Market Analysis Blog » Stock Market

How to make money in stock market look here for 10 strategies

admin — Wed, 03 Jun 2009 02:28:17 +0000

We are seeing High volatility, sharp rallies, unexpected market direction, extremely fickle sentiments and high influence of all markets tantrums in the past few months. Some analysts expect this market volatility will continue for year or so .

The million dollar question now is, “How to make money?” It’s not an easy task in these markets. Market strategies have to be well thought out, those that worked in the past may not work this time. We would now look at 10 strategies that may be used in isolation or in combination to come out with a winning plan that will make money in this market.

Strategy 1:

A good way to judge if the stock is under valued is if it is quoting near its 52 week low. A stop loss at the 52 week low would be desirable to restrict downside risk.

Strategy 2:

If you are an active trader and open to taking short term positions. A thorough tracking of the price volume data will be worth your while before entering sectors and stocks where a significant rise in volumes is being accompanied by a positive price movement. These trading calls can sometimes make you earn a fast buck.

Strategy 3:

Sell out of money calls of stock that you hold Markets are likely to remain range bound for sometime. This strategy restricts the upside potential but generates good, consistent returns in a bear market.

Strategy 4:

This strategy helps to protect downside risk of portfolios when there is uncertainty about the future direction of the markets. This strategy can also generate profits if DOW falls rapidly and there is panic in the markets as we saw in October, November 2008. Selling calls would help you in financing the cost of the puts.

Strategy 5:

Selling calls and puts which are deep out of money can provide you with a limited profit when sold near the expiry date. Only time value exists in these options but to earn limited profit you have to block money in the form of margins and though a rare chance but you could end with an unlimited loss. This, needless to say, is not a very good strategy for risk averse investors.

Strategy 6:

For short term and active traders it may be better to trade in futures instead of buying stocks and holding in depository account. This is because one has to wait for delivery to come on T+2 so as to sell those stocks.

Eg.
If somebody bought 100 shares of IBM on 10th April 2009, then he has to wait till 13th April 2009 to sell them back to the market, otherwise there exists a risk of auction in case of short delivery.

Strategy 7:

In this market Buy and hold strategy is not likely to work. It is better to book your profits as and when you earn. This is not the time to be greedy.

Strategy 8:

For risk averse investors it is better to trade in Options in order to minimise risk. Buy calls of stocks or DOW if you are bullish on some particular shares or the market as a whole in the short term. Conversely buy puts of stocks or DOW if you are bearish. Unlimited profits can be earned by incurring limited cost with no risk in this strategy.

Strategy 9:

If the markets are volatile a useful strategy is to buy both At Money calls as well as puts. Whichever direction the markets take in the short run, you are quite likely to make good returns in the short run.

Strategy 10:

Do not overtrade and take extra risks. Remember cash is king in uncertain times. You are likely to continue getting panic situations going ahead, where cash can be very gainfully deployed. Based on the risk appetite and investment capacity one may use the above in different permutations or combinations.

Note: To conclude these strategies are not cast in stone but one has to be flexible and take into consideration the prevailing market scenario and the future outlook that is emerging from the analysis.

Intro about Orders, Time-related orders, Condition-related orders, Maket orders, Limit Orders, Stop Loss Orders

admin — Fri, 29 May 2009 15:27:00 +0000

Orders you place with your stockbroker neatly fit into two categories:
1) Time-related orders
2) Condition-related orders
Get familiar with both orders, because they’re easy to implement and invaluable tools for wealth building and (more importantly) wealth saving! Using a combination of orders helps you fine-tune your strategy so that you can maintain greater control over your investments. Speak with your broker about the different types of orders you can use to maximize the gains (or minimize the losses) from your stock investing activities. You also can read the broker’s policies on stock orders at the brokerage Web site.

Time-related orders
Time-related orders mean just that; the order has a time limit. Typically, investors use these orders in conjunction with conditional orders. The two most common time-related orders are day orders and good-till-canceled (or
GTC) orders.

Day order
A day order is an order to buy a stock that expires at the end of that particular trading day. If you tell your broker, “Buy BOA, Inc., at $37.50 and make it a day order,” you mean that you want to purchase the stock at $37.50. But if
the stock doesn’t hit that price, your order expires at the end of the trading day unfilled. Why would you place such an order? Maybe BOA is trading at $39, but you don’t want to buy it at that price because you don’t believe the stock is worth it. Consequently, you have no problem not getting the stock that day.
When would you use day orders? It depends on your preferences and personal circumstances. I rarely use day orders because few events cause me to say, “Gee, I’ll just try to buy or sell between now and the end of today’s trading action.” However, you may feel that you don’t want a specified order to linger beyond today’s market action. Perhaps you want to test a price. (“I want to get rid of stock A at $39 to make a quick profit, but it’s currently trading at $37.50. However, I may change my mind tomorrow.”) A day order is the perfect strategy to use in this case.

