- What is a stock?
- Stock Basics
- Describing a Stock
- The Stock Exchange and the Markets
- The IPO Process
- The Balance Sheet, Income Statement and Cash Flow Statement
- Investing Strategies
- Value Investing
What is a stock?
What is a stock? It might strike the experienced investor as an overly simplistic concept, or the beginner as something too hard to understand. Well, it is actually neither.
In general, there are many types of stocks and shares but we’ll be looking at the type that applies to the ones in the stock market. Those stocks are basically pieces of publicly-traded companies, the keyword here being publicly-traded. When a company is trading publicly, then anyone can buy into it and become a part-owner of the company, thus becoming what we call a shareholder. On the right is a list of the largest publicly traded companies by market capitalization.
As a shareholder, you are a partial owner of the underlying company and have a set of rights, which are called Shareholder Rights.
According to Investopedia, those rights include voting power in major issues, ownership of a portion of a company, the right to transfer ownership and entitlement to dividends, which is something we will look at another lesson, the opportunity to inspect corporate books and records, and the right to sue for wrongful acts.
Something important to know is that the larger amounts of shares that a shareholder owns, the more influence he or she has within the company, so they basically have a greater say in the decision-making process. Shareholders will also attend shareholder meetings where key decisions are made. Stock tickers and symbols. This picture is what a Stock Ticker looks like. A stock ticker is a report of the price of a certain stock.
It is updated throughout the day. A change in the price is called a tick. Stock tickers also display the percentage of gain of a stock. In many cases, whenever a price of a stock is up, the ticker for it will be green. And whenever a stock is down, the color will be red. Even though it rarely happens, if the price is unchanged, the ticker will be gray.
A Stock symbol is a unique set of letters which is assigned to a company when open onthe stock market. It is used to facilitate the vast array of trade orders that pass to the stock market every day. On the bottom right-hand side is a table for some popular company symbols. As you can tell, the symbol of letters chosen do not stray away too much from the actual company name. So for example, Google kept the first four letters, Apple added an extra A and removed the P, Yahoo! removed the A, IBM conveniently chose its own letters, and Facebook just kept the F and B.
An important thing to realize is that some companies open to the stock market earlier than others so they have a greater chance of picking the letters they want. So for example, IBM opened in 1978 when there weren’t as many companies as there are now. So for a company like Apple, they were forced to pick the AAPL because another company named Apple Pete Corp picked APPL before them. And this concludes the lecture on what is the stock market.
How is Money Made with Stocks?
How is money made with a Stock? There are actually two main ways this happens.
The first is through what we call Capital Gains. This term is not only used in the stock market but also in the Bond and Real Estate markets. Capital gains occur whenever the price in the underlying stock increases in value from the original purchase price.
For example, say Joe buys ten shares in Boeing, which has a current stock price of $100 a share, for a total evaluation of $1,000. One month later, Joe checks back on his investment and sees that Boeing stock price is at $130 a share. So Joe decides to sell his shares.
Since the stock price increased $30 or a 30%, he made a $300-profit from it. That $300 profit is what we would call Capital Gain. The same thing would occur in the opposite scenario, except we would call that Capital Loss because Boeing stock price would have plummeted.
Something important to know is that the gain is not realized until the stock is sold. Like everything, when you incur Capital Gains, you have to pay what we call Capital Gains
Tax. This tax varies from country to country. In the United States, individuals, as well as corporations, are subject to Capital Gains Taxes on their annual net Capital Gains. And obviously, if Capital Loss occurs, then you’re exempt from the tax.
The second way of making in the stock market is through Dividends. Dividends are a little harder to understand so we’ll start from a definition. A Dividend is an amount of a company’s profits that the company pays to people who owns stock in the company.
A Dividend occurs when a company distributes a portion of its earnings. This process isdecided by its board of directors. The board will always use Dividend distribution in times of profit in order to attract and keep in investors. It can also be interpreted as a statement which says, “We are a strong company.” The Dividend is also called the DPS or Dividend
Per Share. It can also be quoted in terms of percentage. So, Dividend Yield. In many cases, the more stable the company is, the more Dividends it will offer in order to counteract its low price action movement, basically how it moves up or down. On the other hand, a higher growth company will rarely distribute Dividends so the capital can be reinvested in the company to continue its high growth. Let’s take an example.
