What makes a stock valuable, and how does one compare it to other stocks?

A share of stock is simply a fractional piece of a company’s earnings.

In 2012, Apple earned $44.16 per share. On January 25, Apple (ticker symbol: AAPL) traded as high as $456.23 per share. Why would someone pay more than 10 times the price of AAPL’s earnings? Because some believe AAPL’s earnings will grow in the future.

Stocks are mere pieces of paper. Unlike owning a house, a car, or even a baseball card, the only reason to own a stock is investment. Stock investments increase through earnings growth and multiple expansion.

Publically traded companies are legally required to report their earnings four times a year. Of course, that doesn’t stop traders, brokers, pundits, journalists, analysts, and media personalities from speculating about future earnings and their growth, or lack thereof. And more importantly, the stock market is open for trading for far more than four days a year; it’s open Monday through Friday, 9:30 AM to 4:00 PM EST, and the market is never closed for more than three consecutive days. The day after Christmas is trading time!

Considering 43.1 million shares of AAPL changed hands on January 25 alone, it’s clear why stock prices fluctuate much more rapidly than things that are not bought and sold on an exchange. These long days and weeks (and for some, minutes and seconds) between quarters leave plenty of room for speculation and the gamut of emotions: Euphoria, panic, boredom, you name it. Sometimes those feelings are rational, and sometimes they aren’t. The point is, understanding stocks requires much more than crunching numbers.

But how does one value the intangible?

With stocks, you do it with the price-to-earnings ratio, commonly known as the “PE ratio” or “multiple”.

Here’s the equation: Price divided by Earnings equals Multiple.

P/E = M.

For example, let’s say AAPL’s last trade was $450. I want to know AAPL’s PE ratio (multiple) for 2012. As previously stated, AAPL earned $44.16 per share in 2012.

$450 (price) / $44.16 (earnings) = 10.19 (multiple).

So, AAPL trades at 10.19 times its 2012 earnings. In order to compare stocks to each other, you have to know their multiples (more on that later).

For the sake of discussion, let’s use the equation to solve for price. Price equals Earnings times Multiple.

P = E x M.

By looking at this equation, we can clearly see that a larger E (earnings) or larger M (multiple) would give us a higher stock price. But again, companies typically report earnings four times a year. The vast majority of a stock’s price fluctuation is based on the changing multiple (i.e. what people are willing to pay for the company’s earnings). You could say a multiple measures public sentiment, which is another way of saying “demand”. 

Of course, defining “demand” is much easier than figuring out where supply and demand will increase and decrease in the future. That is the key to investing in anything, stocks included.

Speaking of supply, it’s key to answering the next entry’s title question, “How can Facebook at $31 be more expensive than Apple at $450?”

What do the numbers on the CNBC ticker mean?

There, I’ve asked the question you were afraid to ask, and now I, your Dear Stock Leader, shall provide you the answer.

In all seriousness, I couldn’t answer this question until my senior year of college; if I can learn about stocks and make them my living, I have no doubt any of you with enough curiosity to read this can improve your investments and money management skills.

OK, back to the question at hand.

When I was a stock layman, I knew you wanted to “buy” a stock and, in theory, “sell” it for a profit in the future. What didn’t occur to me was that there was another human being on the opposite end of my “buy” or “sell”.

In other words, if I want to buy a share of Apple (symbol: AAPL) for $450, there has to be someone willing to sell me a share for $450. When that happens, a trade is made. THAT is what you see on the CNBC ticker: The most recent price of trades in various companies, including AAPL.

So what I missed by not seeing the human element of all stock trades was that the laws of supply and demand apply equally to stocks as they do to anything people buy and sell. And moreover, while there’s a tangible value to a stock’s earnings and/or dividend payments, every stock has an intangible value that is based on MANY people’s opinion of how the underlying company is doing presently and will do in the future. This is known as “the market”, but you could easily call it “demand”.

Of course, demand can naturally be as fickle as the people that create it, so indeed, understanding human nature and emotions is just as important as understanding your favorite company’s financials.

Next time, I’ll continue this series with “What makes a stock valuable, and how do I compare it to other stocks?”