If you make any trade and don’t specify time with the order, most (if not all)
brokers automatically treat it as a day order.
Good-till-canceled (GTC)
A good-till-canceled (GTC) order is the most commonly requested order by investors. Although GTC orders are time-related, they’re always tied to a condition, such as when the stock achieves a certain price. The GTC order
means just what it says: The order stays in effect until it’s transacted or until the investor cancels it. Although the order implies that it can run indefinitely, most brokers have a limit of 30 or 60 days (or more). By that time, either the
broker cancels the order or contacts you to see whether you want to extend it. Ask your broker about his particular policy.

A GTC order is usually coupled with conditional or condition-related orders. For example, say that you want to buy BOA. stock but you don’t want to buy it at the current price of $48 per share. You’ve done your homework on the stock, including looking at the stock’s price-to-earnings ratio, price-tobook ratio, and so on (see Appendix B for more on ratios), and you say, “Hey, this stock isn’t worth $48 a share. I’d only buy it at $36 per share.” You think the stock would make a good addition to your portfolio but not at the current market price. (It’s overpriced or overvalued according to your analysis.) How should you proceed? Your best bet is to ask your broker to do a “GTC order
at $36.” This request means that your broker will buy the shares if and whenthey hit the $36 mark (or until you cancel the order). Just make sure that your account has the funds available to complete the transaction. GTC orders are very useful, so you should become familiar with your broker’s policy on them. While you’re at it, ask whether any fees apply. Many brokers don’t charge for GTC orders because, if they happen to result in a buy (or sell) order, they generate a normal commission just as any stock transaction does. Other brokers may charge a small fee.
To be successful with GTC orders, you need to know
1. When you want to buy: In recent years, people have had a tendency to rush into buying a stock without giving some thought to what they could do to get more for their money. Some investors don’t realize that thestock market can be a place for bargain-hunting consumers. If you’re ready to buy a quality pair of socks for $16 in a department store but the sales clerk says that those same socks are going on sale tomorrow for only $8, what would you do — assuming that you’re a cost-conscious consumer? Unless you’re barefoot, you’re probably better off waiting.

The same point holds true with stocks. Say that you want to buy MS, at $26 but it’s currently trading at $30. You think that $30 is too expensive, but you’re happy to buy the stock at $26 or lower. However, you have no idea whether the stock will move to your desired price today, tomorrow, next week, or even next month (maybe never). In this case, a GTC order is appropriate.

2. When you want to sell: What if you bought some socks at a department store, and you discovered that they have holes (darn it!)? Wouldn’t you want to get rid of them? Of course you would. If a stock’s price starts to unravel, you want to be able to get rid of it as well. Perhaps you already own MS (at $25, for instance) but are concerned that market conditions may drive the price lower. You’re not certain which way the stock will move in the coming days and weeks. In this case, a GTC order to sell the stock at a specified price is a suitable strategy.

Because the stock price is $25, you may want to place a GTC order to sell it if it falls to $22.50, to prevent further losses. Again, in this example, GTC is the time frame, and it accompanies a condition (sell when the stock hits $22.50).

Condition-related orders

A condition-related order means that the order is executed only when a certain condition is met. Conditional orders enhance your ability to buy stocks at a lower price, to sell at a better price, or to minimize potential losses. When stock markets become bearish or uncertain, conditional orders are highly recommended. A good example of a conditional order is a limit order. A limit order may say, “Buy Google at $45.” But if Google isn’t at $45 (this price is the condition), then the order isn’t executed.

Market orders
When you buy stock, the simplest type of order is a market order — an order to buy or sell a stock at the market’s current best available price. It doesn’t get any more basic than that. Here’s an example: AIG ., is available at the market price of $10. When you call up your broker and instruct him to buy 100 shares “at the market,” the broker will implement the order for your account, and you pay $1,000 plus commission. I say “current best available price” because the stock’s price is constantly moving, and catching the best price can be a function of the broker’s ability
to process the stock purchase. For very active stocks, the price change can happen within seconds. It’s not unheard of to have three brokers simultaneously place orders for the same stocks and get three different prices because of differences in the broker’s capability. (Some computers are faster than others.)

