Why Invest In Stock Market?
Investing in stock market has higher returns than investing in real estate, CDs or bonds. But investing in stocks does have drawbacks which can translate to huge loses. When you look at large investors who knows how to invest in stocks, you will notice they have average returns of about 15% per year whilst the average returns on bonds is about 5% per year.
Long-Term Capital Gain Tax
One good thing about stocks is the tax issue - stocks are taxed as long-term capital gains if you hold them long enough. The long-term capital gain tax is low – currently 15%. CDs are taxed just like your regular earnings and if your earnings are in higher bracket then expect to pay an additional 35% tax on your earnings from CDs. The other good thing about investing in stocks is diversification which means you can have your investment in several industries such that when this industry is not doing well, the other industry is giving you good returns. However, a stock is risky and can drop in value to almost zero whilst CDs have guaranteed return.
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Now you may feel you want to invest in the stock market. To do so you need to buy shares of companies that interests you. To successfully pick on the right stocks and hold them as an investment, there are quite a few financial jargons you need to understand and this article will confine itself on only a few, namely: Book Value, Earnings per Share, Price to Earnings Ratio, and Projected Earning Growth.
Book Value in Stock Equity
The book value of a company is the net value of its total assets less the value of preferred stocks, liabilities and goodwill. It is that value that would remain if the company was to go out of business to be split among the common stocks. Book value is a more accurate measure of valuation for companies than market capitalization. To determine the value of assets, the asset cost is taken and the total depreciation per year is subtracted from the cost. In some countries like UK, the book value is referred to as Net Asset Value. If then you take the net book value of a company and you divide that by the number of common stocks, you will get book value per share. This book value per share is the figure you need so that you can compare with the market prices per share to arrive at more informed decisions.
Earnings per Share
What are Earnings per Share (EPS)? It’s the amount of dividend earned per every outstanding share. It is arrived by taking the total amount earned by a company less the dividends allocated to the preferred stocks and what remains is then dividend by the numbers of outstanding shares. The earning per share will tell you how profitable a company is. The earning per share is one piece of information that is used by many traders when deciding whether to buy a certain stock or not. One big disadvantage of earning per share is that it fails to take into consideration the capital used to generate the earnings. You may have two companies one using twice as much capital as the other to produce the same earnings. In the real sense these are two completely different companies financially but the earnings per share are the same.
What is Price-Earnings Ratio (P/E Ratio)?
This is a ratio that is obtained by taking the current stock price in the market and dividing it with the earnings per share for the last one year. For example: If the stock is currently trading at $20 and the total dividend per share for the last one year is $1, then the Price-Earnings Ratio (P/E Ratio) is 20/1 equal 22. A lower P/E Ratio means that a company has a good earning but the market does not reward the stock with a higher price. A higher value means the market is willing to pay more for a stock with lower earning in expectation that things may get better in the future. To buy a stock, try comparing the P/E ratios of one company to the other companies in the same industry group. That way, you are most likely to make a better decision.
Projected Earning Growth
Earning growth is the net growth of a company’s income over a period of time, usually one year. It is usually expressed as a percentage growth. This is also the earning growth per share. Example: If the earning per share last year was $1 per share and the earning per share this year is $1.2 per share, the earning growth is (($1.2 – $1.0)/$1.0) x 100% equal 20% earning growth. Earning growth is a strong factor that may determine the appreciation of share prices in the market. Projected Earning Growth is the expected growth of a company’s earnings in the future. The company may use the historical earning growth data in the past and extrapolate it into the future to arrive at the projected earning growth.
The Book Value, Earnings per Share, Price to Earnings Ratio, and Projected Earning Growth are all values ones need to consider and interpret before making an investment in stocks. No single value can tell you the complete story and to make it worse, they are all prone to manipulation by the company so that the company can portray its image to probable investors as very good. Take care.
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chamilj from Sri Lanka on April 24, 2011:
You explained basic Stock Market Ratios clearly. Thanks for the great work! Voted up!
Hello, hello, from London, UK on March 22, 2010:
Tank you for your valuable help. I enjoyed reading you interesting hub.