Last week on the WSPD radio show “Eye on Your Money,” I received a call asking about the relationship between the price of a stock and the earnings of the company and why this is so important.
The question made me realize that I sometimes take for granted the technical aspect of investing and think everyone knows all the terms and definitions.
The price of a stock and the earnings of the underlying company have a very important relationship that will help you make the decision whether to invest or not. Actually, it is the ratio of the earnings to the price of the stock, or the P/E ratio, that is important.
One of the most popular stocks is Apple (AAPL) and it is priced today (late April 2012) at $560 a share, which is 16 times annual earnings. Another way of looking atthe same ratio is that it will take Apple 16 years at current earnings to equal today’s price of $560.
This may sound like a long time,but historically a P/E ratio of 16 is not considered too bad, especially considering this is a technology company. IBM, long considered the blue chip of blue chip stocks, trades at just under 15 times earnings.
If more people would have stuck to only investing in companies with low P/E ratios, no one would have been burned during the dot-com bubble. I remember some stocks were trading at 600 times earnings; that’s 600 years of earnings to justify the price of the stock. That is a long time.
Many of the dot-com companies didn’t have any earnings at all but people kept buying and the stock kept going up. What we commonly call “irrational exuberance.”
Getting back to a reasonable P/E ratio, it has been my experience that any stock trading at less than 17 or 18 is worth looking at, along with other fundamentals of the company.
ConocoPhillips, for example, is trading atless than 8 P/E. Compared to Apple, this looks like it should be twice as good an investment but you have to take into consideration the industry. Technology is more volatile than energy. Everyone needs energy but not everyone needs an iPad.
Another important fundamental in looking into a stock is the volume. It is important that a stock have sufficient volume to create the liquidity needed to keep the price from being too volatile.
If a stock is thinly traded and you wish to purchase or, more importantly, sell a large amount of shares, your trade could cause a serious price swing.
I have personally had this happen many years ago, once on the purchase side and once on the sell side. From that point on I set my price — either selling or buying — and if I don’t get my price I don’t do the trade.
A lot of volume during the day will make these trades less troublesome and ensure you that you will buy what you want at the price you have set.
Over the next several columns we will look at some of the different fundamentals that are important as well as take a look at some of the technical chart indicators to look for when evaluating a stock.
The market is an irrational animal regardless of the research you do and the cautions you take. There are always “black swans” out there that no one can see coming.
Regulation is always another important aspect to consider when looking at a particular company. Do you want to invest in a company that is in the regulatory sights of Congress? How about a drug company that is trying to get a new drug approved by the FDA?
Many variables go into evaluating a stock; you should learn which are important to you and stick to them when deciding what to invest in. ✯
Gary L. Rathbun is the president and CEO of Private Wealth Consultants, LTD.
