Stock in a company represents the ownership of a corporation indicated by shares of the company, which represent a piece of the corporation's assets and earnings. A corporation is a company that is registered as a unique entity with a state’s corporation commission.
A corporation can either be a private of public corporation. The vast majority of corporations are small private corporations, such as a local restaurant or dry cleaners. From an investment perspective, we are mainly concerned with public companies. These are corporations that have had a public offering of its stock and are traded on a public stock exchange, such as the New York Stock Exchange or American Stock Exchange.
In this discussion on stocks, we will cover the following:
· Stock value
· Buying and selling short
· Types of stocks
· The US markets
· The Securities and Exchange Commission
· Share price indices
· Researching Stocks
· Charting Stocks
· Stock Splits
When most people think of investing, the first thing that comes to mind is buying stock. A share of stock, or equity, reflects a share of ownership in a company. For example, if XYZ company has 100 shares outstanding and you own five shares, therefore you own five percent of the company.
Online Resources: Sources of Stock Valuation Data and Analysis
· Value Line
· Yahoo Finance
The price of a company's stock reflects the company's current worth and how investors expect the company to perform in the future. The price an investor pays for a share of a widely held company is set by the millions of buyers and sellers in the market. The price is set at the dollar amount where buyers won't pay a higher price and sellers won't accept a lower one.
The price fluctuations of a company's stock reflect the success of the company, the industry, and the overall economy. Because corporate growth drives economic growth, there is a direct relationship between the aggregate stock market performance and the overall growth of the economy. And since changes in inflation, risk and the level of interest rates affects the overall economy, these variable also affect the prices investors are willing to pay for shares of stocks.
In buying stock, the objective is usually very simple – investors expect the share price to increase. Therefore, investors typically want to buy stocks that they feel are under-valued – that is where the market price is below what the investor feels is the stock’s intrinsic value. The investor then hopes that the price of the stock will increase to reflect the stock’s value, as estimated by the investor.
Investors that are concerned with a stock’s value are known as fundamental investors. That is, investors that are concerned with a stock’s fundamentals.
There are probably as many techniques for valuing stocks as there are investors. Later in this Chapter, we will look at these techniques in a little more detail.
When investors buy stock, they take ownership in a company. To buy stock, investors generally buy stock through a stock broker and need to open up a brokerage account. The notion of stock brokers have changed significantly over the past decade. It used to be that the vast majority of investors would purchase stocks through a full service stock broker. Their account would be run by one individual who would call if they needed to make a trade, needed to withdraw money from their account, or their financial position changed such that their investment objectives changed. In addition, the full service stock broker will proactively call their client if they feel that a change is needed to the investor’s portfolio. But since stock brokers are paid based on a commission each time they buy or sell shares of stock for a client, all too often stock brokers may call the client simply to make additional commission income for the stock broker.
With the expansion of the internet, individual investors now have access to a vast amount of stock data and research that was previously only available to stock brokers and professional investors. As a result, discount brokers have become increasingly popular. Individual investors can buy and sell stock through a discount broker at a fraction of the cost of using a full service broker.
In the table below, we outline some of the major differences between full service and discount brokers:
Full Service Broker
Investors do not recognize a gain on their investment until they sell the shares that they hold. For example, let's say you bought a stock five months ago and the price was thirty dollars then and it is now fifty-five dollars. You made twenty-five dollars on the stock (before taxes), but until you sell the shares you hold, the gains you have earned are referred to as paper profits or an unrealized gain. In other words, you have made money on paper but you have no more money to spend than you would if your stock holding had fallen.
But like buying a stock through either a full service or discount broker, you have to sell your shares through a broker. You will be charged a commission to sell your shares.
In addition to simply buying stock, you can use your brokerage account to either enhance a bullish strategy or even make money during a bear market. If you are particularly bullish on a particular investment, you can not only use the available cash in your brokerage account to buy shares of that stock, you can also borrow money from your brokerage account to buy additional shares. This is called “going long” or “buying on margin”. The broker will charge you interest on the funds you have borrowed.
Buying on margin is only recommended for experienced investors. This strategy should be used with caution since the price of the shares could decline after you have borrowed money to purchase those shares. Depending on the specifics of your margin account agreement with your brokerage firm, if the share prices fall such that your level of debt rises to your account maximum, the brokerage firm will issue a margin call. This means that you will need to either add funds to your account and/or sell the shares in your account to cover your account’s losses.
Short selling is a bearish strategy. Investors "sell short" when they expect the price of the security to drop in value. In practice, short selling is a four-step process:
In this example, investor now buys shares of ExpectToDecline for twenty dollars and returns them to the lender and earns ten dollars (thirty dollars - twenty dollars) on the short sale transaction (excludes transaction costs).