Say Joe is in search of another investment after his successful Boeing adventure. A friend who is an investment banker gives him two picks: AT&T or Facebook. AT&T offers what we would call a “fat” 6% dividend yield while Facebook doesn’t offer anything. On the other hand, Facebook is projected to increase 30% in the coming year while AT&T’s projections say it will remain in the same price. Joe faces a tough decision.
It seems as an obvious one, but when looking into it, it becomes harder. Facebook’s projections say it will increase 30% but those are only projections. Nothing is for sure. For all we know, Facebook can plummet another 30%. AT&T provides a solid 6% of the stock price as the Dividend. In this case, what is believed in the investment community is that an older person should invest in the more secure investment while a younger person has the time to risk the capital and take the chance.
Either way, both Capital Gains and Dividends depend on the fortune of the company. Dividends, as the result of the company’s earnings, and Capital Gains, on the investor demand for the stock. So this concludes the lecture of how money is made with a stock.
Describing a Stock
A factor important to the understanding of stocks is learning how they are described. Some of the terms analyzed this lecture will be Market Capitalization, Industries and Sectors, and Cyclical and Secular companies.
Let’s start off with Market Capitalization. You’ll often hear companies refer to as Large-Cap, Mid-Cap, or Small-Cap. All these terms refer to the overall Market Capitalization of a company. This is basically a measure of company size. In other words, it can be described as the dollar value of the company, thus calculated by multiplying the number of shares outstanding by the current market price.
The shares outstanding of a company can be found in any financial website such as Yahoo! or Google Finance, but those are just meant to represent the company’s stock held by all of its shareholders. There’s no specific point in order to qualify a company as being a Large-Cap, Mid-, or Small-Cap but usually, you’ll see a Small-Cap company being valued at less than $1 billion, a Mid-Cap company between $1-5 billion, and Large-Cap, over $5 billion.
Let’s just look at a quick example in order to illustrate the concept. I use Apple stock as an example. Say Apple has a stock price of $500 per share and has 900 million shares outstanding. If you were to multiply both figures, you would find out that it’s Market Capitalization stands at $450 billion, earning it a spot as a Large-Cap company. Larger-Cap companies will tend to be much less vulnerable to the ups and downs of the economy, a large part due to their huge financial reserves.
On the other hand, Small-Cap companies are much more vulnerable to turmoil but can provide for a lot more growth versus Large-Caps. Companies are always divided into Sectors and Industries. A Sector represents a large part of the economy. This can be a Sector from financial to technology companies. Industries, on the other hand, are much more specific and are part of a Sector. For example, banks are in the Industry within the financial sector.
The existence of Sectors and Industries are important to note as they frequently all move together in terms of stock price. And the events in the economy can affect an entire Industry. For example, if there are higher gas prices, the profits of transportation companies would fall, thus causing the company stock price to plummet. Or if an Industry was in the midst of innovation and was the center of attention, much like during the “dot com” bubble, which was a time when investors bought up any tech companies they could finds even though their stock price was worthless.
This resulted in the crash of 2000. An important part of maintaining a healthy portfolio, which means a collection of stocks, is by having stocks that belong to different Sectors and Industries. It is important as if say a stock of one industry were to fall, you would have the downside protection of the other stocks which would belong to different Industries and Sectors. Stocks are also divided into two very important categories: the Seculars and the Cyclicals. The big difference is in the way that they make their profits.
They are for responding to the relative strength and weakness to the economy. Secular stocks make up stocks that people need regardless of the state of the economy. For example, consumer staples, which are basically supermarkets, etcetera, or healthcare, basically, services that people will always use even during a weak economy. Opposite to these are Cyclicals. Sectors and companies that require a strong economy to thrive. Industries such as travel or luxury goods are some of them. During times of economic hardship, they tend to have decreased profits as people try to cut down all their unnecessary expenses.
The three main descriptions of stock discussed in this lecture were Market Capitalization, which is the company’s total value, Sectors and Industries, which are categories in which companies are placed in relation to what they do; and Seculars and Cyclicals, which is related the two different types of companies and how they make their profits. So this concludes this lecture on how stocks are described. Thank you very much.
Types of Stocks
we’ll be looking at different types of Stocks. Many of the things learned today are related to the previously-covered material such as Capital Gains and Dividends. We will also be going through Common and Preferred Stocks as well as their different classes. When you choose to buy a stock, you have the choice of buying two kinds of them: Common or Preferred.
