The stock market has a history of making investors large sums of money over the long term, and yet only 52% of Americans are investing in stocks or stock-based investments (like mutual funds), according to Bankrate.com. Even worse, only 26% of adults under 30 are investing -- despite the fact that investing is most critical at that stage in life.
Among Americans who don't invest in stocks, 21% say they avoid equities because they don't know enough about them. I can empathize: In the early days of my internship with The Motley Fool, I heard dozens of terms, metrics, and stock market buzzwords that left my mind whirling. However, in my time here, I've learned some of the most important terms that investors need to understand in order to evaluate a stock.
If I learned them, then you can, too. So here are four common financial metrics, what they mean, and how you can put them to use.
1. Market capitalization
A company's size isn't determined by its stock price. In other words, if you own a $100 stock, that doesn't mean you own part of a larger company than an investor who holds a $30 stock. The reason is that a company can split its stock, simultaneously increasing the number of outstanding shares and reducing their value. If you own one share of a company valued at $100, and the company splits its stock 2-for-1, then you'll end up with two shares valued at $50 each. The size of your holding doesn't change at all, nor does the size of the company.
How can you measure a company's size then? Think of it this way: No matter how many pieces you slice a pie into, the size of the pie stays the same. The same goes for a company's value; the number of shares available doesn't change the company's overall value. In order to find out the market value, or "size," of the entire company, we multiply every existing share by the current share price. This figure is known as market capitalization, or market cap. The higher the market cap, the bigger the company.
For example, if Company X has 5 billion shares outstanding, priced at $40 each, then the company's market cap is $200 billion (5 billion x $40).
When you hear the terms "big cap," "mid-cap," or "small cap," they refer to a company's size by market capitalization.
2. Net income
A company's size doesn't determine how well it's doing. In order to evaluate a company's performance, we need to know whether it's turning a profit. The metric that tells us this is net income.
To find a company's net income, we start by finding its revenue, i.e., the amount of money it receives in a given quarter or year. Revenue -- sometimes referred to as net sales or the top line -- is the amount of money a company brings in from its customers.
But revenue doesn't tell the whole story; you need to consider a company's expenses as well. If you want to invest in a lemonade stand, then you should know how much money it makes and how much money it spends to earn that revenue. If our lemonade stand sold $1 million worth of sweet and sour beverages last year, but it spent $1.5 million on materials, wages, taxes, loan interest, and other business expenses, then it's a money-losing venture.
The difference between revenue and expenses is called net income, also known as profit, earnings, or the bottom line. Net income shows us how much revenue a company actually gets to keep.
3. Earnings per share
Earnings per share, or EPS, is a basic measure of profitability. It's also pretty self-explanatory: It tells us how much a company has earned for each share outstanding. EPS is typically reported each quarter.
If a company's quarterly net income was $100 million, and there were an average of 200 million shares outstanding during the quarter, then the company earned $0.50 per share ($100 million / 200 million).
When a company's EPS rises, that means it's creating more value for shareholders, as it can use those higher earnings to reinvest in the business or pay out a dividend. EPS is also an important factor in determining a stock's true value.
4. Price-to-earnings ratio
The most basic and commonly used measure of a stock's valuation is the price-to-earnings ratio, or P/E. When investors want to get an idea of whether a stock is overvalued or undervalued, they often with its P/E.
The "price" in price-to-earnings simply refers to the current share price. The "earnings" can refer to either the company's trailing 12-month EPS or its forecast EPS for the next 12 months; the former will give you the trailing P/E, which is based on actual recent earnings, while the latter will give you the forward P/E, which is based on estimates of future earnings. You can use the trailing and forward P/E ratios to compare what the company earned in the past to what it might earn in the future.
Imagine that you purchased shares in two different companies, one for $10 and another for $20. If both companies earned $1 per share, then you paid less for the $10 stock to earn that $1 per share. Don't make the mistake of thinking that a lower share price makes a stock "cheaper." If a $50 stock earns you $40, while a $15 stock earns you $3, then the $50 stock is actually a better value, because it earned more money for every dollar you invested in it.
Keep in mind that the P/E ratio represents the value that investors are assigning to a stock. The earnings part may be a real and fixed number, but the price is subject to the forces of supply and demand. If a stock's P/E ratio is 10, then investors have decided the stock is worth 10 times the company's earnings over a 12-month period. The higher the P/E, the more growth investors expect going forward.
Because the P/E is based on investor perception, it can be wrong. And when you find a difference between a stock's true value and the value the market has given it, then you may have found an opportunity to profit.
First mission accomplished
Now you know some of the core metrics used to value stocks. I'll be honest, though: This is just the tip of the iceberg. There are countless other metrics that go into a company analysis, such as free cash flow, financial statements, and industry-unique metrics that help gauge performance.
But here's the silver lining: Armed with this basic knowledge, you have some context so you can better understand more complex investing concepts. And whenever some stock market jargon confuses you, you can Google your way to understanding. Take it one step at a time. By reading articles like this, you're already on your way to becoming a great investor.