STOCK AND BONDS

                 Introduction to Stocks and Bonds

Many of us deal with stocks and bonds (or want to!) but have no idea what they are worth. Maybe you want to try investing. You may want a better understanding of your 401(k) investments. Or, if you work for a big corporation, your employer may sell shares, and you need to determine whether it's worth the price. Either way, it is good to know the difference between stocks and bonds and have a basic understanding of how they are valued.

A stock is one share of ownership in a company. The person making a purchase is called the investor. The more stock an investor buys in a company, the more ownership she has. If the investor decides that she wants her money back, she is free to sell stock at any time as long as there is someone willing to buy it. If the value of the stock has changed, she will either gain or lose money.

A bond is different. A bond is debt. It is like a small loan. When you buy a bond, you give money to a company who needs cash immediately. That company agrees to pay back the amount of the bond plus interest (the price that company pays for borrowing your money) after a set amount of time ranging from one to thirty years. You cannot change your mind and get your bond money back until the bond matures (meaning the set amount of time has passed).

Stock Valuation

There are three main methods for valuing a share of stock: (1) the P/E method, (2) the Rule of Thumb method, and (3) valuing dividend stocks.

The P/E Method

The P/E Method divides the stock price by the company's earnings per share (EPS), which is the company's profit divided by the total number of shares. What it measures is how much an investor must pay (price) to earn $1 of the company's earnings.

For example, one share of stock in Coke costs $44.78 and the earnings per share (you can get this information from the company) is $.26, the PE ratio is 44.78/.26 or 172.23. This means an investor will have to spend $172 to get $1 of the company's earnings.

What does this mean? Every industry has an average P/E ratio. It is wise to compare the company's P/E ratio with the industry P/E ratio to make sure you are making a good investment. In our example, the industry P/E ratio for soft drinks is 92.78. This means that industry-wide, an investor would spend $92 to get $1 of earnings. At Coke, an investor would have to spend $172! This is not a good time to buy shares in Coke!

Rule of Thumb Method

The Rule of Thumb Method is basically an estimation. An investor would need to estimate the future earnings per share of a stock and multiply that by 10. The result should be the approximate price of the stock.

For example, if future earnings per share is estimated to be $3.00 per share, then you would expect the price to be around $30.00 or 3 x 10. If the price is higher than $30, you may think twice before purchasing. If the price is lower than $30, it may be a good investment.