Knowing These 3 Basics of the Stock Market Will Make You a Better Investor

For the average investor, the stock market can seem somewhat mysterious. Trying to understand what makes it go up, down or why some stocks are more likely to result in dividends takes a little education.

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While there are complexities and nuances to stock market returns, the simplest way to understand them are three key “segments” that work together to make a stock worthwhile to purchase. Read on to learn what they are and how to use them to your advantage when investing.

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Earnings Growth

Warren Buffett, the “Oracle of Omaha” renowned not only for being a billionaire but for having savvy investing strategies, is known for investing only in those companies that he understands how they make money. He looks for evidence that they will continue to earn a profit reliably and steadily over time.

This is because Buffett understands the first principle of “earnings growth” which is that when you buy a stock, you’re essentially reaping a small percentage of the company’s profits. So, if a company seems poised to keep growing and boosting its earnings, that’s a good sign that you will benefit; there’s often a direct correlation between increased earnings and increased stock price (or value).

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Price-to-Earnings Ratio

There are other ways of valuing a company’s stock that aren’t related directly to its current price or the company’s current earnings. A lot of stock value is related to future earnings.

First, you have what’s known as a price-to-earnings ratio (P/E), a simple formula where you divide the stock price by its earnings per share. So a $50 stock with a $2 share price has a P/E of 25.

If a bunch of investors have great confidence in a stock, however, then demand can actually drive up the stock price as investors essentially overbid on the stock, driving up its P/E.

The thing is, this is not something you can do by guessing or a gut feeling. You need to compare a stock’s P/E with its past average and compare its earnings to similar companies. Because a stock can be undervalued or overvalued. If something seems off, you might reconsider your investment or wait for the price to drop.

Dividend Payouts

The sweet spot in investing in the stock market is to find those companies that pay dividends, or a “dividend yield.” These come from companies that earn enough “extra” profits that they can pay some of them back to shareholders annually. The dividend yield is arrived at by taking the annual cash overage for payout and dividing it per share, by the share price. So, a $10 stock yielding a 20-cent annual dividend would have a 2% yield. If you put that 20 cents back into your original investment, giving you $10.20, you’ve made a 2% return. Dividend paying stocks tend to come from those companies with a solid track record, those with stability, strong market capitalization and often name recognition.

By understanding these three key elements of stock market investing, you have more than a good first step at growing your investment.

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This article originally appeared on GOBankingRates.com: Knowing These 3 Basics of the Stock Market Will Make You a Better Investor