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.

The technical side (price of a share of stock) is divided by the fundamental side (earnings per share of common stock) to arrive at P/E.

Example

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

$35 ÷ $6.29=5.6

Example

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

$28÷$2.38=11.8
The P/E ratio is a relative indicator of what the market believes about the particular stock. It reflects the current point of view about the company's prospects for future earnings. As a general observation, lower P/E ratio means your risks are lower. Any ratio is useful only when it is studied in comparative form. This means not only that a company's P/E ratio may be tracked and observed over time, but also that comparisons between different companies can be instructive, especially if they are otherwise similar (in the same sector or same product profile, for instance). In the preceding examples, the first company's 5.6 P/E would be considered a less risky investment than the second, whose P/E is 11.8. However, P/E ratio is not always a fair indicator of a stock's risk level, nor of its potential for future profits, for at least six reasons:
  1. 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.
  2. 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.
  3. 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.
  4. 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.
  5. The P/E itself involves dissimilar forms of information. The P/E ratio compares a stock's priceâ
    By Michael C. Thomsett
    Michael Thomsett is a British-born American author who has written over 75 books covering investing, business and real estate topics.

    Copyrighted 2016. Content published with author's permission.

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