The advantage of a market order is that the transaction is processed immediately, and you get your stock without worrying about whether it hits a particular price. For example, if you buy AIG, with a market order, you know that by the end of that phone call (or Web site visit), you’re assured of getting the stock. The disadvantage of a market order is that you can’t control the price that you pay for the stock. Whether you’re buying or selling your shares, you may not realize the exact price you expect (especially if you’re buying a volatile stock).

Market orders get finalized in the chronological order in which they’ replaced. Your price may change because the orders ahead of you in linecaused the stock price to rise or fall based on the latest news.
Stop orders (also known as stop-loss orders)
A stop order (or stop-loss order if you own the stock) is a condition-related order that instructs the broker to sell a particular stock only when the stock reaches a particular price. It acts like a trigger, and the stop order converts to
a market order to sell the stock immediately.
The stop-loss order isn’t designed to take advantage of small, short-term moves in the stock’s price. It’s meant to help you protect the bulk of your money when the market turns against your stock investment in a sudden manner.
Say that your AIG, stock rises to $20 per share and you seek to protect your investment against a possible future market decline. A stop-loss order at $18 triggers your broker to sell the stock immediately if it falls to the $18 mark. In this example, if the stock suddenly drops to $17, it still triggers the stop-loss order, but the finalized sale price is $17. In a volatile market, you may not be able to sell at your precise stop-loss price. However, because the
order automatically gets converted into a market order, the sale will be done, and you prevent further declines in the stock.
The main benefit of a stop-loss order is that it prevents a major decline in a stock that you own. It’s a form of discipline that’s important in investing in order to minimize potential losses. Investors can find it agonizing to sell a stock that has fallen. If they don’t sell, however, the stock often continues to plummet as investors continue to hold on while hoping for a rebound in the price.
Most investors set a stop-loss amount at about 10 percent below the market value of a stock. This percentage gives the stock some room to fluctuate, which most stocks tend to do on a day-to-day basis.

Unrealised Points to keep in mind while investing in stocks

admin — Tue, 26 May 2009 00:46:39 +0000

Below is the best approach which i considered for investing or holding positions with stocks.

Don’t follow advisory services. They are not infallible
Be cautious with brokers’ advice. They can be wrong
Ignore market sayings, no matter how ancient and revered.
Don’t trade over the counter stocks- trade only listed stocks, there will be always a buyer for it.
Don’t listen to rumors, no matter how well founded they may appear.
The fundamental approach (long term positions) works better than gambling (short term or intraday).
Hold on to one rising stock for longer period , rather juggle with a dozen stocks for shorter period.

List the stocks as below before obtaining positions:

Stocks with top quality rating.
Stocks the experts like.
Stocks selling below book value.
Stocks with strong cash position.
Stocks that have never cut their dividend.

The stocks belonging to the same industry have the tendency to move together in the market, either up or down.Try to find through fundamental analysis of

a) the strongest industry group.

b) the strongest company within that industry group.

Buy the stock of that strongest company and hold on to it, for such an ideal stock must rise.

Whenever a stock started to behave better than the market generally, immediately looked at the behavior of its brothers— stocks of the same industry group. If found that its brothers

also behaved well, look for the head of the family—the stock that was acting best, the leader. If you could not make money with the leader then certainly you will not make money with the others.

Start compiling earnings of whole industry groups finance, metals, oils, auto, consumer etc., compare their past earnings with their present earnings. Then compare these earnings with

the earnings of other industry groups. Carefully evaluate their profit margins, their price-earnings ratios and their capitalizations.

Rating each stock according to relative degrees of safety and value

admin — Tue, 26 May 2009 00:45:20 +0000

High Grade stocks whose dividend payments are considered elatively sure are rated:

AAA—Safest

AA—Safe

A—Sound

Investment Merit stocks that usually pay dividends:

BBB—Best of group

BB—Good

B—Fair

THE FUNDAMENTALIST: Lesser Grade stocks, paying dividends but future not sure:

CCC—Best of group

CC—Fair dividend prospects

C—Slight dividend prospects

Lowest Grade stocks:

DDD—No dividend prospects

DD—Slight apparent value

D—No apparent value

Cash or margin Accounts an Introduction

admin — Tue, 26 May 2009 00:43:46 +0000

Buying or selling stocks is referred to as a “trade.” For instance, if you decide to buy 100 shares of XYZ and the stock price is $100, you are trading your money for the shares. In this case, the trade is $10,000 for 100 shares of XYZ stock.

The exact amount you need to make your first trade depends on a number of factors including:

• Your market selection.

• Size of the transaction (number of shares).

• Risk on the trade.

Your first trade also depends on whether you want to do your trade using a margin or cash account.

