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That's stock-picking's appeal: Buy the right company and make a bundle. But you can also wind up broke. Consider a not-so-lucky investor who bought $1,000 worth of Amazon stock at $105 a share in 1999. The shares are now worth $78 each, and the entire holding, a total of $743.
The point is that stock-market investing is a tricky business, and on average, it is mathematically impossible for investors collectively to beat the market. Don't even try, if you do, chances are the only one who'll come out ahead is the broker who skims a commission off each of your trades.
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That is not to say that you should avoid stocks altogether. In fact, stocks offer one of the best ways to grow your savings over the long term, having returned an average of 6% annually after inflation over the past century. But rather than regard the market like a speculator, constantly swinging for the fences and often striking out, the smart thing to do is act like a long-term investor.
That means either buying stocks you intend to hold on to for years or decades, or, safer still, owning low-cost index mutual funds or exchange-traded funds (ETFs).
However you decide to invest, it helps to know the basics of valuing companies and their stocks.
Owning a stock means becoming a fractional owner of a company. If the enterprise thrives, you get a cut of the profits, either through a rise in its stock price that reflects its growing earnings power, regular payments known as shareholder dividends, or both. If the company becomes sickly, you're likely to suffer too, as the price others are willing to pay you for its stock sinks and its dividend payments are cut or suspended to save cash.
The varying assessments of a stock's prospects are reflected throughout the trading day in its fluctuating price. If more people want to own a stock, its price goes up. If fewer people want it, the price falls.
Price/earnings ratio
Knowing whether a stock is cheap or expensive is a tricky business. The simplest measure, yet one that has proved quite useful over time, is the so-called price/earnings, or PE, ratio. It represents the current price of a stock divided by what the corporation earned for every share outstanding over the past year.
If the stock is trading at $10 per share and the issuer earned $1 for each share outstanding over the past year, the PE ratio is 10. Over many decades, stocks have traded at a PE ratio of around 15 on average, meaning that investors have been willing to pay $15 for every $1 in net profit the company booked over the previous 12 months.
If the PE rises above that level, it typically means investors are expecting the company's earnings per share to rise.
Staff Reporter