Like buying on margin, short selling is a technique that should only be employed by experienced investors. If the price of the stock increases, you will need to sell the shares that you have borrowed at a higher price. This will result in a loss, where you may need to add additional funds to your account to cover the losses.
In the investment industry, the study of stock charts is called technical analysis, while the study of financial statements and all the other aspects of a company's business is called fundamental analysis. Many people use fundamental analysis to decide what to buy and technical analysis to decide when to buy.
The discussion below is by no means intended to be a thorough discussion on stock analysis. It is just to give you a flavor of what is involved in stock analysis and a starting point for additional research.
There are two major aspects of conducting fundamental analysis, quantitative and qualitative. The quantitative analysis focuses on the company's financial performance such as revenues and earnings. Fundamental stock analysts use this financial data to evaluate the stock. Qualitative analysis is often used to feed the quantitative data. Quantitative data assesses the quality of the company's products, the company's marketing advantage, and how effective management is in leading the company into the future.
Many new investors are lured by a company's "story," based solely on qualitative data. But it's important to remember that in the end, financial considerations are what determine share prices and good fundamental analysis is based on solid financial data..
Online Resources: Sources of Fundamental Analysis Data and Tools
Following are some key fundamental data to analyze:
This tells how expensive a stock is in relation to its earnings. Fortunately, you don't have to calculate it yourself because it's usually part of the stock quotation. The P/E ratio is the share price divided by the company's earnings per share. For example, if XYZ is trading at $20 and has earnings of $1 per share, its P/E ratio is 20. If QRS is trading at $60 and has earnings of $2 per share, its P/E ratio is 30. By comparing the two P/E ratios, you see that QRS is the more expensive stock in relation to its earnings.
Now, it may be that the reason the market has placed such a high value on QRS shares is that the company's earnings are growing very rapidly. In this case, its high P/E ratio would be justified because the company could be expected to "grow into" its stock price. So another way to evaluate two growth companies is to divide the P/E ratio by the earnings growth rate. This gives you the PEG ratio. If XYZ's P/E ratio is 20 and its earnings are growing at a 15% rate, its PEG ratio would be 1.33 (20 / 15). If QRS' P/E ratio is 30 and its earnings are growing by 25%, its PEG ratio would be 1.2 (30 / 25). By this measure, QRS is the less expensive stock.
For companies that don’t yet have earnings and are operating at a loss, calculating a P/E ratio can be problematic. Although dot-com implosion has encouraged investors to shy away from companies without earnings, it is still possible to find a solid company that is operating at a loss. For those companies, they are generally re-investing every dollar of revenue to build the company. In this case, analysts look at sales, also called total revenues. The price-to-sales ratio is the stock price divided by sales per share and tells how expensive the stock is in relation to its sales.
As you know, stock prices move up and down as they trade on the open market. One day a stock will close at $25 per share. The next day it will close at $26.50. The day after that it may close at $26. One way to instantly see a stock's trading history is to look at its chart. Stock charts show in a graph each day's closing price so that you can get a picture of how a stock has been trading over a period of time.
Online Resources: Sources of Technical Analysis Tools
Stock charts can be interpreted in many different ways. Some people-called "technicians" in the industry-find all kinds of patterns when analyzing stock charts. They then use these patterns in an attempt to predict where a stock will trade in the future. The theory behind technical analysis is that market participants can be expected to behave a certain way based on recent market activity. For example, if a stock jumps several points on high volume (i.e., many shares exchanging hands in one day), it is assumed that for a time, new investors will notice the activity, and continued demand will drive the price even higher. Then at some point the price will get so high that demand slackens and the price drops back to a more normal trading range.
For most investors who are not day traders, the 50-day moving average line is the most important part of the chart. It essentially smoothes out the daily ups and downs and shows at a glance whether the stock is in an uptrend or a downtrend. A favorable time to buy is when a stock is in an uptrend-but not if it's recently been through a buying mania as described above. In that case, wait until the stock settles back down. If you see that a stock on your buy list is in a clear downtrend, it may mean the stock has further to fall. Proceed with caution and wait for the moving average line to turn up before buying.
Stocks can be classified in several disparate ways. Although all stocks are purchased the same way, different stocks represent different risk/return profiles. It's important to have a basic understanding of each.
· Large Company Stocks
· Small Company Stocks
· Value Stocks
· Growth Stocks
· Income Producing Stocks
· American Depository Receipts (ADR's)
Large capitalization or “large caps” are stocks of those companies with the largest market capitalizations (outstanding value) usually quantified as greater than $1 billion. Large caps tend to be less volatile than their smaller counterparts and are widely held by both individuals and institutions. Shares of large firms, which hold dominant positions within their industries, are often called "blue-chip" stocks. Some of these include American Express, Procter & Gamble, General Motors, and Walt Disney. The Dow Jones Industrial Average (DJIA) is an index of blue-chip industrial companies that is often used as a proxy of the overall market. In other words, if someone asks: "How's the market today?" a common response would be to quote the change in the DJIA - "market's up forty-five points" - which would usually mean the DJIA is up forty-five points.
