A first and easy step in evaluating stock issues is to examine the major characteristics of stock classifications. Here you determine which ones match your investment goals.
Match Your Investment Choices Using P/E Ratio and Beta
Price/Earnings Ratio The price/earnings ratio (P/E ratio) is the current market price of a stock divided by earnings per share over the past four quarters. This ratio is the primary means of valuing a stock. It demonstrates how expensive the stock is versus the company’s recently reported earnings, by revealing how much you are paying for each $1 of earnings. The P/E ratio is also referred to as a stock’s multiple. For example, if the market price of a share of Running Paws stock is currently $25 and the company’s EPS is $1.60, the P/E ratio will be 16 ($25 $1.60 15.6, which rounds to 16). This value can also be called a 16-to-1 ratio or a P/E ratio of 16. The P/E ratios of many corporations are widely reported on the Internet and in the financial section of newspapers. Stocks with low P/E ratios tend to have higher dividend yields, less risk, lower prices, and slower earnings growth.
To assess a company’s financial status, you could compare that firm’s P/E ratio with the P/E ratios for other similar stocks. The P/E ratios for corporations typically range from 5 to 25. The typical market average P/E is about 18, although it varies for different industries. Financially successful companies that have been paying good dividends through the years might have a P/E ratio ranging from 7 to 10. Rapidly growing companies would likely have a much higher P/E ratio 15 to 25. Speculative companies might have P/E ratios of 40 or 50 because they have low earnings now but anticipate much higher earnings in the future. Firms that are expected to have strong earnings growth generally have a high stock price and a correspondingly high P/E ratio. The standard P/E ratio is, in fact, called a trailing P/E ratio measure because it is calculated using recently reported earnings, usually from the previous four quarters. Investors need to focus on future prospects when analyzing the value of a stock. A projected P/E or forward price/earnings ratio divides price by projected earnings over the coming four quarters, an estimate available via online stock quote providers. The earnings yield, which is the inverse of the P/E ratio [Running Paws’ earnings yield is 6.4 percent ($1.60 $25)], helps investors think more clearly about expectations for investments.
Use Beta to Compare a Stock to Similar Investments Beta is a number widely used by investors to predict future stock prices. The beta value (or beta coefficient) is a measure of an investment’s volatility compared with a broad market index for similar investments. For large-company stocks, the S&P 500 Stock Index often serves as a benchmark. The average for all stocks in the market has arbitrarily been assigned a beta of 1.0, and a beta greater than 1.0 indicates higher-than-market volatility.
Beta reports the relative history of an investment’s up-and-down price changes. Most individual stocks have positive betas between 0.5 and 2.0. A beta of less than 1.0 (0.0 to 0.9) indicates that the stock price is less sensitive to the market. This is because the price moves in the same direction as the general market, but not to the same degree. A beta of more than 1.0 to 2.0 (or higher) indicates that the price of the security is more sensitive to the market because its price moves in the same direction as the market but by a greater percentage. Higher betas mean greater risk relative to the market. A beta of zero suggests that the price of the stock is independent of the market, much like that of a risk-free U.S. Treasury security. You may look up betas for stocks at www.investor.reuters.com/stockEntry.aspx?target-/stocks and www.finance .yahoo.com/?u.
Income Stocks
A company whose stock is classified as an income stock characteristically may not grow too quickly, but year after year it pays a cash dividend higher than that offered by most companies. It does so because the firm has fairly high earnings and chooses to retain only a small portion of the earnings. To declare high cash dividends regularly, a company has to have a steady stream of profits. Stocks issued by telephone, electric, and gas utility companies fit this profile and are labeled income stocks. Investors in these companies usually are not very concerned with the P/E ratio or the growth potential of the price of the stock. The betas of such stocks are often less than 1.0. Individuals who desire some income from their portfolio are often attracted to income stocks.
Growth Stocks
The term growth stock describes the stock of a company that offers the promise of much higher profits tomorrow and has a consistent record of relatively rapid growth in earnings in all economic conditions. The return to investors from growth stocks comes primarily from increases in share prices. Such stocks typically pay low or no dividends because most of their earnings are retained to maintain company growth.
Well-Known Growth Stocks Stocks of companies that are leaders in their fields, that dominate their markets, and that have several consecutive years of aboveindustry- average earnings are considered well-known growth stocks. Investorawareness of such corporations is widespread, and expectations for continued growth are high. The P/E ratio is high, too. Many growth stocks have a glamorous reputation that improves or declines sharply in conjunction with the overall market and, therefore, have betas of 1.5 or more. Investors like well-known growth stocks because they typically pay some dividends and offer a good opportunity for price appreciation. In the past, well-known growth stocks have included those offered by Microsoft, Oracle, eBay, Coca-Cola, Intel, Cisco, Nike, and Wal-Mart.
Lesser-Known Growth Stocks Because some lesser-known growth stocks are not as popular with investors, the P/E ratios for such firms are generally lower (although still high) than those of the more glamorous growth stocks. Often such firms represent regional businesses with strong earnings or companies that may be the third or fourth leading firm in an industry. In recent years, lesser-known growth stocks have included Quality Systems, Longs Drug Stores, and Urban Outfitters. Their betas are usually 1.5 or more.