All publicly-traded companies issue Common Stock and some others issue Preferred too. In terms of losses, you could say that Preferred Stock exposes you much less to the risk than Common Stock. On the other hand, it does give you much less potential for total return. Total return basically means the Capital Gains and the Dividends you receive from an investment. When you hold Common Stock, you will definitely feel the ups and downs of the company as their shared price would rise or fall continuously.
They reflect the investor demand and the state of the markets. There are also no price ceilings so their share price could possibly triple, but also lose that value. It is possible that the issuer of the Common Stock pay Dividends but is not required to do so. And if it were to, the Dividends wouldn’t be guaranteed. A company could even cut or eliminate the Dividends, though it would be a rare scenario as it would send the wrong message about the company’s financial health. When you’re a holder of Preferred Stock, you’re usually guaranteed the Dividend payments.
More importantly, the Dividend is paid out before the Dividends of the Common Stockholders. Unlike Common Stock, the price of Preferred Stock doesn’t move as much though. Something interesting to look at is when a company goes bust or bankrupt. In that scenario, the priority and obligations go first to the Preferred Stockholder before the Common Stockholder. In a very basic way, you could say that if you are in search of Capital Gains, then you should go for a Common Stock. But if you prefer Dividends, then Preferred Stock is for you.
Let’s illustrate everything. So Joe is back for Round 3. He’s got his eye on Apple this time. He decided whether he should buy its Common Stock or Preferred Stock. Joe is around 50 and he’s looking for a stock that he can hold until his late 80’s. In this case, since he’s willing to buy and hold to a stock for so long, it would be recommended that he go for the Common Stock as he will experience a larger gain through his capital gains. Buying Preferred Stock would apply more to him if he weren’t 60 years old and he was looking to live off passive income, as we call it, which is basically Dividends.
There’s another classification of Stock. In addition to the choice of Common or Preferred Stock, some companies may offer a choice of publicly-traded Share Classes. These classes are designated by letters of the alphabet, usually A and B. A company may offer a Class of Stock which is reserved for one of its divisions, like another company it might have acquired. In another case, a company might issue different Stock Classes and have them trade the different prices and have different Dividend policies.
When a company has dual Share Classes, it’s more common for one share class to be trading publicly while the other one is non-trading. Non-traded shares are usually kept for the company founders and management. Those shares are kept under tight restrictions from being sold and they tend to have what is called Super-Voting Power.
This way it makes it possible for insiders to own less than half of the total company shares, yet control the outcome of issues that are Preferred shareholder vote. For example, a decision to sell the company. In order to recap everything, Common Stocks have to do more with Capital Gains and because of that, tend to have much more risk than their Preferred counterpart. Preferred Stock is more in relation with Dividends and is consequently a much safer investment with limited upside. Stock Classes are just the classification of stocks and are used differently according to the company. So this concludes this lecture, I hope you enjoyed
Why do Stock Prices Move?
So what makes the stock price change. The answer to this question can be as simple. Or as complicated as one wishes it to be. The most basic level stock prices move as a result of what we call market forces. Market forces is the word used to describe supply and demand. So a stock will move depending on its demand versus supply. If more people want to buy a stock which is the demand then sell it which is the supply the price will move higher.
But on the other hand, if more people want to sell a stock than buy It’s there will be greater supply and demand. Consequently, the price will fall. As William O’Neill, a very famous stockbroker said it takes big demand to move supplier and the largest source of demand for stocks is by far the institutional buyer one of the major investors in the market X exert tremendous influence overstock prices. So those are institutions such as mutual funds pension funds banks etc. they exert the force due to the sheer size of their orders on a stock. These large transactions tend to drive prices up or down depending on the degree of buying or selling. How can you tell if people are buying or selling the stock.
Well there is this metric called Boim the why of stock basically tells you the number of shares being traded during a period of time. Therefore a large increase in volume percentage can indicates increasing demand from those institutional investors.
This is followed by increasing share prices. Keep in mind that institutional investors aren’t the only ones who can make stock prices change. Regular investors can’t too. It’s just that it would take more investors to deploy the same amount of capital as institutional investors do. Understanding supply and demand is easy. Where it gets a little more complicated though is fairing out why people like or dislike a particular stock.
