The Three Possible Sources Of Profit in Stocks
There are three main components that determines the value of a stock (dividends, growth, and changes in the valuation). To measure these three things every investor needs a game plan to follow from the swing trader to a long term investor. For long term investing you need to be meticulous and have a checklist of requirements that the stock satisfies before you should even considering purchasing it. This is a form of stock screening which Warren Buffet was an expert at long before you could find all this information easily available online to the average investor.
There is a great article over on about money that will show three simple rules for setting up and evaluating stocks that you have thought about investing in.
- The initial dividend yield on cost
- The growth in intrinsic value per share (for most firms, this amounts to the growth in earnings per share on a fully diluted basis)
- The change in the valuation applied to the firm’s earnings or other assets, often measured by the price-to-earnings ratio
That is it. Those are the only three ways that someone who invests in stock can benefit economically. He can collect cash dividends, he can share in the proportional growth of the underlying earnings per share, and he can receive more or less for every $1.00 in profit a company generates based upon the overall level of panic (fear) or optimism (greed) in economy, which in turn drives the valuation multiple, also known as the price-to-earnings ratio.
You can swap anyone one of these three guidelines with another metric if you like they are just a starting point. For example the P/E ratio is very limited because it doesn’t include the future growth rate of the company in the evaluation. Many investors use the PEG (Price Earnings Growth) Ratio instead of the P/E ratio because it includes growth in the calculation. Investing is not purely a science it is more of an art with a strong psychological component. There is no one way to do it.
Review the three simple rules here and get started developing your own stock screening plan today it could save you thousands.
About Shaun Archer Tatum Shaun works in corporate finance in New York City. He has done financial consulting for several start-ups and has worked at several Fortune 500 companies. He has contributed several finance/investing articles on Seeking Alpha which have been published on Yahoo! Finance.