What's a P/E? (And 9 other 'dumb' questions)

By Michael Brush

It's downright nasty out there. Jobs keep disappearing. Scared consumers have stuffed money under mattresses instead of spending or investing.

We're all getting back to basics like friends, family and frugality. In the market, old hands have been forced to reconsider their basic assumptions, and newer investors wonder whether anything they've learned thus far still holds.

To help sort through the confusion, here are my answers to 10 simple (and not-so-dumb) questions we have to be able to answer before we can move ahead.

1. Should I own stocks?

This may seem like a candidate for Dumb Question of the Year in the midst of a precarious rally following an epic bear market that saw a fall of 50% from its high. But the answer is the same as it has always been: Yes, you should own stocks, assuming you are saving for a long-range goal like retirement or college tuition. Over the long run, stocks do better than other investments.

But here's a good basic rule of thumb: Don't put or keep money in stocks if you need it in less than five years. (Read "When's the right time to invest?" for more on this.)

2. How do I know what a stock is really worth?

In the short term, what a stock is worth is exactly what someone will pay for it today. But that doesn't help you invest for tomorrow.

The value gauge used most often by the pros is the price-earnings ratio. To calculate the ratio, take the current price of a stock and divide it by its earnings for a year. If a stock trades for $50 and is expected to earn $1 a share next year, it trades for a P/E ratio of 50.

Investing guru John Neff counted it as one of the key tools behind the 13.7% average annual returns he produced while he managed the Windsor Fund (VWNDX) from 1964 to 1995.

This ratio tells you whether a stock is cheap, meaning that it trades for a lower P/E than stocks of similar companies. But the biggest insight from the ratio, Neff says, is that it tells you what kind of growth other investors expect. If their expectations are too high, they're willing to pay more, and the P/E ratio will be high.

For example: If one stock trades for a P/E of 50 and another trades for a P/E of 10, it means investors are willing to pay five times as much for a dollar of earnings at the first company. That's usually because they expect earnings to grow much more rapidly at the first company. Neff reasoned that since investors have higher expectations for that stock, it runs a higher risk of crashing if it posts disappointing results, writes John Reese in his recent book "The Guru Investor."

Neff, as a value investor, favored cheap stocks of companies that were so disliked that people wouldn't pay much for them. They had extremely low P/E ratios -- often in the single digits. He knew that bad news wouldn't drive them much lower and that any improvement would drive them much higher.

3. What's a PEG ratio?

So-called growth investors prefer stocks in fast-moving sectors such as technology, which tend to have high P/E ratios because of higher growth expectations.

They compare a company's P/E to its expected growth rate. Generally, a company is considered fairly valued if its P/E is the same as its growth rate. And it's considered cheap if the P/E is below the growth rate. This ratio of P/E to expected growth is called the PEG ratio.

The PEG ratio helped one of the world's most successful investors ever -- Peter Lynch -- produce 29.2% annual growth at Fidelity Investment's Magellan Fund (FMAGX) when he managed it from 1977 to 1990.

4. How much do dividends matter?

Cautious investors love companies that send profits to shareholders. Companies that pay dividends tend to be in more-stable sectors, such as consumer staples or utilities, and they pay investors through good market times and bad. And with so many of us suspicious about Wall Street, dividends are real money you can trust more than forecasts or projections.

• Talk back: What investing basics do you still follow?

When shopping for dividend plays, though, avoid the trap. If dividend yields -- dividend divided by stock price -- are sky-high, it could be because the stock price has tanked or because of some serious problem not yet revealed. Troubled companies eventually cut their dividends. Be suspicious of a yield over 10%. (Read "Stocks that pay you to own them" for more.)

5. Should I buy individual stocks or mutual funds?

These days, some experts say single stocks are simply too risky for most investors. The real answer depends on how much time you have.

If you go with stocks, you're going to need a portfolio of at least a dozen and probably more. A variety keeps you diversified, so that problems in one company or sector won't wipe you out. You also need the time to understand and track those stocks; if you don't, you're speculating, not investing.

Video: What's a P/E, anyway?

Mutual funds let investors pool their resources so that a professional money manager can invest for them. The problem here is that the returns posted by most mutual fund managers trail the market, partly because of their fees. (Read "Are fund managers worth their pay?" for more.)

You also get a tax bill as they buy and sell and, hopefully, collect capital gains.

A solution is to go with index funds that invest in a broad basket of stocks such as the S&P 500 Index ($INX). The fees are lower, and you get the diversification you need. Plus the stocks are traded less often, so the tax burden is usually lower.

Continued: 5 more questions

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