Small caps represent those companies that tend to be younger and have small market capitalizations. These equities tend to be more volatile and less liquid than the large caps. The Russell 2000 is an index that is made up of 2000 small cap stocks.
In theory, value stocks provide investors with good value for their money. Value stocks are stocks whose market price is perceived by the investors to be below the intrinsic value of the company. Investors buy value stocks hoping to get a bargain on a stock that will go up over time.
In traditional fundamental analysis, a companies intrinsic value is the net present value of the company’s future stream of earnings. In other words, what is the value, after adjusting for the cost of capital and inflation, of the company based on how much money you expect the company to make over time. One of the most famous value investors is Warren Buffet – the second wealthiest person in the United States.
Although there are fairly complicated formulas used by investors to estimate a company’s value, an easy way to compare the value of companies is to compare companies’ P/E ratios. Stocks with low P/E ratios relative to either their peers or the overall market are classified as valued stocks. Investors who focus on value stocks tend to favor stocks with low P/E's that are expected to increase with time.
Growth Stock refers to companies that tend to have rapidly growing earnings. In order to grow, they re-invest their profits and pay little or no dividends. In terms of their P/E ratios, they are often more expensive than value stocks, but do offer investors a higher potential return.
One of the most famous growth investors is Fidelity Investments’ Peter Lynch. He coined the phrase “growth at a reasonable price.” He combined the use of the P/E ratio in conjunction with earnings growth, the price-earnings-growth ratio as described above.
Rather than re-invest their earnings in the company's operations, some companies elect to pay out a portion of earnings as dividends to shareholders. Such firms are usually past the stage of rapid growth and do not need to reinvest the cash.
Although dividends have been typically been associated with less high-tech industries such as automobile manufacturing and utilities, technology companies, such as Microsoft have began to pay a dividend in 2003. As a result of both the dividend tax cut in 2003 and Microsoft’s desire to shore up investor confidence and to set it apart from the rest of the beleaguered technology sector, Microsoft decided to pay an 8 cents per share annual dividend.
American Depository Receipts, or ADR's, are a way that shares of foreign companies listed on foreign stock exchanges can be traded in dollar denominated securities and in bearer form in the US domestic market. The price of the ADR is adjusted for the exchange rate movement and closely parallels the price of the underlying shares in their respective domestic market.
Although Initial Public Offerings, or IPOs, are have been somewhat scarce since 1999, there was a time when IPOs were a daily occurrence. An IPO takes place when a company issues shares to the investing public for the first time for the purpose of raising capital. The existing company's owners sell a portion of the corporation to investors in the form of common stock. Such a sale raises money for the company and/or its owners.
In practice, the IPO process is fairly standard. The company hires an investment bank (e.g., Merrill Lynch or Goldman Sachs) to manage the IPO process and "underwrite" the stock offering. The underwriter's job is to complete the due diligence on the company and then lead the process of selling the shares to both institutional and individual investors. The company files an S-1 registration statement with the SEC (Securities and Exchange Commission) and this document is later presented to investors as a way for them to evaluate an investment in the company. Investors express their interest in purchasing shares of the company and the underwriter uses these indications of interest to set the offering price at which the shares will be sold to the public. Usually, underwriters set the price at a level that provides the company the necessary capital but also gives investors upside on their investments.
When a company's stock price gets so high that new investors may be discouraged from buying it, the company will often split the stock in order to bring the price of each individual share down to a reasonable buying range.
For example, a stock trading at $150 per share may seem expensive to new buyers. So the company may announce a two-for-one stock split to bring the price down to $75. When a stock splits two for one, everybody who owns stock on the split effective date gets the same number of shares they had previously held, doubling their holdings. However, the value doesn't change because each share is now worth half as much. Investors who hold their stocks in a brokerage account will see the new shares on their next statement. Investors who hold stock certificates will receive in the mail a certificate for the additional shares.
A stock split is the equivalent of swapping a dime for two nickels. It shouldn't affect the company's overall value. However, the market tends to react positively to stock splits. The main cause for optimism is that with the stock now more reasonably priced, more investors will want to buy it, and this renewed demand can be expected to drive up the price of the stock.
Not all stock splits are two-for-one. Some are three-for-one. Some are three-for-two. Sometimes a company will even announce a reverse split. This happens when the stock price has sunk so low that the company wants to boost it higher to convey the perception of respectability. In this case, it will announce a reverse split, say a one-for-two split, where existing shareholders will end up with half as many shares, each worth twice as much.
Most shares of stock are traded on one of two distinctly different markets: organized securities exchange markets (stock exchanges) and over-the-counter markets (OTC).
