If you plan to make money in the stock market you'll need to know some stock market basics, like how to tell when stocks are cheap and when they are not. Here's the traditional way millions of investors do it.
If you take an investment course you should learn a few stock market basics... like what a P-E ratio is. Understanding this basic tool is one thing, putting it to use to make money in stocks is quite another. Let's take a look at the P-E, often called the price multiple, and see how this stock market ratio works.
The performance of the stock market is tracked by major indexes or averages, the Dow Jones Industrial Average being the most popular. Wall Street follows a broader-based index called the S&P 500, which we will focus on here. Basically, it tracks 500 of the largest and most valuable U.S. corporations in terms of market value. The index is simply a number, and its price or value stood at over 1100 in early 2010. Simply put, when the S&P 500 is up the market is up, and vice-versa.
In terms of stock market basics, the question of the day year in and year out: are stocks selling cheap or are prices high compared to the profits, or net earnings per share, of the companies in the S&P 500? That's what the P-E ratio tells you. Each stock has a P-E ratio as well. For example, if ABC Company is selling for $20 with earnings per share of $2 for the past 12 months, its P-E is 10... it is selling at 10 times earnings.
Investors make money in the stock market when they can buy when prices are cheap and sell when things get pricey. That's why they follow this popular ratio. Over the past 100 years or so, the market's P-E ratio has basically been in a range of 5 to 44, with 15 being the mean or average. The greatest stock market run in history started in 1982 with a P-E of about 7 or 8 for the S&P 500, and ended at year-end in 1999 with a P-E of 44.
Getting back to stock market basics, it looks like if you want to make money in stocks you should buy when the market's P-E is low, and buy stocks with low P-E ratios. Then sell when the ratio is high. Wouldn't it be great if it was that simple to make money in the stock market? The problem is that if you had waited for a low P-E before buying in the 1990s, you could have sat on the sidelines and missed about 10 years of soaring stock prices. The P-E started that decade at over 15, and continued upward to 44.
As long as corporate profits are climbing, it's a good thing when prices are climbing even faster causing the P-E to go higher. But, when earnings fail to keep pace and stagnate or decline it is time for concern. If you want to make money in the stock market pay attention to the P-E, but pay attention to the E (earnings) part of the ratio as well. When prices get high and can no longer be justified by earnings growth the party is about to end.
Knowing stock market basics is important because otherwise you are just flying by the seat of your pants. The P-E ratio is a good basic tool but it can be misleading to the inexperienced investor. For example, JKL Company is selling at a P-E of 5 times earnings while the market is selling for 20 times. Is JKL cheap and a good investment? Probably not. Most likely informed investors are selling and sending the price down because they anticipate a poor earnings report from the company in the future. A $10 stock with $2 a share in earnings sells at 5 times earnings. If earnings fall to 10 cents, the P-E zooms to 100. JKL no longer looks cheap.
