Lesson 1 The tool box

I think we all have the basic tool box at home. You know, the one with a screwdriver, hammer, and wrench that's stored in the kitchen drawer with all the other important stuff we almost never use.  I think my friend calls it Donna's drawer.  We call ours Gail's drawer.

The point is, from time to time, we all look for that tool box to maintain items in our household.  If we don't take on these periodic maintenance tasks, our household becomes less inviting and begins to lose value.  Stock investing requires its own set of tools to evaluate a potential buy (or, position, as it is called ) and to monitor or maintain existing positions (or, portfolios, as they are called ).

The earnings per share of a company is considered the most important statistic to comprehend before investing in a company's stock.  Before starting a position in a stock, you need to review current, past and future earnings projections.  Earnings are important to you because they tell you the relative profitability of the company.  Relative will become the key word when learning how to use tools.  Earnings per share is defined as the net income of a company ( after taxes ) divided by the number of outstanding shares of common stock.  These two statistics are readily available on Yahoo finance or Edgar on line.  Earnings per share measure is important because it's the amount of money left over for shareholders ( you ).  Companies then have a choice to distribute that cash in the form of a dividend, or keep the cash in retained earnings, allowing  an internal source of capital to support the growth of the company.  Both choices have obvious rewards to shareholders.

Now that you know how to arrive at earning per share you can engage the first tool used by investors to evaluate their potential stock picks or review their holdings ( portfolio ).  Price to earnings ratio (P/E) is the price of the stock divided by the earnings per share.  For instance, a stock price of $ 25.00 divided by earnings per share of $ 1.80 equals a P/E ( price to earnings ratio ) of 13.88.  This metric becomes important for multiple reasons.  It establishes how the company compares to competitors in the same sector of business.  It can also reflect the potential earnings growth over time.  If we believe a company will grow 20% + over the next five years, and the price to earnings ratio (sometime referred to as multiple), is only 10, then the growth is not being factored into the stock price.  In other words, the stock is undervalued by almost two times.

I wish it were all that simple and we could  pick winners and know when to buy and sell a stock.  Price earnings multiple is the first of many factors in making a decision.  Please feel free to ask me any questions to help understand this metric.

(Reminder:  Check this blog's archives for other artcles.)

Until next time,

Steve M