A Beginner's Guide to the Stock Market

by Matthew R. Kratter

The single most important decision in evaluating a business is pricing power. If you've got the power to raise prices without losing business to a competitor, you've got a very good business. And if you have to have a prayer session before raising the price by 10 percent, then you've got a terrible business.

P/E is a company’s “price to earnings ratio.” Let's say that a company's stock trades for $100 and that the company has earnings per share (EPS) of $6.50 over the last 12 months. We can calculate a trailing ("last 12 months") P/E ratio for that stock by simply dividing the stock price ("P") by the EPS ("E"), so 100/6.50 equals about 15.

Companies that are growing their revenues or earnings quickly ("growth stocks") tend to have P/E's above 25. So, for example, today Microsoft has a P/E of 27.70 and Amazon has a P/E of 79.

Companies that are in trouble often have P/E's below 10.

Until you become an advanced investor, don't ever buy a stock with a P/E of 10 or less.

When the P/E of a company hits a 5-year low, many analysts will recommend the stock as a "cheap stock." Unfortunately, there is a very real tendency for cheap stocks to get even cheaper.

Paying a cheap price for a stock that is going to zero is never a good deal. We call these situations "value traps." They look like good values, but they turn out to be traps.

A growth stock is simply the stock of any company that is expected to rapidly grow its revenues or earnings.

Great companies that are rapidly growing will always trade at high P/E's.

Value investors will always tell you to stay away from companies with high P/E's or companies that are losing money. But if you do that, you will miss out on some of the greatest stock runs of all time. Microsoft, Starbucks, Home Depot, and Amazon all traded at very high P/E's for many years. Amazon still does.

Companies with high P/E's are pricing in high growth in future earnings. If it looks like growth is slowing or that those earnings may never appear, the market will trash the stock. That’s why we always trade growth stocks with a clear stop loss.

If you are Warren Buffett investing in a mature company, the P/E does matter. If you are holding a growth stock for a few weeks or even months, nothing could matter less than the P/E.

I like to buy growth stocks that are hitting new 52-week highs, or even all-time new highs.

If you study the greatest growth stocks of the past, you will begin to notice that they spend a lot of time trading at all-time new highs. This makes sense simply because any stock that goes up a lot must (almost by definition) spend a lot of time trading at new highs.

At a new all-time high, everyone who owns the stock has a profit.

Meanwhile, a stock that has recently moved up a lot begins to be featured on CNBC and discussed by online commentators. This publicity brings in a new wave of buyers, who continue to drive the stock higher and make it hit even more new all-time highs.

I like to call these "rocket stocks." One way to find them is to constantly scour the list of stocks at 52-week highs or new all-time highs,

This is a chart of The Trade Desk (TTD). The upper line is the 50-day moving average, and the lower line is the 200-day moving average. When a stock looks like this, you know that it is in an uptrend.

Never buy a growth stock if the stock is trading below its 200-day moving average, or if the 50-day moving average is trading below the 200-day moving average.