When the stock market is going up over a long period of time, investors can beco

Question

When the stock market is going up over a long period of time, investors can become complacent about the risks of being a stockholder. After the significant decline of the stock market in 2008, people have begun to rethink the risk involved in owning stock. What kinds of risks do the owners of publicly-traded companies face? What could you do, as an investor, to continue to invest in the market but minimize your risk? Select two companies that you would invest in if you had the money. Find their financial statements on the Internet and examine the shareholders

Explanation / Answer

When you buy a stock, you're buying part ownership of a company, so the questions to ask as you select among the stocks you're considering are the same questions you'd ask if you were buying the whole company:

Because each company is a different size and has issued a different number of shares, you need a way to compare the value of different stocks. A common and quick way to do this is to look at the stock's earnings. All publicly traded companies report earnings to the Securities and Exchange Commission on a quarterly basis in an unaudited filing known as the 10-Q, and annually in an audited filing known as the 10-K.

If you check those reports, the company's annual report, or its Web site, you'll find its current earnings-per-share, or EPS. That ratio is calculated by dividing the company's total earnings by the number of shares. You can then use this per-share number to compare the results of companies of different sizes. EPS is one indication of a company's current strength.

You can divide the current price of a stock by its EPS to get the price-to-earnings ratio, or P/E multiple, the most commonly quoted measure of stock value. In a nutshell, P/E tells you how much investors are paying for a dollar of a company's earnings. For example, if Company A has a P/E of 25, and Company B has a P/E of 20, investors are paying more for each dollar earned by Company A than for each dollar earned by Company B.

There's no perfect P/E, though there is a market average at any given time. Over the long term that number has been about 15, though higher in some periods and lower in others. Value investors tend look for stocks with relatively low P/E ratios

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