Common Stocks and Uncommon Profits
The Fourth Dimension
The fourth dimension of a stock involves the P/E ratio. To understand a company’s P/E ratio, it is important to understand why a company’s price is going up or down.
A stock’s price goes up or down based on the sentiments of a group of investors, i.e., the financial community appraises the stock of the company. There can be a situation where a company has good financials but is trading at a low price. A company trading at a very low P/E ratio can be categorised as a good stock on most of the occasions.
A conservative investor should look at the industry in which a company is operating. When the market perception of an industry is negative, almost all of the stocks in that industry will have a low P/E ratio.
Hence, it becomes important for an investor to analyse an industry before analysing a stock. This is known as a Top-Down approach.
The performance of the stock market is an important factor in determining the returns of an investor. When a recessionary period hits, investors get pessimistic about an economy and sell off excessively. This brings down the returns of an investor and can prove to be a good buying opportunity.
There are three external factors which affect the stock market performance:
1. Interest Rates - When interest rates go up, investors sell their stocks and buy fixed-income securities.
2. Savings Rate - When the rate of savings goes down, money flows out of the stock markets.
3. New Issues - New issues suck money out of stock markets.