Value Stocks
A value stock is one that tends to trade at a low price relative to its company fundamentals (dividends, earnings, sales, and so on) and thus is considered undervalued by a value investor. A value investor believes that the market isn’t always efficient and that it is possible to find companies trading for less than they are worth. Value stocks often operate within industries that benefit from a growing economy. Stocks that have a relatively high dividend yield, low price/sales ratio, and/or low P/E ratio are classified as value stocks. The low valuations that value stocks enjoy are often a result of some type of bad news (poor earnings report, bad press, legal issues, and so on). Although their stock prices may have changed, some past examples of value stocks have included General Motors, General Electric, DuPont, Merck, Citigroup, and AT&T.
Speculative Stocks
The term speculative stock describes the stock of a company that has a potential for substantial earnings at some time in the future. These stocks are considered speculative because those earnings may never be realized. A speculative stock may have a spotty earnings record or is so new that no earnings pattern has emerged. Investors in these companies accept some risk because they expect the companies to be highly profitable in the future. They hope that the company will make a new discovery, invent a new product, or generate valuable information that later may push up the price of the stock, creating substantial capital gains.
Examples of speculative companies include computer graphics firms, Internet applications firms, small oil exploration businesses, genetic engineering firms, and some pharmaceutical manufacturers. For these firms, the P/E ratio fluctuates widely in tandem with the company’s fortunes, and beta values exceeding 2.0 are common. For every speculative company that succeeds, many others do poorly or fail altogether.
Tech Stocks
Tech stocks are those in the technology sector. Technology firms are dominant in the stock market and include firms that offer technology-based products and services, biotechnology, Internet services, network services, wireless communications, and more. Some are large blue-chip firms, such as Microsoft and Cisco Systems, while most are speculative ventures, such as Human Genome Sciences and Cognus Corporation.
Blue-Chip Stocks
The term blue-chip stock suggests a company that has been around for a long time, has a well-regarded reputation, dominates its industry (often with annual revenues of $1 billion or more), and is known for being a solid, relatively safe investment. Typically, bluechip companies have a history of both good earnings and consistent cash dividends, and they grow at approximately the same rate as the overall economy. The term comes from poker, in which the highest chip denomination is colored blue.
Blue-chip stock shares are widely held by individual investors, mutual funds, and pension plans. The earnings of blue-chip companies (whose stocks are usually considered income stocks or well-known growth stocks) are expected to increase at a consistent but unspectacular rate because these highly stable firms are the leaders in their industries. Examples of such stocks are Wal-Mart, Coca-Cola, Berkshire Hathaway, and Exxon Mobil. Investing in such companies is considered much less risky than investing in other types of firms.
Large-Cap, Small-Cap, and Midcap Stocks
A company’s size classification in the stock market is based on its market capitalization. This is the total value of a company’s common stock shares determined at its current market price. Large-cap stocks are those of firms that have issued $3 billion to $4 billion (or more) of stocks. Most are considered blue-chip companies, too. Examples include Texaco, Microsoft, Time Warner, and General Foods. Stocks of midsize and smaller firms often outperform large-cap stocks. Midcap stocks are the stocks of those remaining companies that are quite substantial in terms of capitalization perhaps $750 million to $3 billion in size but not among the very largest firms. Examples include Wendy’s and Starbucks. A small-cap stock is stock of a company that has a capitalization of less than $750 million. Microcaps are firms with less than $100 million in capitalization, and perhaps as littleas $10 million. When the smaller firms achieve substantial increases in sales and earnings, their stock prices typically jump quite sharply.
The term blue-chip stock suggests a company that has been around for a long time, has a well-regarded reputation, dominates its industry (often with annual revenues of $1 billion or more), and is known for being a solid, relatively safe investment. Typically, bluechip companies have a history of both good earnings and consistent cash dividends, and they grow at approximately the same rate as the overall economy. The term comes from poker, in which the highest chip denomination is colored blue.
Blue-chip stock shares are widely held by individual investors, mutual funds, and pension plans. The earnings of blue-chip companies (whose stocks are usually considered income stocks or well-known growth stocks) are expected to increase at a consistent but unspectacular rate because these highly stable firms are the leaders in their industries. Examples of such stocks are Wal-Mart, Coca-Cola, Berkshire Hathaway, and Exxon Mobil. Investing in such companies is considered much less risky than investing in other types of firms.
Large-Cap, Small-Cap, and Midcap Stocks
A company’s size classification in the stock market is based on its market capitalization. This is the total value of a company’s common stock shares determined at its current market price. Large-cap stocks are those of firms that have issued $3 billion to $4 billion (or more) of stocks. Most are considered blue-chip companies, too. Examples include Texaco, Microsoft, Time Warner, and General Foods. Stocks of midsize and smaller firms often outperform large-cap stocks. Midcap stocks are the stocks of those remaining companies that are quite substantial in terms of capitalization perhaps $750 million to $3 billion in size but not among the very largest firms. Examples include Wendy’s and Starbucks. A small-cap stock is stock of a company that has a capitalization of less than $750 million. Microcaps are firms with less than $100 million in capitalization, and perhaps as littleas $10 million. When the smaller firms achieve substantial increases in sales and earnings, their stock prices typically jump quite sharply.
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