When you are thinking about buying something at a store, how do determine if it is a good price or not?  What if it was a differentiated product that was only sold at one store (no shopping around to just find the cheapest price)?  How would you determine its value?  Obviously, if the product has no use then it is simply a judgment call based on how bad you want it.  But if it has a use you might give the benefit of that use some further thought.

    Lets say you are thinking about buying a new machine to automate a portion of your manufacturing business: You would first attempt to quantify the benefit that machine would provide each year (lets say it would save you $10 a day for the next year) -You have determined what price you would be willing to pay for that benefit.  You would then compare that price with the price tag on the machine to make you decision.  If the machine costs $3,650 you would probably not buy it because it would not be worth the hassle (it only breaks even plus it does not consider the present value of money).  If it were priced at $2,000 you would make the purchase.  This is a basic purchasing decision that happens practically automatically every time you shop.

    How would you apply this method to the stock market?  How do you know what a company is worth?  It probably owns land, buildings, equipment, patents, and who knows what else.  Have you tried to look at a balance sheet to determine what a company's assets are lately?  Probably not, because unless you are a CPA (and on the inside) financials are very difficult to decipher.

    The answer is this:

        Stocks are priced based on the company's earnings.

    After all, if you if you think about it fundamentally; a company's earnings are the reason you are investing in that company.  The assets are only there to help them earn money.  Of course, its stock price will fluctuate based on market factors and the greater fool theory; but at the core of its value is its earnings.  (By the way, you can forget about trying to find a company where their stock price is lower than the value of their assets - these have all been chopped up and sold off already).

    That is why the buzz in the news always has such a focus on each company's earnings reports.  The prediction of a company’s future earnings are perhaps even more important then their current earnings.  You may be following a dot com issue that doesn't even have any earnings or even significant losses on the horizon.  The reason this works is because investors feel that the potential for that company's future earnings is huge.  Most companies though have earnings and the best way to use their earnings to determine price is called the P/E ratio.

P/E Ratio - Price divided by earnings