The reason why it is so difficult to understand is because every investor has his or her own strategy which should be executed. But all in all this comes down to figuring out what use is positive or negative for company. The principal theory is that price movement of stock indicates what investors feel and companies’ worth. If you remember from a few lectures back that is market capitalization. To further complicate things the stock price doesn’t only reflect the company’s current value but also reflects the growth that investors are expecting in the future. By far the worst affected companies for you are earnings. Publicly training companies are required to report their earnings four times a year once each quarter. Since most of those companies report them during the same time investors call those periods earning seasons.
Investors watch company earnings with a lot of attention. If a company’s results are better than expected the stock price will drop. But if the company’s results disappoints the price will sink. Obviously earnings aren’t the only way that public sentiment can change concerning the stock. A famous example is the 2000 dot.com bubble when dozens of Internet companies rose to have huge market capitalizations without making the smallest profit. As you might already know the valuations did not hold in those companies.
Other stock prices plunge and valuations shrink. The fact that prices moved that much shows that there are many other factors besides earnings that can influence a stock. So in conclusion what makes the price change. Well no one really knows for sure. Some think that it is impossible to predict how prices will change while others use different strategies to figure out the next move which is what we will be looking at in the next lecture.
The most important concepts to grasp from this video are number one. Stock prices are fundamentally driven by supply and demand which in a way you can look at it as public sentiments. Number two is that in theory earnings are what effect the valuation of a company. But there are other ways. Investors used to predict stock prices but something important to remember is that investors sentiments and expectations are what ultimately affect the stock price.
The Stock Exchange and the Markets
We will be looking in the Stock Exchange where nearly everything stock-related happens. I say nearly because recently, being a huge shift to online investing without the actual use of the physical exchange. We will come to that later. We will also be looking at the different types of markets: the primary, the secondary, and the OTC or over the counter markets.
The Stock Exchange is an exchange for stockbrokers and traders that trade stocks. The function of an exchange is to insure fair and orderly trading as well as the dissemination of price information of any stock on the exchange. The exchange gives companies a platform to sell their stock to the investing public. In order to trade a stock, it must be listed in the exchange. They’re usually used to be a central location for record-keeping but it is currently becoming less linked to a physical place as markets are now electronic networks which then gives the advantage of the speed and reduced cost for transactions.
The trading of the exchange only happens with members, some brokers and dealers basically. When a company chooses to go public, they go through an IPO which stands for Initial Public Offering. This process is done in the primary markets. The Primary Market is the market that issues new stocks on the exchange. It is facilitated by what is called an underlying group, which is basically an investment bank that sets the beginning price for the stock and sells it to the investors. Once the IPO is done, the actual trading of the stock happens in the secondary market, which is the stock market. In addition to the primary and secondary markets, there are also the third and fourth markets.
They aren’t as important because they don’t concern individual investor, all they do is make market transactions between brokers and dealers as well as large institutions through what we call the OTC market. The OTC market is a decentralized market which means that it doesn’t have a central location. The transactions occur through various communication modes such as through the telephone or by email. OTC markets are much less transparent and are subject to a few regulations. Let’s take a look at the history of the exchange.
The first real company that issued shares was the East India Company. The shares were issued on paper so investors could then sell the paper to other investors. At that point though, which was during the 1600s, there was no real stock exchange in existence so investors would have to track down a broker to make a trade. In London though, brokers and investors would meet and do business in coffee shops. The first stock exchange in London was created in 1773, 19 years before the New York Stock Exchange. At that time though, the London Stock Exchange was forbid to deal stocks while the New York Stock Exchange could from the very start. The New York Stock Exchange actually has a rather interesting history. It was formed by brokers that used to deal under a Buttonwood tree, which was located on Wall Street.
The reason why it grew to be the most powerful exchange was because of its location. It was in the heart of all business and trade coming and going from the United States as well as the base for most banks and corporations. Back in Europe, London Stock Exchange emerged as the leading exchange in Europe. Exchanges are located all around the globe, with some of them more famous ones, being at the New York stock exchange, the NASDAQ, and the Tokyo Stock Exchange.
The New York Stock Exchange is primarily auction-based, with specialists being physically present on the exchange trading floor. Each of this specialists specializes in a particular stock, buying and selling it in the auction. There is an ongoing rivalry between the specialists and the electronic-only exchangers that claim to be more efficient because they are able to execute trades much faster by eliminating human intermediaries.
