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Advice On Stocks – Definitions and Valuation Methods

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Advice On Stocks – Stock Definitions

Advice on Stocks – Stock Definitions

Advice on Stocks

Finding advice on stocks via the Internet, including stock definitions and valuation methods, can be confusing due to the vast amount of information available on this topic.  The following is a concise one-stop source for advice on stocks.

A stock is a financial security that is sold by a corporation that represents a share or fraction of ownership in a corporation.  Corporations issue stock to raise capital for various needs, such as business expansion.  There are two types of stock that a corporation can issue that have specific rights and privileges associated with ownership:  a common stock and a preferred stock.

A common stock includes company ownership rights.  A person who owns common stock in a corporation has the right to vote on a slate of board of directors and on policies proposed by the company or other common shareholders.  If a company enters bankruptcy and is eventually liquidated, holders of common shares are last in line for reimbursement, with preferred shareholders and holders of debt, such as bondholders, having priority.

A preferred stock usually has no voting rights associated with ownership, but will often include a legally defined dividend that is payable to preferred stockholders before a dividend is paid to holders of common stock.  Preferred shareholders are given preference over common shareholders in the event of liquidation of company assets.

There is a variation of preferred stock called convertible preferred stock, which is a preferred stock that can be converted into specified number of common shares after a specific date has passed.

Advice on Stocks – Stock Valuation Methods

There are many valuation methods used by both individual and professional investors to help them determine the actual value of a stock and to make informed investment decisions.  The most common and most widely used stock valuation method is the price-to-earnings ratio (P/E ratio).

The P/E ratio is a number that is derived by dividing the price of a stock by the past year of reported company earnings per outstanding shares (known as trailing earnings).  For example, if ABC Corp is selling for $40 per share, and it earned $2.00 per outstanding shares, then ABC Corp’s stock has a P/E ratio of 20.

Turning a P/E ratio valuation into a useful real world valuation is a lot more complicated.  This is because there are many factors that can affect the P/E ratio going forward, including the future stock price, future changes in the number of outstanding shares, and future changes in earnings.  P/E ratios are also valued on less tangible measures, such as the industrial sector that the stock is in and whether the overall stock market is in a bull market (rising) or a bear market (falling).  For example, if ABC Corp’s stock has a P/E ratio of 20, whether or not this P/E number is overvalued or undervalued is dependent upon not only whether the earnings in the future will keep pace with or exceed the prior year, but is also upon the industrial sector that ABC Corp is in and where the overall stock market is heading.  For a banking stock, a P/E ratio of 20 would be considered high regardless of other factors.  However, for a technology stock, a P/E ratio of 20 would be considered low, especially in a bull market.

PEG ratio has become a popular stock valuation method because it builds upon the P/E ratio to include a stock’s earnings growth rate.  The G is for growth.  To calculate a stock’s PEG ratio, use a forward P/E estimate for the year ahead and divide it by the anticipated earnings growth rate for the year ahead.

Other common stock valuation methods include (but are not limited to):

  • Book value
  • Earnings per share (EPS)
  • Earnings yield

An investor can often save themselves from doing complicated stock valuation analysis by reading stock analyst valuation assessments, since many stock analysts publish advice on stocks based on various stock valuation methods..

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