Knowledge Now Means Dollars Later

“Never invest in a business you cannot understand.”—Warren Buffett

Okay, step away from the TV and all of the news about the AIG executive bonuses. Sure, it feels great to get pissed off right now—and it’s completely justified. But we must focus on what we can do in the upcoming months and years for our long-term personal financial security. An economic recession begets a slowing economy as we all tighten the purse strings to try to ride this thing out. Maybe with some understanding of how the economy works, we can feel more confident and perhaps even loosen our purse strings.

I have had a ton of questions regarding your 401Ks and what’s actually in them. Understanding the basics of financial instruments like stocks, bonds, CDs, etc. is important if we want to capitalize on our economy turning around—and it will turn around! Your 401K is simply just a grouping of financial instruments that some financial planner has deemed best for you and the company you work for. Let’s look this week at what a common stock is.

A stock is a type of security (or financial instrument) that indicates actual ownership in a corporation and represents a claim to the assets of that company. (A bond, on the other hand, is a loan to a company or government agency for which you are paid back with interest.) There are many ways to value a stock. It’s somewhat like going to the farmers market and comparing corn sold by two different vendors. Say an ear of corn is 50 cents at one booth but 75 cents at the other, and the quality is the same. You would more than likely buy the 50 cent corn. But if the 50 cent corn is rotten or otherwise inferior, the 75 cent corn is the better choice. The same sort of logic and diligence should be used when choosing a company to invest in. Too often we just send our money to our broker, or press “buy stock” on some Internet site without doing any research on the company we are buying into. We’re not entirely to blame—we have just not been taught how to value an individual company and the industry it competes in.

A price-to-earnings ratio—or P/E ratio—is simply the price the stock is currently trading at divided by the earnings per share. (Earnings per share are calculated by taking a company’s net earnings and dividing it by the number of outstanding shares.) If a share price is $20 and the earnings are $1 per share, then the P/E ratio is 20. P/E ratios are one of the main tools investors use to gauge not only a company’s value, but also where they stand in their particular industry—to be able to compare ears of corn, in the example above.

One way to find a P/E ratio for an entire industry is to look at websites like Yahoo Finance. You can find a chart listing with “industry statistics,” including the sector-wide P/E ratio. By comparing the stock you are interested in to the industry average (as well as by comparing that industry with other industries), you will have another gauge for your decision-making process.

There are other bits of information to look for in the news about a company. Here are a few:

Good earnings reports: It’s often a good sign if a company reports good or better-than-expected earnings. Bad earnings will usually have a negative effect on a company’s stock price.

A new product or service: If a new product is created by a company, it could mean increased profits. The potential downside would be liability issues arising if the product were found to be defective, for instance.

Financial problems: If independent analysis reports problems with a company’s financial health, that’s something to take into account. (A company’s annual report is required to have a statement from an independent analyst. These independent analysts must report their true findings under penalty of the law.)

A new business deal: Keep an eye out for company announcements of favorable business deals such as a joint venture.

Even if you are not in the market right now to buy stock, try tooling around the web and getting in the habit of educating yourself. Figure out what sites offer the information you want in ways you like. As I have said before, if we are prepared and educated, we can hope to avoid another economic downturn like the one we are currently witnessing. Shit, I’d like to prosper on the way up and out of this thing. How about you?