Up On the Basics
Your mail tells me
that sometimes my columns assume a familiarity with terms and concepts
that many beginning investors don’t have. With that in mind, I’m going
to use this column to explain a few basic stock market concepts. But,
don’t tune out if you think you know this stuff. I’ve included enough of
my own arguable opinions to make it interesting for you too.
A price chart graphically illustrates a stock’s price action over a
selected timeframe, one-year, for instance. Some investors, called
technical analysts or chartists, feel it’s a waste of time examining
financial statements, dissecting analysts’ forecasts or pondering a firm’s
prospects vis-à-vis the competition. Instead, they believe that a stock’s
price chart tells them everything they need to know about a stock.
Chartists say stock
prices move in trends. That is, a stock that has already been moving up in
price (uptrend) will continue its winning ways, while one going the other
way (downtrend) will continue to disappoint its shareholders.
As simplistic as that
idea sounds, in my experience, it’s true more often than not. While
understanding a firm’s fundamental outlook is crucial, I believe that it’s
also important to look at the charts.
Fortunately, you don’t
have to be a charting expert to do the analysis. Start on Yahoo (finance.yahoo.com)
by clicking on “Basic Chart”
after getting a
By default, Yahoo displays a one-year chart, which is ideal for spotting
which way a stock is trending.
The analysis is easy. If
the stock is in an uptrend, the price will be higher on the right side
than in middle or left side of the chart. Conversely, the right side will
be lower than the middle or the left side if it’s in a downtrend.
If you don’t see a
trend, the stock is probably in a consolidation pattern (no-trend).
Even if a firm’s
fundamental outlook looks rosy, avoid stocks that are consolidating or
trending down. Instead, check the stock’s chart once a week or so, and
wait for an uptrend.
Valuation ratios help you to understand how the market views a company.
Most market players are “growth” investors, meaning that they prefer
stocks with strong future sales and earnings growth expectations. High
valuation ratios signal that a firm is “in-favor,” with growth investors.
By contrast, low
valuations tell you that a stock is “out-of-favor” with the growth crowd.
“Value investors” search through these stocks looking for those with the
best prospects of recovering from the problems that caused growth
investors to shun them.
All valuation ratios
compare a company’s recent share price to a fundamental factor.
The price to earnings,
or P/E, is the most widely followed ratio. It compares the recent share
price to 12-month’s earnings, expressed on a per share basis. For
instance, the P/E would be 10 if it earned $5 per share and recently
traded at $50 per share. Growth stocks usually trade at P/Es above 20, and
P/Es below 15 identify value-priced stocks. Stocks with P/Es between 15
and 20 could be either growth or value, depending on the circumstances.
Price/sales (P/S), which
compares the recent share price to 12 month’s sales per share, is another
popular valuation ratio. Some investors prefer P/S instead of P/E because
sales generally don’t fluctuate as much from quarter to quarter as
earnings. Also, you can still calculate P/S, but not P/E, when a company
reports a loss (negative earnings). P/S ratios of 4 and above usually
identify growth-priced stocks while ratios below 2 signal value stocks.
You can see the
valuation ratios on many investing sites. On Reuters Investor (www.investor.reuters.com),
get a price
quote, then select
All it takes is a rumor that a company might fail to send its share price
into the dumpster. That’s why it’s important to include financial strength
in your analysis when you size up a candidate.
The good news is that
you don’t have to don green eyeshades and dig into financial statements to
make that assessment. Checking one financial strength gauge will do the
The debt/equity (D/E)
ratio compares a firm’s long-term debt to its shareholders equity or book
value (assets minus liabilities). A firm with no long-term debt would have
a zero D/E, and the higher that debt, the higher the ratio. Generally
companies with ratios above 1 are considered high debt and those with
ratios below 0.5 are low-debt.
However, the definition
of low and high varies with industry. Software companies typically carry
no long-term debt while banks and utilities often carry high D/E ratios.
So you can do a better job of evaluating debt by comparing a company’s D/E
ratio to its industry.
You can do that on MSN
by getting a
quote, selecting “Financial
Results,” then “Key
Ratios,” and finally, “Financial
Condition.” To reduce your risk of picking a financially troubled
firm, avoid stocks with D/E ratios above their industry average.
That’s all I have room
for today. Let me know of any other basic terms I’ve used that require
explanation. If I get enough questions, I devote another column to the