The NASDAQ is another large exchange in the US. It is an electronic exchange and sometimes called screen-based because buyers and sellers are connected only by computers. To sum up everything, we looked at how exchanges work as well as their history. We also looked at the functions of the primary, secondary, and OTC markets.
The IPO Process
The initial public offering, or IPO, takes place in the primary market and basically occurs when a company chooses to list itself on the stock market. To become a good investor, its necessary for us to explore how and why this takes place. Any company that is created and incorporated is initially a private company, meaning that it is completely controlled by a group of owners.
The reason why it is considered private and not public is that no other owner can come in and buy a stake in the company unless there is a special agreement. At the same time, no shares are traded on the stock exchange. On the other hand, a public company simply means that it trades on the exchange. Lets use Twitter as an example of an IPO. Twitter was founded in 2006 by a group of computer scientists. Over time, Twitter has become one of the largest social networks, rivaling Facebook and Instagram. After growing to over a 200 million active users, the owners of the company were faced with an important decision, to go public or remain private.
They ended up opting to go public in September of 2013 in one of the biggest IPOs on the New York Stock Exchange. There are a couple of characteristics of a public company, or a company that has chosen to list itself on the stock market. The first is that the company is listed on a stock exchange, whether it be the New York stock exchange, like Twitter chose to do, or the NASDAQ. Another vital characteristic is that a public company can be owned by thousands if not millions of different people, all of whom become shareholders.
This means that the previous owners lose some control of the company, since anyone, whether it be you or me, can buy shares in the company. So, typically whats the purpose of an IPO? Why would the owners of Twitter want anyone to become a part owner? Well companies typically choose to go public for many reasons. Probably the most significant is to raise capital. Companies can raise tons of money if they choose to get listed on a stock exchange. Twitter itself planned to raise over $1 billion dollars through its IPO. Businesses need to raise capital if they want to expand their operations. In Twitter’s case, they need data centers to ensure information from tweets gets stored.
Those data centers can be very expensive and cost up to $50 or $100 million. So their two only options to fund that investment is to either raise debt or equity. Debt basically means taking a loan from a bank and equity means issuing shares in the company and allowing other people to become shareholders. The advantage of equity over debt is that equity does not have to be paid back. When you take a loan, you are obliged to pay back the amount you borrowed with interest. With equity however, someone can invest in your company and own shares, which hopefully will increase in value. People who bought shares in Twitter at the initial price of $26 dollars made a 70% return if they held to the end of the day. So how does this impact you? Well as we just saw from Twitter, IPOs can sometimes present great buying opportunities.
The biggest issue that an average investor can face when trying to invest in an IPO is actually getting a hold of shares to buy. Since its become so competitive, priority is given to large institutional clients such as mutual funds or big investment firms. Nevertheless, depending on the broker you choose to use, which we will talk about in another lesson, IPOs might be available to you. Another point to remember about public companies is that they are required by law to report all financial information, whether it be revenue, expenditures or assets, to the public. So if you’re a prospective investor, its your duty to take a look at these results to understand how a company operates and determine whether it would make a good investment.
To sum things up, there are many reasons a private company will choose to go public. Raising money is probably the most important one. When Twitter went public in 2013, the share price opened at $26 and ended the day at $44. Anyone who bought shares at $26 made over 70% return in a single day. So not only did it benefit the investors who become shareholders but it also benefited the company, which raised over $1 billion dollars. That said, the IPO process is not all roses.
There are a few issues a company has to deal with. A big one is that the owners lose some control of the company and they become accountable to shareholders. This is the reason why public companies are meant to report all financial results to the Securities and exchange commission, whose website anyone can access. So if you’re a shareholder or potential investor, it is in your benefit to check up on the results of a company to verify if it is a truly worthwhile investment. So, that’s all for the Initial Public Offering.
The Balance Sheet, Income Statement and Cash Flow Statement
At the basis of investing is having the ability to read through a company’s financial reports. I’ll be honest with you and say that you’ll probably not find this part too interesting, but it turns out this is probably the most important part. Knowing the ins and outs of financial statements is actually what distinguishes great investors from mediocre ones.