The largest, and most well known US market exchange is the New York Stock Exchange (NYSE), which is also known as the Big Board. Registered as a national securities exchange with the U.S. Securities and Exchange Commission on October 1, 1934, the NYSE is an actual, physical place where transactions take place.
Prices are determined by specialists who are assigned specific stocks and work on the actual trading floor. Their job is to maintain a fair, competitive, orderly, and efficient market.
All firms with stocks trading on the NYSE are subject to stringent registration and disclosure requirements. Additionally, once listed on the NYSE, companies are required to comply with ongoing reporting requirements. While these requirements are costly to a company, the marketing benefits and prestige of being listed on the NYSE usually outweighs the costs.
The best known electronic market is the NASDAQ. As opposed to the NYSE, the NASDAQ is not an actual place, but an electronic network over which transactions are conducted. Prices are determined by negotiation (bid and asked prices) rather than by a specialist as is found on the organized exchanges.
The SEC controls all securities exchanges. It is an authority that was founded by the US government following the Securities Act of 1933 and the Wall Street crash in 1929. In order to protect investors, the SEC has established guidelines for all securities exchanges. These include:
Online Resources: Securities and Exchange Commission
· Securities Act of 1933: http://www.law.uc.edu/CCL/sldtoc.html
· Invetment Company Act of 1940: http://www.law.uc.edu/CCL/sldtoc.html
· Securities and Exchange Commission: http://www.sec.gov
There are a number of indices that track the US equity markets. These indices are a proxy for the direction for the overall stock market. Many of these indices are reported in the daily financial press.
In addition, these indices are very helpful in analyzing a mutual fund’s performance and in analyzing which mutual funds to purchase. We will discuss more on how to use stock market indices in mutual fund analysis and selection in Chapter 6. The most common are:
· Dow Jones Index (^DJX: http://finance.yahoo.com/q?s=^DJX&d=t )
· Standard and Poors (S&P) 500 Index (^SPX: http://finance.yahoo.com/q?s=^SPX&d=t )
· New York Stock Exchange (NYSE, ^NYA: http://finance.yahoo.com/q?s=^NYA&d=t )
· NASDAQ (^IXIC: http://finance.yahoo.com/q?s=^IXIC&d=t )
There are four Dow Jones Averages:
· Dow Jones Industrial Average (DJIA, (^DJX: http://finance.yahoo.com/q?s=^DJX&d=t ) --one of the most frequently quoted indices in the world. It is the simple average of price movements of thirty large manufacturing companies.
· Transportation average (^DTX: http://finance.yahoo.com/q?s=^DTX&d=t ) -- The transportation average is the average of the price movements of the twenty transport companies.
· Utility average (^LDU: http://finance.yahoo.com/q?s=^LDU&d=t )-- The utility average is the average of price movements of fifteen utility companies.
Online Resources: Share Price Graphs and Component Companies
· Dow Jones Industrial Average Graph: http://finance.yahoo.com/q/bc?s=^DJI&t=5y&l=on&z=m&q=l&c=
· Dow Jones Industrial Average Stocks: http://finance.yahoo.com/q/cp?s=^DJI
· S&P 500 Graph: http://finance.yahoo.com/q/bc?s=^SPX&t=5y&l=on&z=m&q=l&c=
· S&P 500 Stocks: http://finance.yahoo.com/q/cp?s=^SPX
· New York Stock Exchange Graph: http://finance.yahoo.com/q/bc?s=^nyx&t=5y&l=on&z=m&q=l&c=
· NASDAQ Graph: http://finance.yahoo.com/q/bc?s=^IXIC&t=5y&l=on&z=m&q=l&c=
This index differs from the DJIA in that the companies within the index are weighted by their market value. In other words, the larger the company, the greater it affects the index. The index is considered a broader, more representative measure of the US market than the DJIA. Like the Dow Jones Indices, there are additional S&P Indices:
· Standard & Poor’s 500 Index (^SPX: http://finance.yahoo.com/q?s=^SPX&d=t )
· S&P 600 SMALLCAP (^SML: http://finance.yahoo.com/q?s=^SML&d=t )
· S&P HEALTHCARE (^HCX: http://finance.yahoo.com/q?s=^HCX&d=t )
126.96.36.199 New York Stock Exchange Composite (NYSE, ^NYA)
( http://finance.yahoo.com/q?s=^NYA&d=t )
This is an index that covers all common stocks traded on the New York Stock exchange. Like the S & P500, it is weighted by market value.
Due to the recent popularity of technology stocks, the tech-heavy NASDAQ composite is quickly becoming one of the most well followed indices. There are a wide variety of NASDAQ indices, measuring the performance of shares traded in the over-the-counter market. These indices are weighted average share prices of companies within specified sectors and are posted, and updated, regularly.