When investors talk about "growth", they're not talking about size. They're talking about profitability, that is, earnings.
It means the profits are growing. The company will earn more money this year than last year, just as it earned more money last year than the year before that.
- A company doubling its earnings in 12 months can cause a wild celebration on Wall Street, because it's very rare for a business to grow that fast.
- Big, established companies are happy to see their earnings increase by 10 to 15% a year, and
- younger, more energetic companies may be able to increase theirs by 25 to 30%.
One way or the other, the name of the game is earnings. That's what the shareholders are looking for, and that's what makes the stocks go up.
People who buy shares are counting on the companies to increase their earnings, and they expect that a portion of these earnings will get back to them in the form of higher stock prices.
This simple point - that the price of s stock is directly related to a company's earning power - is often overlooked, even by sophisticated investors.
The earnings continue to rise, the stock price is destined to go up. Maybe it won't go up right away, but eventually it will rise.
And if the earnings go down, it's pretty safe bet the price of the stock will go down. Lower earnings make a company less valuable.
This is the starting point for the successful stockpicker. Find companies that can grow their earnings over many years to come.
It is not an accident that stocks in general rise in price on average of about 8% a year over the long term. That occurs because companies in general increase their earnings at 8% a year, on average, plus they pay 3% as a dividend.
Based on these assumptions, the odds are in your favour when you invest in a representative sample of companies. Some will do better than others, but in general, they'll increase earnings by 8% and pay you a dividend of 3%, and you'll arrive at your 11% annual gain.
Stock Price Watchers
The ticker-tape watchers begin to think stock prices have a life of their own.
- They track the ups and downs, the way a bird watcher might track a fluttering duck.
- They study the trading patterns, making charts of every zig and zag.
- They try to fathom what the "market" is doing, when they ought to be following the earnings of the companies whose stocks they own.
"Expensive Shares"
By itself, the price of a stock doesn't tell you a thing about whether you're getting a good deal.
You'll hear people say: "I am avoiding IBM, because at $100 a share it's too expensive."
- It maybe that they don't have $100 to spend on a share of IBM, but the fact, that a share costs $100 has nothing to do with whether IBM is expensive.
- A $150,000 Lamborghini is out of most people's price range, but for a Lamborghini, it still might not be expensive.
- If IBM is earning $10 a share this year, then you're paying 10 times earnings when you buy a share for $100. That's a P/E ratio of 10, which in today's market is cheap.
- On the other hand, if IBM only earns $1 a share, then you're paying 100 times earnings when you buy that $100 share. That's a P/E ratio of 100, which is way too much to pay for IBM.
