Suppose you went shopping for a new car. The dealer showed you two different cars. One costs $50,000 and the other costs $6,000. Which one is the better value?
Hopefully, you'd say you need a bit more information first. Sure one car is cheaper, but if it breaks in a month, you'd hardly call that a good value. Furthermore, if the expensive car required no gas or maintenance for the life of the car. and it could cook you breakfast while you drove, you might have found quite a valuable car. Naturally, it is safe to say that you should expect quite a bit more from the $50,000 car than from the $6,000 one.
Shares of stock are no different. Remember, for the sake of this example, a company's price tag is not the share price listed in the newspaper; it is the P/E ( Price to Earnings) Ratio. Earlier we stated that when investors buy shares, they are showing their confidence in a company's future. Buying causes the share price to rise, increasing the P/E ratio. The P/E ratio is absolutely essential in determining a company's price tag. But remember that a P/E is a look at the current share price and the past earnings.
Imagine two companies with the same EPS numbers. You might imagine that these two companies should have roughly the same share price since they are both making an equal amount of money per share price. But what if everyone agreed that Company A is growing a lot faster than Company B. You would expect investors to buy more of company A, raising the share price, and thus Company A would have a higher P/E ratio. This is no different than paying more money for brand name goods over generic ones - you are expecting a little more out of them.
You might be asking, "If we need to focus on the future, why am I bothering to learn a P/E that represents the past?" Resist the temptation to treat this ratio as insignificant. It is extremely important. One of the most important predictors of future earnings is past earnings. In other words, investors will want to see the EPS growth of past quarters to determine an idea of the growth of company. It is also important to see if the share price (and PE) has grown in line with the EPS.
So, it is important for investors to look to the past and the future of a company. A successful investor will try to determine a projected growth rate for each company she is considering. Usually this yearly percentage increase is a look into the company's future for the next 3-5 years.
Naturally, each investor tries to determine growth in their own way using a variety of data. Some of the more common include:
There are different ways for predicting growth rates. Some people only look at past earnings, some at social norms, some simply rely on other investors' ideas, or any combination of any of the above. If you'd really like to learn more about predicting future growth, including some common equations that investors often use, check out the web sites listed at the end of this tutorial. Don't worry! These methods are not that difficult. It is also important to keep in mind that successfully predicting a company's growth rate is an art and a science.
Summary: What gives a share price its value?
In this section, you were asked some questions which you should now be able to answer.
The prices of shares that appear in the newspaper tell us very little about how expensive one company is in relation to another. Share prices are used to determine the value of a company, but companies differ in how many shares they offer to the public. Valuing a stock is further complicated by the fact that investors are generally placing their confidence in future earnings (and not in the current value of the sale of all the company's assets). Companies earn different amounts, but a company's Earnings Per Share (EPS) represents a way to compare a share's value.
When we compute a stock's PE (Price to Earnings) ratio, we get a much better idea of how expensive different stocks are - much like the price tag on products we see everyday. Expensive stocks have a higher PE.
It is not always the best decision to buy stocks with the lowest PE. Share prices operate on supply and demand and companies with the best potential for future growth tend to have higher PEs. This decision amounts to the same choice that consumers face when they decide whether to buy a high quality product or save money on a discount brand.
Before going any further, take a few moments to see if you can successfully answer some questions to make sure you understand growth rates.
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Investors' Perceptions in a Rational Market