Forget name recognition and stick to fundamentals when investing.
You are one lucky guy if, back in 1997, you beat the crowd and bought stock in a new Internet book store called Amazon.com. Back then, if you'd ponied up $1,000 to buy shares in the firm at $2.50 each, your stake would now be worth $31,000.That's stock-picking's appeal: Buy the right company and make a bundle. But you can also wind up broke. Consider a not-so-lucky investor who bought $1,000 worth of Amazon stock at $105 a share in 1999. The shares are now worth $78 each, and the entire holding, a total of $743.
The point is that stock-market investing is a tricky business, and on average, it is mathematically impossible for investors collectively to beat the market. Don't even try--if you do, chances are the only one who'll come out ahead is the broker who skims a commission off each of your trades.
In Pictures: How A Billionaire Values Stocks
That is not to say you should avoid stocks altogether. In fact, stocks offer one of the best ways to grow your savings over the long term, having returned an average of 6% annually after inflation over the past century. But rather than regard the market like a speculator--constantly swinging for the fences and often striking out--the smart thing to do is act like a long-term investor. That means either buying stocks you intend to hold on to for years or decades, or, safer still, owning low-cost index mutual funds or exchange-traded funds (ETFs).
However you decide to invest, it helps to know the basics of valuing companies and their stocks.
Owning a stock means becoming a fractional owner of a company. If the enterprise thrives, you get a cut of the profits, either through a rise in its stock price that reflects its growing earnings power, regular payments known as shareholder dividends, or both. If the company becomes sickly, you're likely to suffer too, as the price others are willing to pay you for its stock sinks and its dividend payments are cut or suspended to save cash.
The varying assessments of a stock's prospects are reflected throughout the trading day in its fluctuating price. If more people want to own a stock, its price goes up. If fewer people want it, the price falls.
Knowing whether a stock is cheap or expensive is a tricky business. The simplest measure--yet one that has proved quite useful over time--is the so-called price/earnings, or PE, ratio. It represents the current price of a stock divided by what the corporation earned for every share outstanding over the past year.
If the stock is trading at $10 per share and the issuer earned $1 for each share outstanding over the past year, the PE ratio is 10. Over many decades, stocks have traded at a PE ratio of around 15 on average, meaning that investors have been willing to pay $15 for every $1 in net profit the company booked over the previous 12 months.
Google ( GOOG - news - people ) is currently trading at a PE ratio of 28. The reason it's so high is that investors, in aggregate, expect the company's earnings to rise dramatically, as they have the past few years. Union Pacific ( UNP - news - people ), on the other hand, has a price-to-earnings ratio of 10 and is not expected to grow earnings much in the staid railroad business.
When someone bought Amazon at $105 in 1999, the company did not have any earnings at all. Instead, the share price reflected investors' enthusiasm about the prospect for Internet retailers to earn big profits in the future. In retrospect, their hopes were overblown, and the prices of many e-retailers collapsed when that reality hit home.
One way to avoid buying into similar duds is to favor companies that pay dividends. These are payments a business makes out if its earnings on a regular basis (typically once per quarter) to its shareholders. Many highly speculative stocks have no earnings and pay no dividends.
Another reason dividends are important is that they represent roughly half the profits investors have earned on stocks over the long term. Dividend-paying stocks tend to be issued by established companies, like
A company's dividend is measured in terms of its yield. This is the percentage of the stock's current price that you get back through dividends. If you pay $50 for stock in a company that pays investors $2 per share in annual dividends, its yield is 4%. That's as much as you're likely to get these days in a bank savings account or from a highly rated corporate bond. If, instead, you pay $100 for a stock paying $2 a year in dividends, your yield falls to 2%.
If high dividends sound like a good deal, consider a low-cost index fund that specializes in high-dividend stocks. Most are easy to find by screening for mutual funds or ETFs by category, or searching for funds with the word “dividend” in their names. But remember: Other investors know as much about dividends as you do.
In the long run, owning an index fund that invests in the entire market is likely to do just as well as a high-dividend one--and a far sight better than a series of hot stock you bought based on the advice of poker buddies and cocktail-party tipsters.
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