When to Buy or Sell Stock
A number of fundamental indicators are useful in deciding when to buy or sell stock; these tests should always override the attributes in the options. Remember, options are always related to stock valuation, and trying to make profit through options on stocks that are not worthwhile investments is a losing strategy. A worthwhile investment has to be defined as one containing fundamental strength: revenues and earnings, dividend history, and capitalization. One indicator that enjoys widespread popularity is the price/earnings ratio (P/E ratio). This is a measurement of current value that utilizes both fundamental and technical information.
Calculating the P/E: A company's stock recently sold at $35 per share. Its latest annual income statement showed $220 million in profit; the company had 35 million shares outstanding. That works out to a net profit of $6.29 per share: $220 ÷ $35. The P/E ratio is
A Second Calculation: A company earned $95 million and has 40 million shares outstanding, so its earnings per share is $2.38. The stock sells at $28 per share. The P/E is calculated as
- Financial statements may themselves be distorted. A company's financial statement may be far more complex than it first appears, in terms of what it includes and what it leaves out. Conventional rules for reporting revenues, costs, expenses, and earnings may not convey the whole picture, and a more in-depth analysis of core earnings is an important step to take.
- The financial statement might be unreliable for comparative purposes. Companies and their auditors have considerable leeway in how they report income, costs, and expenses, even within the rules. This makes valid comparison between different companies problematical.
- The number of shares outstanding might have changed. Because shares outstanding is part of the P/E ratio equation, its comparative value can be affected when the number of shares changes from one year to another.
- The ratio becomes inaccurate as earnings reports go out of date. If the latest earnings report of the company was issued last week, then the P/E ratio is based on recent information. However, if that report was published three months ago, then the P/E is also outdated.
- The P/E itself involves dissimilar forms of information. The P/E ratio compares a stock's priceâ
By Michael C. Thomsett