How to value a stock (page 2 of 2)

If the PE is lower, it often means the market expects earnings to fall.

Google is currently trading at a PE ratio of 28. The reason it's so high is that investors, in aggregate, expect the company's earnings to rise dramatically, as they have the past few years. Union Pacific, on the other hand, has a price-to-earnings ratio of 10 and is not expected to grow earnings much in the staid railroad business.

When someone bought Amazon at $105 in 1999, the company did not have any earnings at all. Instead, the share price reflected investors' enthusiasm about the prospect for internet retailers to earn big profits in the future. In retrospect, their hopes were overblown, and the prices of many e-retailers collapsed when that reality hit home.

Paying dividends

One way to avoid buying into similar duds is to favour companies that pay dividends. These are payments a business makes out if its earnings on a regular basis (typically once per quarter) to its shareholders. Many highly speculative stocks have no earnings and pay no dividends.

Another reason dividends are important is that they represent roughly half the profits investors have earned on stocks over the long term. Dividend-paying stocks tend to be issued by established companies, like General Electric, Kraft Foods and Consolidated Edison. Technology firms, like Cisco and Apple, have avoided paying dividends by arguing that their assets can be more profitably employed through investments in promising new ventures.

A company's dividend is measured in terms of its yield. This is the percentage of the stock's current price that you get back through dividends. If you pay $50 for stock in a company that pays investors $2 per share in annual dividends, its yield is 4%. That's as much as you're likely to get these days in a bank savings account or from a highly rated corporate bond. If, instead, you pay $100 for a stock paying $2 a year in dividends, your yield falls to 2%.

If high dividends sound like a good deal, consider a low-cost index fund that specializes in high-dividend stocks. Most are easy to find by screening for mutual funds or ETFs by category, or searching for funds with the word "dividend" in their names. But remember: Other investors know as much about dividends as you do.

In the long run, owning an index fund that invests in the entire market is likely to do just as well as a high-dividend one, and a far sight better than a series of hot stocks you bought based on the advice of poker buddies and dinner-party tipsters