How to Understand What Goes On in the Stock Market

When it comes to being a savvy investor in the stock market, you want to know that you are always making the right investment decisions for your portfolio. In today’s world where there are so many decisions and data points to assess, how does anyone really know what to look at and when to make the right decisions.

The goal is to always buy low and sell high. Therefore, you want to buy a stock that is undervalued and/or has high growth prospects. Most smart investors will tell you that the price of a stock is meaningless, but you should look at two main metrics. The first is a price to earnings ratio (PE). What this means is what the price of a share is worth in relation to a company’s earnings per share. Usually, for most profitable companies, a stock will trade at a huge multiple to earnings.

In most cases, the higher the PE ratio, the more of a premium the stock trades for. While a high PE may signal more confidence in its ability to grow, you are taking on risk because it could also be overvalued. Alternatively, lower PE signals that investors do not have a lot of confidence in the stock’s long-term prospects. However, it could also mean a good deal because you might be able to buy a stock cheap before other people see the value themselves. In this case, it is always good to look at to see companies where insider trading is outpacing fund management investors.

The downside of the PE ratio is twofold. One, it does not account for growth projections by analysts nor does it work for companies that are not profitable. For example, most companies that have not been in the market exceptionally long are reinvesting capital and operating revenue into their business and are not recognizing profits on paper due to the increased expenses. They are hedging that their reinvestment will yield bigger revenues in the future and thus bigger profits to come with it. Therefore, their earnings would be negative. A negative PE ratio is not meaningful in this case.

A standardized way of assessing a company against its PE is to look at it in comparison to its projected growth rate, often referred to as a PEG ratio. While a PE is an objective number, growth projections are modeled estimates based on surveyed analysts who follow the stock. However, if enough analysts look at a stock and make a consensus growth projection, it signals that investors are going to be anticipating high demand for the stock.

Looking at high growth projections is key to signal any good investment, but one way to know you are getting the best investment is to assess a company’s PEG ratio. This looks at the price to earnings over the growth rate and helps signal if the investment is sound. Therefore, if a company is trading at a high price to earnings ratio but there is also a high projected growth rate, then it may turn out that a company with a high PE ratio is still a good investment. Even better, you may find a company with a high growth rate with a low PE ratio that is an ultimate winner. For example, many renewable energy stocks fell into this category in 2019.

When you are trying to invest in a non-profitable company, price to sales is a reasonable alternative. This just measures the company’s stock price in comparison to its revenue. If a company is growing revenue year over year, that ultimately translates into a profit down the line. A high PS multiple signals belief that the company will ultimately turn profitable.

What will ultimately drive a stock up long term is seeing its earnings go up year over year. In essence, this comes down to growing revenue that signals demand for a product, as well as ensuring that the product the company is delivering is innovative for the long term. There are many stocks to look at for new investors, and it is easy to make money in the market now more than ever before.

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