I’ll try to simplify things and leave out some of the more complicated terminology. So, lets dive in. As we talked about in the IPO lesson, every public company is required by law to report and disclose its financial information to the public. In the United States, all the information is available on the Securities and Exchanges’ website. The Securities and Exchange Commission, or SEC, is the main organisation charged with regulating the financial markets.
They’re kind of like a financial police, and they aim to make investing as fair as possible. As you can guess, to make informed investment decisions, you’ll ideally need to go through the material a company publishes to really get a grasp of what it does and how it performs financially. Financial reports might seem incredibly complicated but it turns out they are relatively simple if you understand their overall structure and some of the more complicated words they use.
The important thing for you to remember is that every financial filing is split into three key sections, the balance sheet, the income statement and the cash flow statement. So let’s start with the Balance Sheet. This basically consists of assets and liabilities, and applies to companies as much as they apply to us personally. Anything that has value is an asset. Whether it’s a computer, a house, clothes or a book. A liability, on the other hand, is a debt or obligation.
This can include your credit card bills or student loans. When you subtract liabilities from assets, you will get your personal net worth, which are the net assets. Your personal net worth is just as important as the net worth of a company. However, investors typically never refer to a company’s assets minus liabilities as net worth, and they instead use a fancy word called shareholder’s equity. A balance sheet is important for many reasons. It can give an investor an easy look at how a company manages its finances.
To illustrate the example, let’s look at a company called Banana Motors Production run by a CEO named Steve. Banana Motors is a startup automobile manufacturer. To better understand the situation, lets dig into the details of Banana Motors’ balance sheet starting with its assets. Something you’ll notice in every financial statement for any company is how there are two columns with figures, in this case 2015 and 2014.
This is mainly done by the company to help investors look at how a firm progresses over time and year by year. Assets are split into three main categories, current assets, other assets and property. All these add up to the total assets. Current assets are anything that are valuable and can be converted to cash quickly and within 1 year. Obviously cash is the most important current asset, but there are also other things, like marketable securities, which can be shares the company owns and that can be sold immediately for cash as well as inventories, so the two cars Steve built. Adding them up would give you $500,000 dollars, Banana Motors’ total assets for 2015.
When comparing the company’s performance to the previous year, you’ll notice that its assets have shrunk year-to-year. To find out why, look no further than the inventories, where you’ll see that the value has fallen from 300,000 to 200,000 dollars. From that we can figure out that Steve sold one of his cars for 100,000 dollars. At the same time, we see that cash has gone up by 50,000, so we can tell that Steve kept half of what he made from the sale of the car and spent the other half.
Now lets take a look at the company’s liabilities. Liabilities are split under three key sections, current liabilities, long term liabilities, and deferred income taxes. Current liabilities are the same as current assets except while current assets provide value within a year, current liabilities are obligations that have to be paid within a year. So while one adds, the other subtracts. Current liabilities are made up of accounts payable, which are things Banana Motors still has to pay for, like tires that is used for the cars, payroll, which is the salary Steve pays his employees, as well as taxes, which are pretty self-explanatory.
Total liabilities have increased by 5,000 dollars due to a rise in short-term expenses. So why are large liabilities bad for a company? Well in Banana Motors’ case, the firm is very limited in what it can and can’t do. Its like if you personally took a loan to buy a house, so a mortgage. If you had to make consistent payments back to the bank, you wouldn’t have the freedom to for example switch to a nicer but less safe job. A lot of debt restricts people and companies alike and prevents them from expanding, not to mention that too much debt decreases profits.
The last part of a balance sheet is actually shareholder’s equity but through our discussion we will cover this. Alright so lets review Banana Motors’s balance sheet. As assets have gone down, liabilities have moved slightly year over year, which is negative for the business. That said, given how large assets are relative to liabilities, it shouldn’t be anything to worry about in the short term. As long as Steve is able to keep up production, he should continue to thrive. Let’s move on to the next section.
The income statement is the second part of a financial filing and contains two key metrics for an investor: revenues and expenses. While the balance sheet is a measure of the company’s overall strength, the income statement gives an investor a better understanding of how the company is receiving and spending the money it has. The revenues of a business are what it takes in and the expenditures are what is taken out, so costs. If you want to figure out whether the company can grow in the future, this is where you’ll get that information.
