Profit From Investing in the Stock Market
When you are investing in stocks (this includes stock mutual funds such as the Vanguard S&P Index Fund) you are basically becoming a part owner of that company. Sure, you own a very, very small part but it’s a part.
The most important thing to realize about investing in stocks is that there is no guarantee of profits and you can lose everything, just like the company can go out of business.
In theory, the price, or value, of a share of stock, will increase at the same rate as the companies profits. For example, if the company increases it’s profits from one year to the next by 10%, the value of your stock, should increase by 10%.
So if you paid $50 for a share of stock in company XYZ, a 10% increase would be $5 and one share of stock would now be $55.
However, while the value or price of stock will most likely trend that way over the long term, many, many factors may come into play over the short term that have the price of stock be wildly different than the profits of a company.
For one example, if a company is doing really well, is growing rapidly and there is a positive outlook over time that it may grow profits by 50%, 100% or more over the next year or two, that value may already be priced into the stock because of all the people purchasing shares.
If you get into a stock after that has happened, it’s most likely that you will not enjoy the price increases as those people that got in early may begin selling shares, as they already got the value increase and want to keep their profits.
This is one of the major reasons you should not be investing in stock with money you need in the short term. It’s too risky.
Look longer term for stock investing, say at least a five year time frame.
Do some research on companies to get an idea of what the outlook is for them in terms of sales and profit growth over the longer term of 5, 10 or more years.
One last tip for investing that plays into the scenario above is that of the price to earnings ratio, or P/E. The price to earnings ratio is the price of a stock divided by the earnings per share.
If a stock is currently valued at $50 and the earnings per share is $5, then the P/E is 10.
What does this mean? Going back to our theory on growth, all other things being equal, a stocks P/E should equal it’s growth rate. If the P/E is 10, the companies growth rate should be 10.
But again, many other factors come into play. One is that a fast growing company will come at a premium price. If a company is growing rapidly in a growing industry, say at 40% a year, you may pay a premium and the company could have a P/E of 80, 100 or more.
The bigger the premium on the P/E the more risk because over the long term, the P/E will revert closer to the profit growth of the company.
There is a lot to cover when discussing investing. It is not as simple as just buying shares in some “hot” company you heard about in the office break room.