• Cash trades require you to put up 100 percent of the money in cash. All costs of the trade need to be in the account before the trade is placed. For example, to buy 100 shares of IBM at $100 per share, you would have to pay $10,000 plus commissions up front.

• Margin trades require traders to only put up half the total amount to purchase shares while their brokerage lends them the other half at a small interest rate. So for the same IBM example you would have to pay $5,000 plus commissions up front.

The term margin refers to the amount of money an investor must pay to enter a trade, with the remainder of the cash being borrowed from the brokerage firm. The shares you have purchased secure the loan. Most traders prefer a margin account because it allows them to better leverage

assets in order to produce higher returns. In addition, a margin account is usually required for short positions and options trading.

Based on Securities and Exchange Commission (SEC) rules, the margin requirement to purchase stock equals 50 percent of the amount of the trade. At this rate, margin accounts give traders 2-for-1 buying leverage. If the price of the stock rises, then everyone wins. If the price of the stock falls below 75 percent of the total value of the initial investment, the trader receives a margin call from the broker requesting additional funds to be placed in the margin account.

Brokerages may set their own margin requirements, but it is never less than 75 percent—the amount required by the Fed. Brokerages are usually willing to lend you 50 percent of a trade’s cost, but often require a certain amount of money be left untouched in your account to secure the loan. This money is referred to as the margin requirement.

Of course, brokers don’t lend money for free. They charge interest on the loan amount over and above the commission on the trade. The interest and commissions are paid regardless of what happens to the price of the stock. The margin’s interest rate is usually the broker call rate plus the firm’s add-on points. This rate is cheaper than most loans, as it is a secured loan—they have your stock, and in most cases will get their cash back before you get your stock back.

Ultimately, there are no absolutes when it comes to margin. Combining the buying and selling of options and stocks may create a more complex margin calculation. However, these strategies usually have reduced margin requirements in comparison to just buying or shorting stocks

alone. Since every trade is unique, margin requirements will depend on the strategy you employ and your broker’s requirements.

Market Capitalization an Introduction

admin — Tue, 26 May 2009 00:41:59 +0000

Market capitalization is defined as the total dollar value of a stock’s outstanding shares and is computed by multiplying the number of outstanding shares by the current market price. Thus, market capitalization is a measure of corporate size. With approximately 8,500 stocks available to trade on U.S. stock exchanges, many traders judge a company by its size, which can be a determinant in price and risk. In fact, there are four unofficial size classifications for U.S. stocks: blue chips, mid-caps, small caps, and micro-caps.

1. Blue-chip stocks. Blue chip is a term derived from poker, where blue chips in a card game hold the most value. Hence, blue-chip stocks are those stocks that have the most market capitalization in the marketplace (more than $5 billion). Typically they enjoy solid value and good security, with a record of continuous dividend payments and other desirable investment attributes.

2. Mid-cap stocks. Mid-caps usually have a bigger growth potential than blue-chip stocks but they are not as heavily capitalized ($500 million to $5 billion).

3. Small-cap stocks. Small caps can be potentially difficult to trade because they do not have the benefit of high liquidity (valued at $150 million to $500 million). However, these stocks, although quite risky, are usually relatively inexpensive and big gains are possible.

4. Micro-cap stocks. Micro-caps, also known as penny stocks, are stocks priced at less than $2 per share with a market capitalization of less than $150 million.

Some traders like to trade riskier stocks because they have the potential for big price moves; others prefer the longer-term stability of blue-chip stocks. In general, deciding which stocks to trade depends on your time availability, stress threshold, and account size.

Ten ways to Keep your protfolio healthy – Trading tips

admin — Tue, 26 May 2009 00:37:30 +0000

1. The market teaches humility. As soon as you believe you know why the market acts, you will be proven wrong. Arrogance can kill a portfolio. You must be able to admit defeat and preserve enough capital to fight again. Following the point and figure charts, which depict the battle between supply and demand, helps keep you out of the “I know why” attitude of investing.

2. When a sector reverses up, wait until you feel comfortable to buy. Falling into this trap is a great way to ensure that you buy the stock at a higher price. We use the bullish percent indicators to track the risk in sectors. These indicators are soulless. In otherwords, they are not emotional and do not get caught up in recent news events and common thinking. When sectors reverse up from oversold levels, it is often when the news is the most dire. Conventional wisdom would suggest this is the last place in the world you would want to invest. Buying at this time is gut wrenching, but to be successful you must have complete confidence in the indicator. As the sector moves higher, the comfort level increases. If you use comfort level as your guidance, however, you will for sure leave a lot of money on the table, or worse, buy as the sector peaks.

