Invest Like an Owner

May 27th, 2007

For those that are new to investing or know very little, here is a neat little article.  If you’re an expert, you can skip it.  It is common for people in the public to see a stock price of $20.00 and think the company is worth more than a company that has a stock price of $10.00. Not true. The company with a stock price of $20.00 per share may only have 100 shares outstanding. That would make the entire company valued at just $2,000. The company that has a stock price of $10.00 may have 45 million shares outstanding. In order to buy 5% of the first company, it would cost $100, which would be 5 shares. To buy 5% of the second company, it would cost $22,500,000, which would be 2,250,000 shares. See the difference?

When investing in a company you must think like an owner. If you had enough money, would you buy the entire company at that price? Then look at it in terms of ‘per share’.

How is the share price calculated? Price and demand of the stock cause its price to fluctuate. Press releases and news can have dramatic affects on the price as well. In order to determine if the company is ‘cheap’ and a good buy many people use ratios and indicators. Let’s look at a few.

Price Earnings Ratio

Commonly referred to as P/E ratio. The price of the stock divided by the earnings per share.

Company A has a price per share of $5.54 and earnings per share (EPS) of $0.85. This would give them a P/E ratio of 6.59. For every $1 in earnings the company has, you will pay $6.59 to buy the company. The cheaper you can buy a company the better. The lower the ratio, the cheaper the stock is relative to its earnings. You wouldn’t want to pay $100 per share for a company that is only making $1 per share in profits. Generally P/E ratios hover between 5 and 35. As a general rule of thumb, try and stick to stocks that have a P/E ratio of 10-15 or less.

Earnings per Share

EPS is calculated by taking the earnings of the company and dividing it by the total number of shares outstanding. This tells you how much money, per share, the company made during the last year.

There are literally hundreds of ratios, too many to list here. If you want to learn more about ratios, check out Investopedia.com.

Summary

As you can quite easily see, when investing in the stock market you are essentially buying a peice of a company. Treat it like the process it is and do your due diligence. You deal with companies every day of the week. Pay attention and you may find some great companies to invest in.

Entry Filed under: Articles