These Are the 4 Terms You Need to Know to Get Started in Stocks
Whether you are looking to set up your nest egg or start a new life as a rapid fire day trader, the stock market can be simultaneously exciting and overwhelming. Movies like "The Wolf of Wall Street" simplify the world of shares and trading, making it appear as though anyone with half a brain can jump in and make a fortune. However, while the potential for turning a profit is there, considerable knowledge is required to navigate the loaded language and confusing jargon of the stock market.
Whether you're working through a licensed broker or trying to go it alone, it's important to know the lingo. Here are few key terms to get you started. (See also: Why Invest in the Stock Market?)
What Is a Stock?
A stock, simply put, is a piece of a company. Most people have heard the phrase, "buy low, sell high." While this is perfectly sound advice, determining which companies will give you a return on your investment is a bit more complicated.
Fortunately, boring old research is your best friend in the world of stocks, and the perplexing phrases doled out by Wall Street big shots are nothing more than indicators of stock performance. Once you know the basic definitions, you can start making moves on the trading floor just like all of the Geckos and Belforts out there.
Market Capitalization (Market Cap)
Like a lot of things, the stock market is often more complicated than it should be. Market capitalization is a fancy way of stating the current price per share multiplied by all of the outstanding shares, where outstanding shares refers to the number of shares held by investors.
What does this mean to the average Joe? Market capitalization gives you a general idea of the value of a company. Since share price fluctuates and the number of shares available differs for each company, the market cap allows you to compare the value of companies with a similar number of outstanding shares.
Earnings Per Share (EPS)
Earnings per share is generally considered the single most important stock performance indicator. EPS essentially tells you how profitable a company is by taking the net income of that company and dividing it by the average number of outstanding shares.
Wait… what? In a nutshell, the value of the company becomes diluted by how many shares are out there. Because of this, each share or "piece" of the company becomes less valuable. Of course, EPS is significantly more complex than this because the world of accounting wants to make you as uncomfortable as possible.
Price to Earnings Ratio (P/E)
This is the current share price divided by the earnings per share (or EPS). This figure tells you how much the market is willing to pay for a company. For example, if a stock has a price to earnings ratio of 10, that means folks are willing to pay 10 times that company's earnings to own the stock.
What does it all mean? Without getting too complicated, stocks with a higher P/E are generally perceived to have greater growth potential. Essentially, investors are betting that the company will continue to prosper. Stocks with a low P/E are seen as high-risk investments, meaning that the market isn't willing to pay a high price for the level of risk involved. However, as with most of these indicators, nothing is guaranteed.
Price to Sales Ratio (P/S)
The price to sales ratio can determine if a stock has potential for revenue growth or if it is overvalued. This ratio is determined by a company's market capitalization divided by its total sales over the previous 12 months. The lower the ratio, the better the investment.
Why does this matter? The price to sales ratio is simple way to size up stocks by showing how much the market values the company's sales instead of its earnings. For example, if the P/S is 1, that means you are paying $1 for every $1 of sales the company generates. If the P/S is .5, then you are paying $0.50 for every dollar of sales, which is obviously a bargain.
While these metrics and many others are useful, they are by no means a guarantee. The stock market is as volatile as the fickle people who invest. Because of this there is debate as to whether or not any of these metrics do any good, or if they are all simply value traps. But then again, what's the fun if there isn't any risk involved? (See also: 2 Investing Concepts You Should Know)
What do you look for in a stock before investing? Let us know in the comments!
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A great article to teach newbies about stocks and investing. I would go one further and explain the concept of dividend growth investing. We'll all need to rely on another source of income in our retirements as social security and other entitlements will become insignificant in the decades to come.