3. Be afraid to buy strong stocks. Do this to make sure you stay out of the long-term winners. Don’t avoid stocks just because they have gone up. Doing this will keep you out of the leaders. This mentality would have kept you out of General Electric (GE), which was up 188 percent between January 1995 and December 1997 only to see it rally another 96 percent by the end of 2000. It also would have kept you out of Cisco (CSCO), which was up 376 percent between January 1995 and December 1997, and then it moved up another 312 percent by the end of 2000. These are only two examples, but there are many others. More important than how much the stock is up is its supply and demand relationship. By evaluating the point and figure chart, you can gain insight into this relationship and whether or not the stock is likely to move higher. Stocks that double can easily double again. Don’t miss out on these great opportunities.

4. Sell a stock because it has gone up. Doing this cuts profits short. Buying a stock right is only half the battle. You have to be able to sell it right to win the war. Just because a stock has rallied 30 percent or 50 percent, don’t be tempted to take your trade off for that reason alone. Consider trimming the position and leave part on the table to continue in the uptrend. Let profits run.

5. Buy stocks in sectors that are extended because it’s different this time. On the surface, the stock market appears different all the time. The leadership changes: in come the Nifty 50, and then out they go. Small-cap stocks outperform for a while, then it’s back to the large caps. However, the underlying forces that drive the stock market are always the same. They are true and time-tested and do not change. They are supply and demand. That’s why buying sectors that are extended (overbought) will not be different this time.

6. Try to bottom fish a stock in a downtrend. “The trend is your friend” is a true statement. So don’t go against it without some inkling that the trend has changed. Bottom fishing a stock in a downtrend is the opposite of being afraid to buy strong stocks. Do not buy a stock just because it fell sharply. You want to buy a stock that is likely to move higher, not one that is not likely to fall further. At a minimum, wait for the stock to show a sign that demand is back in control and suggesting higher prices. That may be a simple buy signal on the chart or a reversal back to the upside after holding an area of support. Also remember why you initiated the position. Be careful not to let a trade turn into something else.

7. Buy a stock because it is a good value. These days, value is in the eyes of the holder, and therefore it is a subjective term at best. If a stock has become a good value, ask why. This is important, because a stock can stay a good value by not moving for the next decade, or worse, become a better value by dropping another 20 percent. The true value of a stock is determined by its capital appreciation potential, not numbers on a balance sheet. The basis for capital appreciation lies in the supply and demand relationship of the stock. Appreciation can occur only if demand grows stronger for the stock and buyers are willing to pay a higher price. Watch the point and figure charts to determine if a stock is likely to move higher in price and become a good value.

8. Hold on to losing stocks and hope they come back. Hope is eternal, but your portfolio is not. Holding on to a losing stock is the best way to let your losses run. Combine this mistake with selling a stock that has gone up and you can create a portfolio of dogs. When buying stocks, there will always be some losers: Count on it. However, how you manage that loss often determines the success or failure of the overall portfolio. Keep losses small so that you have the capital to play again. Hanging on to losing positions, hoping that they will come back, can be deadly. A $50 stock that is stopped out at $40 is a 20 percent loss. It’s a bad trade, but it is manageable. In order to recoup that loss you would have to make 25 percent on a $40 stock. What if you held on to that $50 stock, hoping that strong earnings would come in and turn it around, but instead it continued lower to $25? Finally, you decide to exit, but now it takes a 100 percent return from a $25 stock just to get back to even. Those results are hard to find, and if you are able to find one, you don’t want to waste it on getting back to even. Learn to recognize your losing positions for what they are. If a stock cannot trade above its support line or is not outperforming the averages, find one that is and swap it.

9. Pursue perfection. There are two types of mistakes to discuss here. The first is the constant belief that there is a better system out there, and you need to find it. Using a new system to invest each week will not get you to your goal. You will become good at nothing and moderate to bad at everything. To be good requires that you stay focused, disciplined, and skilled at whatever methodology you choose. You need to have the strength of conviction in your chosen discipline to learn from mistakes rather than to run away from them and find another methodology. There is no Holy Grail in investing. The second mistake is to wait for the perfect trade. There is no such thing. If you only buy stocks that have all positive attributes you will maintain a portfolio of cash. Rarely, if ever, do you find a stock that has all the pluses on its side. Look for the big ones like relative strength, trend, and signal. Also remember that 80 percent of the cause of price movement in a stock is based on the market and sector. You are better off being approximately right than precisely wrong.