The income statement also indicates one of the most important measures for an investor, earnings. As we have already talked about several times, at the end of the day, its all about earnings, and especially earnings growth. A stock cannot advance without the underlying business earning more money. In the income statement, earnings are listed as net income. To illustrate the income statement let’s use a pizza restaurant chain called PizzaLand. Please do keep in mind however that each of the three parts of the financial statement is interrelated.
The revenue part is pretty simple. The company generated 500,000 dollars through its stores, which is 100,000 dollars more than the year prior. Expenses are listed as operating costs and expenses and comprise of restaurant-related expenses as well as general administrative and selling expenses. As we can directly see, there’s been an increase of 100,000 dollars between 2014 and 2015, meaning that as revenues move up, so do expenses.
This is certainly not a positive but is what happens to many businesses. In this case we see most of the money is going towards employee payments, or payroll. A solution to this is to pay employees a constant amount. Last but not least there’s the income. As you can see, there’s a difference between operating income and net income. Amongst other things, net income takes into account the taxes a business pays. In this case pizzaland pays 50% in combined taxes and interest which leaves it with 50,000 in net income.
The real negative about Pizzaland’s financial position is really that it is seeing no growth in net income. Someone like Warren Buffet or Peter Lynch would want to invest in a stable company that increases its profits over time. In this case, this is not happening. At the same time, if the management of the company can solve the issues of increasing labor costs, then net income will increase significantly. Only then would it prove to be a solid investment.
The last part of a financial statement is the cash flow statement. And it is split into three main parts, cash flow from operating activities, investing activities and financing activities. Overall cash from operating activities is what is taken in and cash from investing and financing is what is taken out. Let’s take a look at the cash flow statements using another company called BlueBerry Computers, which is a computer manufacturer. First off is the cash from operating activities.
At the top we see net income, followed by the two main categories of cash provided by operations, charges and credits and changes in working capital. Charges and credits includes things like depreciation, which is how the value of an asset decreases. Companies can write off a portion of that decline for tax purposes, which in turn increases their net income. Next are the changes in working capital. Accounts receivable are what the company is owed and accounts payable are what the company still owes.
Here we can see that cash decreases since someone owes 50,000 dollars to blueberry computers. Something really really important to note is that in accounting, whenever a negative number is expressed, we always use brackets. So the 50,000 is in fact negative. As we said earlier, cash flow from investing typically takes out money from a business, which is why the figures are negative.
Capital expenditures refers to investments made on machinery for the business, in this case automatic assembly lines to produce the computers. Investing is essential to keep a business up to date. Finally, cash flow from financing refers to how a business actually finances, or funds, its activities. As we looked at the lecture on IPOs, businesses raise capital either by issuing debt or by issuing shares. Overall, BlueBerry has seen an increase of 30,000 in cash outflows from financing from 2014.
Overall BlueBerry Computers’ cash flow statement proves that the business is stable and running smoothly. Though net income is staying flat, the business is investing more money for future growth, which is surely a positive. Certainly we would need to look at Blueberry’s balance sheet and income statement to determine its worthiness as an investment but based solely on its cash flow you could expect that it would pay a large dividend but wouldn’t see much growth in share price. To sum things up, the balance sheet, income statement and cash flow statement are all incredibly important and show different parts of a business’ financials.
While the balance sheet showcases what a business has, through its assets and liabilities, the income statement focuses on how it spends its money, through revenues and expenses. Finally the cash flow statement shows how money moves in and out of the business. The ideal company would sport many financial features, including high net income growth, a high level of assets relative to liabilities as well as a high degree of cash inflows. These are the types of businesses worth looking into as an investor.
Fundamental vs. Technical Analysis
In Trading and Investing, there are many different types of strategies that market participants employ. In this lecture, we’ll be looking at some of the larger and most important types. The two main types of Investing are Fundamental and Technical Analysis. We’ll be starting off with Fundamental. Fundamental Analysis is extremely broad.
You could say that Fundamental Analysis is the cornerstone of Investing. The biggest part of Fundamental Analysis involves delving into company financial statements and looking at different aspects of a company such as the revenue, assets, expenses, liabilities, et cetera. This is most definitely geared towards the mathematical side of trading. It involves a wide range of calculations to figure out stock prices in the future.
According to Investopedia, Fundamental Analysis is a technique that helps determine a securities value, by focusing on underlying factors that affect a company’s actual business and its future prospects. Fundamental Analysis can be performed on industries or the economy as a whole. So as opposed to Technical Analysis, which we will be looking at after, which involves analyzing based on price movements, Fundamental Analysis goes beyond that and looks at the overall well-being of a company.
