What is a Stock?

A stock can also be called a share. The basic idea behind stocks is you’re owning a portion of a company you believe will be successful and profitable. You are paying for the right to share part of the company’s earnings. The company can choose to take their earnings and do 3 things:

Invest money back into the company to grow from buying more factories or buying other company’s etc.
Buying back their own shares therefor driving up the share price.
Pay a portion of their earnings directly to share holder as cash.

In order to understand shares you need to understand earnings.

Earnings

A company's earnings are the profits or after-tax net income the company made in a fiscal quarter (reported 4 times a year) or the total for the year. If earnings are going up quarter after quarter or year after year that could be a sign the company is doing well.

Earnings Per Share (EPS)

EPS is the reported earnings in a quarter or year divided by the number of average shares for that period. There are two types of average shares, basic and diluted.

Basic Average Shares
The average number of shares over the quarter or year that investors, the general public and company insiders own.
Diluted Average Shares
The same as basic average shares but you add shares for anything that could be converted into share such as; employee stock awards, convertible securities and options.

Basic EPS = Earnings/(Number of Basic Average Shares)

Diluted EPS = Earnings/(Number of Diluted Average Shares)

Price to Earnings Ratio (P/E)

The PE ratio is used to compare a company’s earnings per share (EPS) to the price you pay per share. As a share holder you are paying to own a tiny fraction of the company and it’s earnings. Therefor if a company’s earnings (profit) are $10, and a share costs $200 the PE Ratio is:

$200 per share / $10 earnings = $20 per share/ $1 earnings
Or simply put the PE Ratio = 20

Special Cases

No PE Ratio: If a company is just starting out they may not have any earnings so there is no PE Ratio.

Negative PE Ratio: If a company lost money or spend more than they earned during a period they may have a negative PE Ratio.

Company’s earnings are frequently changing, so the PE Ratio often uses the Trailing Twelve Months (TTM) earnings in the calculation.

Trailing Twelve Months (TTM)

Trailing twelve months is the current share price divided by the last 4 quarters earnings.

Example PE Ratio

Here’s a Real Example of PE Ratio (TTM) Using Google’s 2020 Stock (GOOG)

Up to date data is available here from ycharts.

Using Googles Income Statement:

Net income at the end of 2020 (Earnings) = $40,269,000

Basic EPS = $59.15

Using ycharts:

Net income (Earnings) [TTM] = $51,360,000

Diluted EPS (TTM) = $75.12

Share Price July 29th 2021 = $2,730.81

PE Ratio (TTM) = 2730.81/75.12

PE Ratio (TTM) = 36.35

Low PE Ratio

A low PE Ratio could mean a stock is undervalued or cheap to buy. A PE Ratio less than 20 is often considered low. This could mean the company is expected to have slow growth. The Toronto-Dominion Bank (TD.TO) has a PE Ratio of 10.68.

High PE Ratio

A high PE Ratio could mean a stock is overvalued or expensive to buy. A PE Ratio greater than 20 is often considered high. A high PE ratio could also be an indication that a company will grow very quickly. Tesla (TSLA) has a PE Ratio of 362.26.

Takeaways

Now that you know what a stock is, there are lots of different metrics you can use to compare stocks. An easy one I like is the PE Ratio. All you need to know is the company’s earnings, the number of outstanding shares and the stock price. This can give you an idea what you are getting for your money. Some websites display the PE Ratio but if they don’t, you can calculate it yourself from the company’s balance sheet using the methods in this article link here.

The Basics for Understanding Stocks