10. Do anything based on a magazine cover. Following the hot news that appears on magazine covers is a shortcut to the poorhouse. Why should you follow the advice of someone who has just

moved from the society pages to the business section?

Few common Investor Mistakes

admin — Tue, 26 May 2009 00:35:56 +0000

◆ Falling in love with a position.

An account has limited capital, soask yourself if the position is the best one to be in here. Are you tying up capital that can be put to better use elsewhere? Don’t get sucked into the fundamental story—that is, don’t hold on to a stock whose technical picture has deteriorated just because you are intoxicated with the reasons for your choice.

◆ Buying the stock right, but forgetting to sell it right.

Thereare two foul shots to make successfully with respect to investing. You must buy the stock right, and then you must sell the stock correctly. Therefore, once you buy a stock you must review it on a regular basis; don’t just forget about it. Attempt to sink both foul shots.

◆ Not having a game plan for investing.

Investors will haphazardly, especially in a strong market, pick stocks to buy, thinking that the stock market is easy to beat. They fail to realize there is risk, not only reward. Therefore, it is essential to have a game plan that helps dictate what stocks to buy and when, and also tells you when to sell or play defense.

◆ Buying stocks that are extended. When you buy a stock that is up on a stem, it increases your risk and diminishes your potential reward. Rather, it is best to buy a stock when it pulls back closer to support, thereby increasing the potential upside reward, and diminishing the risk to the stop-loss point.

◆ Taking small gains, but not being willing to take small losses.

Be willing to take small losses by adhering to your stop-loss points. Avoiding large losses will keep you in the game. You will not be right on every trade, so be willing to bail out and take the small loss when the technical picture so dictates.

◆ Buying a stock that is trending down, thinking that it is cheap, or a value.

Often, these types of stocks become an even better value because they continue to fall in price. Ideally, it is best to stick to stocks that are in an overall uptrend, trading above their bullish support line and exhibiting positive relative strength. These are the stocks that are in demand and should be considered for purchase.

◆ Acting on poor advice, tips, and financial media hype.

Many investors try to get rich quick without doing their homework. They rely on the TV or financial media to tell them what to buy. Instead, take the time to educate yourself, to arm yourself with a game plan. Then you will be able to make sound, informed decisions. Take responsibility for your own success. Don’t rely on get-rich-quickschemes and rumors. Do your own research.

◆ Getting emotional and not being able to stay objective.

Any investor knows that emotions can be your worst enemy. Try to stay objective. The point and figure chart helps you accomplish this because a picture paints a thousand words. When looking at the chart, cover up the name of the stock. Make your decision on what the chart is telling you, therefore taking the emotion out of knowing the name of the stock.

Tooling the stocks with ratios

admin — Tue, 26 May 2009 00:34:56 +0000

A ratio is a helpful numerical tool that you can use to find out the relationship between two or more figures found in the company’s financial data. A ratio can add meaning to a number or put it in perspective. Ratios sound complicated, but they’re easier to understand than you think. Say that you’re considering a stock investment and the company you’re looking at has earnings of $1 million this year. You may think that’s a nice profit, but in order for this amount to be meaningful, you have to compare it to something. What if you find out that the other companies in the industry (of similar size and scope) had earnings of $500 million? Does that change your thinking? Or what if you find out that the same company had earnings of $75 million in the prior period? Does that change your mind? Two key ratios to be aware of include

Price-to-earnings ratio (P/E)
Price to sales ratio (PSR)

Every investor wants to find stocks that have a 20 percent average growth rate over the past five years and have a low P/E ratio (sounds like a dream). Use stock screening tools available for free on the Internet to do your research.

Many brokers have them at their Web sites (such as Charles Schwab at www.schwab.com and E*TRADE at www.etrade.com). Some excellent stock screening tools can also be found at Yahoo! (finance.yahoo.com), Business Week (www.businessweek.com), and Nasdaq (www.nasdaq.com). A stock screening tool lets you plug in numbers such as sales or earnings and ratios such as the P/E ratio or the debt to equity ratio and then click! Up come stocks that fit your criteria. This is a good starting point for serious investors. Check out Appendix B for even more on ratios.

The P/E ratio

The price to earnings (P/E) ratio is very important in analyzing a potential stock investment because it’s one of the most widely regarded barometers of a company’s value, and it’s usually reported along with the company’s stock price in the financial page listing. The major significance of the P/E ratio is that it establishes a direct relationship between the bottom line of a company’s operations — the earnings — and the stock price. The P in P/E stands for the stock’s current price. The E is for earnings per share (typically the most recent 12 months of earnings). The P/E ratio is also referred to as the “earnings multiple” or just “multiple.” You calculate the P/E ratio by dividing the price of the stock by the earnings per share. If the price of a single share of stock is $10 and the earnings (on a per-share basis) are $1, then the P/E is 10. If the stock price goes to $35 per share and the earnings are unchanged, then the P/E is 35. Basically, the higher the P/E, the more you pay for the company’s earnings.

