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?”
