Understanding Stock Markets


This Stock Market Guide explains the basics of Market Timing and other simple Market Analysis.

Let us first take common stocks. Consider both the earnings and the dividends as they relate to the price. Check the historical trading pattern of the shares concerned. This will give you a clue as to whether the stock has been a volatile performer and whether it has fluctuated with cyclical trends in the economy and the stock market.

One of the most important economic indicators is the bank prime rate — the rate of interest at which commercial banks lend money to their best customers. This interest rate is a good indicator of the general level of interest rates, since most other rates rise and fall with it.

You should seek to determine whether interest rates are likely to rise or fall in the near future. The financial press frequently discusses these matters. Often in the past, stock and bond prices have generally fallen when interest rates rose. As a result, if you expect a rise in interest rates, you should consider keeping your funds liquid. On the other hand, if you expect that interest rates will fall, you should consider investing in stocks and bonds as interest rates start to drop.

Price-earnings ratios

For stocks, the price-earnings ratio and the dividend yield are important indicators. The price-earnings ratio, or earnings multiple, as it is sometimes called, is the ratio of the price of a company's stock to the annual earnings per share. The P/E is simple to calculate: Divide a company's annual earnings per share into the prevailing price of one share of the stock. If ABC Corp. had profits of $2 per outstanding share in its latest full fiscal year and its shares are trading at $18, then ABC would have a P/E of 9. If the stock was selling at $50, its P/E would be 25.

What does a P/E mean and what does it indicate? When you buy a stock, you buy a piece of the company and its profit potential. Thus, the greater the potential for growth, the higher the potential value of its shares. A P/E of 10 indicates that the market is willing to pay the equivalent of 10 years' profits for the stock. At 20 times earnings, the market has put a much more optimistic and thus more expensive value on the shares. A stock with a low P/E is often considered to be low growth, or mature, and a stock with a high multiple is considered to have high potential.

Price-earnings ratios are also a good guide to risk. A stock with a low P/E may not have much growth potential, but it is a lot less vulnerable to a sharp drop in price than a high flyer. Nothing drops as fast as a stock whose profit growth does not live up to the market's optimistic expectations. As the sad truth finally dawns on investors, the stock price will drop back to a level justified by the more modest earnings.

Most financial and daily newspapers provide regular information on P/E and average dividend yields. Before you buy any security, you should always check its P/E in relation to its growth potential and compare it with other comparable stocks and to the broad market indexes.

Changes in price-earnings ratios

The price of any stock reflects two dynamic forces: its profit potential and the value the market puts on this potential.

Stock prices often begin to rise before profits begin to grow because the markets "expect" that profits will increase. Thus, investors are willing to pay a higher P/E multiple for the shares. On the other hand, rising profits are no guarantee that the stock price will continue to move up. If the rate of profit growth is not up to the market's ex­pectations, then the market will, in effect, place a lower P/E multiple on the issue and the price will drop. This is termed a multiple correction.

The phenomenon of the multiple correction has trapped many small investors in the stock market. The trap works something like this: The investor buys a high multiple stock on rumors that profits are likely to continue rising. But not knowing how to interpret the high multiple, the investor fails to bail out in time when growth rates are dampened by, say, anti-inflationary monetary policies.

The perfect situation is a sleeper stock with an unsuspected earnings potential and a low multiple. The odds are that its stock price will rise much faster than its profits once investors discover its new horizons. Their buying will push up the P/E multiple.

Now, what is a low multiple and what is considered a high multiple: Historically, the average P/E of stocks covered in the Standard & Poor's Composite Index ranges from about 5 to 25 times average annual earnings. There is a wide variance within various industrial groups and within the other major groups. High-technology stocks often trade as much as 50 times their earnings per share or more, while bank stocks have traded at 4 to 15 times earnings.

The higher P/E for high-tech stocks indicates the speculative expectation that data processing demands, micro-circuitry development and the accelerating use of computer hardware and software will create rapid and substantial growth in the profits of these companies.

The low P/E for bank stocks reflects the market's view that this industry's growth is slowing and that investors expect no immediate improvement. However, it could also indicate an overlooked stock or perhaps a temporarily out-of-favor one.

Dividend yield

The dividend yield is very simple: Divide the annual dividend rate by the market price for the stock. A 50 cents dividend on a $10 stock works out to a 5 percent yield.