UNDERSTANDING THE STOCK MARKET'S TERMINOLOGY: MARKET CAPITALIZATION AND PRICE-TO-EARNINGS (P/E) RATIO

Basically, a company’s worth its total value in the stock market is called "Market Capitalization" and it is represented by its stock price. To put it in a simple term, Market Cap (Market Capitalization) is equivalent to the stock price multiplied by the number of shares outstanding or being traded.

For example, a stock with a $5 stock price and 10 million shares outstanding/being traded is worth $50 million ($5 x 10 million). If we take this one step further, we can see that if a company that has a $10 stock price and one million shares outstanding (the market cap = $10 million), then the company is worth less than the one with a $5 stock price and 10 million shares outstanding (market cap = $50 million). Thus, the stock price is a relative and proportional value of a company’s worth and only represents percentage changes in market cap at any given point in time. However, any percentage changes in a stock price will result in an equal percentage change in a company’s value. This is the reason why investors are so concerned with stock prices and any changes that may occur even if it is just a $0.10 drop in a $5 stock can result in a $100,000 loss for shareholders with one million shares.

Aside from market capitalization, one way to determine the value of a company’s business is with the Price-to-Earnings Ratio or the so-called "P/E" Ratio. The price-earnings ratio (P/E) can be calculated as "Market Value per Share (Stock Price) / Earnings per Share". For example, let’s say that a company is currently trading at $43 a share and its earnings over the last 12 months were $1.95 per share. The P/E ratio for the stock could then be calculated as $43/$1.95 (Stock Price / Earnings per Share) or about 22x (22 times). In essence, the price-earnings ratio indicates how many years an investor has to wait at the current earnings to get all their money back. If the P/E ratio is 22x, it will take you 22 years for the company to earn how much you bought the stock for $43. In general, a high P/E suggests that investors are expecting higher earnings growth in the future compared to the ones with a lower P/E. And a low P/E can indicate either a company may currently be undervalued or the company’s profits are expected to decline.

Perhaps, there are some rules of thumb when you think of the P/E (Price-to-Earnings) Ratio as the price you pay for a stock:

1. The average P/E over the past decade is 15x. An average company should be worth about 15x.

2. The typical great companies with very high returns and consistent earnings growth tend to trade about 20-25x P/E, while bad companies or the ones whose earnings are unpredictable and make low returns usually trade at below 10x P/E.

3. A company should trade at about the P/E as its earnings are expected to grow in the future. For example, companies with growing profits 30% per year may be justified to trade at 30x P/E while the ones with not growing may trade at 5-10x P/E.

Overall, below here is a quick chart to measure what P/E Ratio should be so that you will have a better understanding of the above rules of thumb which has already been explained.