Stocks, also called equities, represent shares of ownership in a company. The value goes up and down based on the performance of the company. Here are two ways stocks can generate investment returns for stockholders: 1) price appreciation – selling the stock for more than the purchase price, and 2) dividends – periodic distributions of the company’s earnings to stockholders.
When you buy stocks, there is no guarantee that the value will go up. In fact, the value could go down. Historically, over the long term stocks have provided the greatest growth potential of the major asset classes, but also the greatest volatility and risk. Past performance is not a guarantee of future results.
Choosing what stock to buy is a bit more complicated than throwing darts at a board. Stock analysts use a variety of formulas to help estimate a stock’s value. One of the most common measures of a stock's value is the price-to-earnings (p/e) ratio.
How Is the P/E Determined?
Typically, the p/e is determined by dividing the share’s price by the company’s earnings per share. Earnings per share is calculated by dividing a company’s net income by the total number of outstanding shares. For example, a company with $100 million in net income and 10 million outstanding shares would have earnings per share of $10 ($100,000,000/10,000,000). If the stock price is $50, than the p/e ratio is 5 ($50/10).
A high p/e can mean the stock is overvalued (investors are paying more for the stock than it may be fundamentally worth). A low p/e can mean the stock is undervalued (the stock is selling at a bargain price compared to its fundamental worth). But as with most issues involving the stock market, it’s not that simple.
What Is a Desirable P/E?
The answer is – it depends. The p/e may provide an idea of how much investors are willing to pay for a stock and can be used to compare different companies’ performance. However, desirable price-to-earnings ratios will vary depending on the industry and period during which the p/e is measured. Investors may be willing to buy stocks with a high price and low earnings if they feel the stock has long-term growth potential. They may snub stocks with low p/e’s if the industry is out of favor or if the company is experiencing temporary problems.
Making Stock Ownership Easier
Most individuals do not have the time, expertise or interest to study financial reports and research individual stocks. Your 403(b) plan typically includes stock funds, also called equity funds or mutual funds, managed by professional investors. These funds diversify and invest in dozens or hundreds of different individual stocks.