Investing 102: Pick a stock and buy it

By Harry Domash

In "Investing 101: Buy your first stock or fund," I helped new investors get started by explaining a few of the basics about buying your first mutual fund. This week, I'll look at what is probably a more difficult mission: buying your first stock.

One of the first things to understand about buying stocks is that what you buy is in some ways a function of who you are. If you're an optimist, growth investing might be for you. Long on patience? Value investing may be the better fit.

Individual investors generally fall into one of three categories: growth investors, value investors or dividend investors.

Growth

A stock's price often reflects how profitable investors think a company will be in the future. So most investors follow a growth strategy, which means that they look for companies with strong prospects for growing their sales and earnings. Definitions vary, but stocks expected to increase their sales (and their net income) from one year to the next by at least 15% generally qualify as growth stocks.

Here’s a link to an article describing how to pick growth stocks. Here’s a link to the screen described in that article for finding growth candidates.

Value

Value investors follow a different path. They believe that the broader stock market always overreacts to news about a company. They seek out formerly hot stocks that have stumbled and whose share prices are at bargain levels.

Being cheap, though, isn't enough by itself. Value investors try to zero in on stocks that were beaten down due to temporary problems that can be fixed. Here’s a link to an article describing how to pick value stocks. Here’s a link to the screen described in that article for finding value candidates.

Dividends

Dividend investors buy stocks that pay a cash dividend based on the number of shares you own, usually on a quarterly basis. Unlike value and growth investors, who only make money when they sell, dividend investors get paid while they hold the stock.

Thus, dividend investors buy stocks as much for the income as they do for capital appreciation (which is what you get when you sell a stock at a higher price than you paid for it). Dividend investors look for financially solid companies with the wherewithal to continue paying their dividends, regardless of what's happening in the economy.

Here’s a link to a screen for finding dividend stocks.

Putting a price on a stock

How do you know whether a stock is a value or priced for growth? Most investors rely on certain ratios that compare a stock's price to the underlying company's results.

The most commonly used valuation ratios are:

• Price-to-earnings (P/E): This is a company's stock price divided by how much it earns per share over 12 months (expressed as earnings-per-share, or EPS). Most often, the EPS used is the most recent 12 months' earnings. Another way to calculate P/E is by using the consensus of Wall Street analysts' forecasts for a company's earnings in the current fiscal year. P/E is the most widely used valuation gauge.

• Price-to-sales (P/S): A company's stock price divided by the most recent 12 months' sales-per-share. Some investors favor P/S over P/E because sales don’t vary as much as earnings from quarter to quarter. Another advantage is that you can calculate P/S, but not P/E, when a company loses money in a quarterly or annual reporting period.

• Price-to-book (P/B): Also called book value, this is a company's assets minus its liabilities. A P/B ratio divides a company's stock price by its book value per share. Value investors tend to favor P/B.

There is no universal agreement on ratio values that define value or growth. Here’s my simplified take.

Defining value and growth
Ratio	Value	Growth	Overpriced Growth
P/E	Less than 15	More than 20	More than 50
P/S	Less than 2.5	More than 3	More than 10
P/B	Less than 3	More than 5	More than 15

Stocks with valuations in the gaps between the value and growth definitions -- say, a P/E of 18 and a P/B of 4 -- could be in either category, depending on the circumstances. Valuations in the Overpriced Growth column define stocks that many investors would consider overpriced.

Your research doesn't end with these ratios. Figuring out whether a stock is worth buying is another task. A stock may be a value in terms of price, but its price may be depressed because something is seriously wrong. These ratios can help you understand whether a company's shares are cheap or expensive. If they are cheap, and you've done your work trying to find out why, then they may be attractive as a buy.

Making your trade

There are three basics ways to trade stocks: buys, sells and short sales. Here's a quick look at each:

• A buy is an order to buy a specified number of shares, either at the best price the broker can get at the time you enter the order (a market order), or a specified maximum price (a limit order). If you place a market order, your purchase is usually executed within a few seconds. If you place a limit order, the order may not be processed if no seller is willing to sell at your specified price. Limit orders usually have a predetermined expiration date. If not filled, the order remains open until it expires.

• A buy limit order is useful for preventing you from overpaying for a fast-moving stock. For instance, say the last time you looked, the stock you want was going for $25 per share. But big news has hit the wires and now the stock is starting to move. By setting a limit of, say, $27 per share, you can avoid overpaying.

• A sell is an order to sell shares that you own, either at the current market price (market order), or at a specified minimum price (limit order). As with buy limit orders, a sell limit order will only be executed if a buyer wants to pay your specified price.

• A sell stop is an order to sell a stock if it drops below a specified price. You can use sell stops to minimize your losses when you make a mistake. For instance, say you buy a stock at $40 and, instead of going up, it heads down. A sell stop at $36 would convert to a market sell if your stock hits that price, which, in most cases, would limit your loss to 10%. However, setting a sell stop doesn’t guarantee that you will get that price. Bad news could hit, for example, and the stock might open for trading on a given day at $30 -- after closing a $40 the day before. In that instance, you would only get $30 for your shares, even though you had set a $36 sell stop.

• A short sale is an order to sell a stock that you don’t own. Short-selling involves borrowing shares from your broker and selling those borrowed shares in the hope that the price will drop, and you will be able to replace the borrowed shares by buying them at the lower price. Selling short requires that you have a margin (credit) account with your broker.

Submitting your order

Entering a buy or sell transaction is straightforward with most online stockbrokers once you've opened an account. Generally, all that’s required is the ticker symbol, the number of shares you want to trade and a decision whether you want to trade at the market price or want to specify limits.

Your broker will respond with the company's name and current bid (the price current buyers are willing to pay) and ask (sellers are requesting) price. If you confirm your trade, you will probably pay between the bid and ask.

This is the time to slow it down. You can make costly mistakes at this point. Confirm that the company name corresponds to the stock you really want to buy or sell. Make sure that you didn’t type 1,000 shares when you really meant 100 shares.

Harry Domash, alas, does not hold or control a position in Google, the only stock mentioned in this column.

Domash publishes the Winning Investing stock and mutual fund advisory newsletter and writes the online investing column for the San Francisco Chronicle. Harry has two investing books out, the most recent being "Fire Your Stock Analyst," published by Financial Times Prentice Hall.