times more shares than the company with a float of one million shares.

How do we then compare these companies Apples to Apples?  We use a "PE Ratio", or a price-to-earnings ratio.  This ratio allows us to see the company for what it earns, per share outstanding, and factors the current price of the stock.  Sometimes, people call the PE, the "multiple".

Basically the ratio, takes the "Price" of the stock, and divides it by the "EPS".  You can calculate the earnings per share for any company, by taking their total income for the year, and dividing it by the amount of shares outstanding.  This will get you the "Earnings" for the stock.  You can then take the price the stock is currently trading at, and divide by the EPS, and come up with a PE ratio.

This is exactly why the price of a stock has almost zero value.  You can't look at a stock like Apple trading around $440, and call it expensive.  Tomorrow Apple could do a 10-1 share split, increase their float tenfold, but the share price going forward would only be $44 each. 

Buying Apple at $440 with a billion shares outstanding, is the same as buying it at $44, with 10 billion shares outstanding.  The price may seem more attractive, but both buys are exactly the same.  Sure, you can buy 10 times more shares at $44, but there's also 10 times as many shares out there.

You can't just compare EPS to EPS, because we'd be completely ignoring what price the stock is currently trading at.  The last step, dividing the Price by the EPS gets you a PE ratio, which will factor the price the stocks are trading at, as well.

If your calculations lead you to conclude that Apple is trading at a 16 PE, and MSFT is trading at a 12 PE.  You can say for certain that MSFT is cheaper than Apple at that point in time, assuming earnings projection for the year are accurate.  In some cases, you'd buy MSFT because it was a better value. Other times, it's okay to pay more for a better quality stock, with better growth options if that's what you decide makes sense.

Different sectors, and different size companies have a different baseline, for what is a usual PE for that "group" of similar stocks.  Safe, establish companies might only warrant a 10-12 PE due to slowing growth.  A small cap tech stock,  with a hot story, might warrant a PE of 100.

There is a ton more about PE's I can't discuss in this blog post.  Understand one thing about PE's though, they are subject to interpretation.  PE's make the market.  Usually at what growth rate a stock has, has a big impact over what PE it deserves.  In the end, the market will decide what fair PE is for certain stock in certain sectors.

The winners in each sector always deserve a premium to the rest of their group, because that business has superior earnings, and prospects.  The best companies, in their respected sectors, are called "Best Of Breed".  If you see a best of breed company, trading in line with it's pears, after previously out performing, check out their core business.  If they truly are a better company, it's might be just the time to snatch them up.

Time to bend the laws of gravity, in "What Goes Up, Doesn't Need To Come Down"...

Big Caps Vs. Small Caps

The word "Cap" is short for Market Capitalization.  Market Capitalization is simply the amount of shares a company has in their float, multiplied by their current stock price.  This number is supposed to give you an idea of a company's overall value, and size.

There's small caps, mid caps, and big caps.  All they're referring to, is how big and established the company is.  Most people who own, and trade stocks, use mostly big caps to do so.  These companies are established.  They have been around for years.  They have name recognition.  They have an earnings history.  They have a chart you can study.  They have big name CEOs.

Big caps are the easiest, and safest stocks to trade, for all the factors I just listed.  For a company like IBM to lose half of their share value would be completely shocking.  It would take a market crash at this point, or a complete business catastrophe, to ever get back to that level, and it the decline could take weeks.  By contrast, a small cap could lose half it's value in a day, pretty easily.

With small caps, a lot of time we're taking about companies who aren't currently making money.  You have to be extremely careful with companies that aren't making money.  If they aren't making money, they are burning, or spending it.  At some point, if that little company can't turn a profit, it will need more funds to survive.  They can add debt, if a lender is willing to lend them money, they can sell assets, or they can attempt to release brand new shares into the market.

Any shares issued by a company after they've had their inital public offering (IPO), are called a "Secondary".  When this happens, most of the time, it's a bad thing.  As more shares are added to the float, your current shares become less valuable, because there are more of them distributed.  The company is in a sense, selling more pieces of itself into the market, and they will recieve money back for each piece.  We'll talk about "Dilution" more in a future post. 

Understand, there is more risk in small caps, but there is also more profit to be had.  You would be surprised how many small and mid caps, go virtually unnoticed, even if they are doing a great job.  Quality small businesses do go largely unnoticed in this game.  Big money likes established names, and predictable earnings.  Much of the time, they completely ignore these smaller companies, even knowing they are good, and will wait until they grow more.  Basically you will find gems out there, and it will be easier than you think, because these small companies just don't get exposure.

Most people when they start this game make the huge mistake of allocating a lot of funds, to small cap companies.  The market offers all kinds of business' from very safe, to very risky.  I'd prefer the first stock you sink some real money into, is a reliable big cap.  You'll have more information to work with, and the stock will have less volatility.  You'll have a trust that this company will be around for a long time.

There's a huge difference between buying McDonalds, a big cap, with great earnings viability, and a dividend, and a small cap Chinese semi-conductor company, with no earnings, that trades on the Chinese stock exchange.

Let me teach you "Averaging Up And Down"...

Bulls, Bears, and Pigs

There's a classic saying in investing, "Bulls make money, Bears make money, but Pigs get slaughtered."  There are two different opinions, on the overall direction of the market, and they are called Bulls, and Bears.  Bulls think the market, or a certain stock, will go higher.  Bears think think the opposite.

Both parties are able to place their bets the way they want, as Bears can "Short" the market, and basically play to profit on the downside.  It's a good thing, because it keeps the market is check.  You need Bears.  If you're a Bull, and correct in your opinion, the Bears are the ones that are paying you.

A Pig is either a Bull, or a Bear, that has stayed in a trade for too long, gave back all their profits, and then some.  Pigs are stubborn.  They won't listen when the facts change.  They've been right for so long, they'll ignore all the signs that go against their opinion.  They'll ignore the both the fundamentals, and the technicals, and it will drive you mad, but also drive you find great prices on merchandise.

Fundamentals, are the actual dollars and cents behind the business.  When companies report their earnings, it's all there for you, in black and white.  Wallstreet calls these accounting numbers, the "Balance Sheet".  It calls quarterly earnings reports, "Earnings".  To know a companies "Earnings" and have an understanding of their "Balance Sheet", is essential.  Without that you might as well put a blindfold on.  You just have no idea what shape the company is in.

Technicals, are what the chart says.  You can look up any companies chart, and begin to analyze certain things.  How many shares are trading per day, which they call the "Volume".  You can analyze patterns and make suggestions as to what you believe will happen going forward.  Technicals do have merits, and I use them on every trade I make, however I do believe fundamentals are trump card.  When both fundamentals and technicals align, I like the stock even more.  Basically, if the company look poised to grow and make money, and the chart looks healthy, it's probably a good buy.

Companies either have "cash" or "debt" on their balance sheet.  Companies with good amounts of cash per share, can weather storms.  See, when a company reports a loss for the quarter, they are burning up money.  When that money runs out, they either have to borrow more, or issue new shares into the market, if they can.

Sometimes debt can absolutely swallow a company.  When you see a company in debt, and losing money, you should probably cut your losses.  I start by never buying them.  Or at least not unless I'm speculating, which means investing a small percentage of my portfolio, on something higher risk.

On to "Dividend Stocks and Money Management"...