Why would you buy stock in one company with a relatively high P/E ratio instead of investing in another company with a lower P/E ratio? Keep in mind that investors buy stocks based on expectations. They may bid up the price of the stock (subsequently raising the stock’s P/E ratio) because they feel that the company will have increased earnings in the near future. Perhaps they feel that the company has great potential (a pending new invention or lucrative business deal) that will eventually make the company more profitable.

More profitability in turn has a beneficial impact on the company’s stock price. The danger with a high P/E is that if the company doesn’t achieve the hopeful results, the stock price could fall. You should look at two types of P/E ratios to get a balanced picture of the company’s value:

Trailing P/E: This P/E is the most frequently quoted because it deals with existing data. The trailing P/E uses the most recent 12 months of earnings in its calculation.
Forward P/E: This P/E is based on projections or expectations of earnings in the coming 12-month period. Although this P/E may seem preferable because it looks into the near future, it’s still considered an estimate that may or may not prove to be accurate.

The following example illustrates the importance of the P/E ratio. Say that you want to buy a business and I’m selling a business. If you come to me and say, “What do you have to offer?” I may say, “Have I got a deal for you! I operate a retail business downtown that sells spatulas. The business nets a cool $2,000 profit per year.” You reluctantly say, “Uh, okay, what’s the asking price for the business?” I reply, “You can have it for only $1 million! What do you say?” If you’re sane, odds are that you politely turn down that offer. Even though the business is profitable (a cool $2,000 a year), you’d be crazy to pay a million bucks for it. In other words, the business is way overvalued (too expensive for what you’re getting in return for your investment dollars). The million dollars would generate a better rate of return elsewhere and probably with less risk.

As for the business, the P/E ratio ($1 million divided by $2,000 = a P/E of 500) is outrageous. This is definitely a case of an overvalued company — and a lousy investment. What if I offered the business for $12,000? Does that price make more sense? Yes. The P/E ratio is a more reasonable 6 ($12,000 divided by $2,000). In other words, the business pays for itself in about 6 years (versus 500 years in the prior example). Looking at the P/E ratio offers a shortcut for investors asking the question, “Is this stock overvalued?” As a general rule, the lower the P/E, the safer (or more conservative) the stock is. The reverse is more noteworthy: The higherthe P/E, the greater the risk.

When someone refers to a P/E as high or low, you have to ask the question, “Compared to what?” A P/E of 30 is considered very high for a large-cap electric utility but quite reasonable for a small-cap, high-technology firm. Keep in mind that phrases such as “large-cap” and “small-cap” are just a reference to the company’s market value or size. “Cap” is short for capitalization (the total number of shares of stock outstanding times the share price).

The following basic points can help you evaluate P/E ratios:

Compare a company’s P/E ratio with its industry. Electric utility industry stocks generally have a P/E that hovers in the 9–14 range. Therefore, if you’re considering an electric utility with a P/E of 45, then something is wrong with that utility.
Compare a company’s P/E with the general market. If you’re looking at a small-cap stock on the Nasdaq that has a P/E of 100 but the average P/E for established companies on the Nasdaq is 40, find out why. You should also compare the stock’s P/E ratio with the P/E ratio for major indexes such as the Dow Jones Industrial Average (DJIA), the Standard & Poor’s 500 (S&P 500), and the Nasdaq Composite .
Compare a company’s current P/E with recent periods (such as this year versus last year). If it currently has a P/E ratio of 20 and it previously had a P/E ratio of 30, you know that either the stock price has declined or that earnings have risen. In this case, the stock is less likely to fall. That bodes well for the stock.
Low P/E ratios aren’t necessarily a sign of a bargain, but if you’re looking at a stock for many other reasons that seem positive (solid sales, strong industry, and so on) and it also has a low P/E, that’s a good sign.
High P/E ratios aren’t necessarily bad, but they do mean that you should investigate further. If a company is weak and the industry is shaky, heed the high P/E as a warning sign. Frequently, a high P/E ratio means that investors have bid up a stock price, anticipating future income. The problem is that if the anticipated income doesn’t materialize, the stock price could fall.
Watch out for a stock that doesn’t have a P/E ratio. In other words, it may have a price (the P), but it doesn’t have earnings (the E). No earnings means no P/E, meaning that you’re better off avoiding it. Can you still make money buying a stock with no earnings? You can, but you aren’t investing; you’re speculating.

Listening to a PSA about PSR

The price to sales ratio (PSR) is the company’s stock price divided by its sales. Because the sales number is rarely expressed as a per-share figure, it’s easier to divide a company’s total market value (see the section “Market value,” earlier in this chapter, to find out what this term means) by its total sales for the last 12 months. As a general rule, stock trading at a PSR of 1 or less is a reasonably priced stock worthy of your attention. For example, say that a company has sales of $1 billion and the stock has a total market value of $950 million. In that case, the PSR is 0.95. In other words, you can buy $1 of the company’s sales for only 95 cents. All things being equal, that stock may be a bargain.

Analysts frequently use the PSR as an evaluation tool in the following circumstances:

In tandem with other ratios to get a more well-rounded picture of the company and the stock.
When you want an alternate way to value a company that doesn’t have earnings.
By analysts who want a true picture of the company’s financial health, because sales are tougher for companies to manipulate than earnings, which are easier to manipulate.
When you’re considering a company offering products (versus services).

PSR is more suitable for companies that sell items that are easily counted (such as products). Companies that make their money through loans, such as banks, aren’t usually valued with a PSR because deriving a usable PSR for them is more difficult.

Compare the company’s PSR with other companies in the same industry, along with the industry average, so that you get a better idea of the company’s relative value.

Various Types of Brokerage Accounts

admin — Tue, 26 May 2009 00:33:35 +0000

When you decide to start investing in the stock market, you have to somehow actually pay for the stocks you buy. Most brokerage firms offer investors several different types of accounts, each serving a different purpose. I present three of the most common types in the following sections. The basic difference boils down to how particular brokers view your “creditworthiness” when it comes to buying and selling securities. If your credit isn’t great, your only choice is a cash account. If your credit is good, you can open either a cash account or a margin account. Once you qualify for a margin account, you can (with additional approval) upgrade it to do options trades.

To open an account, you have to fill out an application and submit a check or money order for at least the minimum amount required to establish an account.

Cash accounts

A cash account (also referred to as a Type 1 account) means just what you think it means. You must deposit a sum of money along with the new account application to begin trading. The amount of your initial deposit varies from broker to broker. Some brokers have a minimum of $10,000, while others let Going for Brokers 95 you open an account for as little as $500. Once in a while you may see a broker offering cash accounts with no minimum deposit, usually as part of a promotion. Qualifying fora cash account is usually easy as long as you have cash and a pulse. With a cash account, your money has to be deposited in the account before the closing (or settlement) date for any trade you make. The closing occurs three business days after the date you make the trade (the date of execution). You may be required to have the money in the account even before the date of execution.

In other words, if you call your broker on Monday, October 10, and order 50 shares of CashLess Corp. at $20 per share, then on Thursday, October 13, you better have $1,000 in cash sitting in your account (plus commission). Otherwise, the purchase doesn’t go through. If you have cash in a brokerage account, see whether the broker will pay you interest on the uninvested cash in it. Some offer a service in which uninvested money earns money market rates and you can even make a choice about whether the venue is a regular money market account or a tax-free

municipal money market account.

Margin accounts

A margin account (also called a Type 2 account) gives you the ability to borrow money against the securities in the account to buy more stock. Because you have the ability to borrow in a margin account, you have to be qualified and approved by the broker. After you’re approved, this newfound credit gives you more leverage so that you can buy more stock or do shortselling.

For stock trading, the margin limit is 50 percent. For example, if you plan to buy $10,000 worth of stock on margin, you need at least $5,000 in cash (or securities owned) sitting in your account. The interest rate that you pay varies depending on the broker, but most brokers generally charge a rate that’s several points higher than their own borrowing rate. Why use margin? Margin is to stocks what mortgage is to buying real estate. You can buy real estate with all cash, but many times, using borrowed funds makes sense since you may not have enough money to make a 100% cash purchase or you prefer not to pay all cash. With margin, you could, for example, be able to buy $10,000 worth of stock with as little as $5,000. The balance of

the stock purchase is acquired using a loan (margin) from the brokerage firm.

Option accounts

An option account (also referred to as a Type 3 account) gives you all the capabilities of a margin account (which in turn also gives you the capabilities of a cash account) plus the ability to trade options on stocks and stock indexes. To upgrade your margin account to an options account, the broker usually asks you to sign a statement that you’re knowledgeable about options and familiar with the risks associated with them. Options can be a very effective addition to a stock investor’s array of wealthbuilding investment tools.