Some questions a Fundamental Analyst might ask are
Is the company’s revenue growing?
Is it making profit?
Is it able to repay its debts?
How does it compare to industry competitors?
Those are some of the few, but basically you would look at whether the company stock is a good investment. So the intrinsic value.
Fundamental is based on the concept that the price of the stock does not fully reflect its real value. In the financial world, that real value is called the Intrinsic Value. So let’s take a small example. Say Microsoft is trading at $28 per share
After much analysis, you figure out that its intrinsic value, how much it’s really worth, stands at $34 per share. That is 21% higher than its Current Value.
In the eyes of the Fundamental Analyst, that presents a great buying opportunity, as the stock would be called undervalued. In the opposite case where the current price is $34, but you find out that it’s actually worth $28, you would say that it’s overvalued.
The largest assumption in Fundamental Analysis is that in the long run, the stock will alwaysreflect the fundamentals. But no one really knows how long the long run is.
It could be a period of days or even years. So that is what Fundamental Analysis is really about. By focusing on a company or the economy, an investor can determine its Intrinsic Value and find opportunities to buy or sell. If all goes as planned, the investment should pay off over time as the market catches up to the fundamentals.
On the other side of fundamental analysis is Technical Analysis. Unlike Fundamental Analysis, Technical Analysts, or Technicians as we would call them, don’t care about the value of the company or the company as a whole. All they really care about is the price movements in the market. They employ lots of fancy and exotic tools to study the supply and demand in the market in order to attempt to determine the direction or trend in the future. Another way of describing them is that they try to understand the emotions of the market by studying the market itself, as opposed to its components like Fundamental analysts do.
Technicians evaluate stocks by analyzing the statistics generated by market activities, such as prices and volume. They do not attempt to measure the Intrinsic Value but instead use charts and tools to figure out the pattern.
Technical Analysis is based on three assumptions.
#1. Market discounts everything.
#2. Price moves in trends.
#3. History tends to repeat itself.
Technical analysts only consider price movements and ignore the fundamental factors of a company.
The reason for this is that technicians assume that at any given time, a stock price reflects everything that has or could affect the company, including the fundamental factors.
They believe that the company’s fundamentals, as well as market psychology, are priced into the stock. Therefore, there is no need to analyze the company itself.
Technicians believe in a concept called the efficient market hypothesis, which states that stock market efficiency reflects and incorporates all relevant information in a stock price. So it basically goes against what Fundamental Analysts believe in. In Technical Analysis, stock price movements are said to move in trends.
That means thatwhen a trend has been located, the future price will move in the same direction as the trend. The last important idea of Technical Analysis is that history repeats itself.
The “repetitivity” is due to market psychology. Market participants tend to provide a consistent reaction to similar market activities. Technicians use chart patterns to analyze market movements and understand trends.
Technical versus Fundamental analysis. In a way, you could say that it’s like comparing financial statements versus charts. A Fundamental Analyst tries to determine the intrinsic value of a company by looking at its statements and determining whether it is over- or undervalued.
Technicians believe analyzing a company’s financial statements is redundant as it is all accounted for in the stock price. Therefore, they place the efficient market hypothesis at the top of their beliefs. Usually, Fundamental Analysis is used when you’re looking towards the long-term in a stock while technical analysis is used for short-term trading.
Even though they might seem contrary to each other, they can still both co-exist. It can actually give the trader or investor a higher chance of success as he or she can analyze both the long and short term of a stock.
At the end of the day, making money in the stock market depends entirely on your investment strategy.
By now we have looked at some of the greatest investors of all time and how they were able to generate high returns, and we’ve also had the opportunity to explore financial statements and discuss why they are important.
Now we are going to tie everything in by looking at one of the most popular ways of investing, value investing.
As we talked about with Buffett, value investing involves looking for undervalued stocks whose prices are cheap relative to what they are actually worth.
The most important tool a value investor can have is time.
If you don’t invest time and effort into looking for companies, you won’t reap the benefits.
Here’s Warren Buffett speaking to a group of Columbia Business School students and talking about the importance of investing time to do your research.
Let’s recap what Buffet and other value investors look for: The first trait is that the company should be simple and easy to understand.
We’ve talked about this many times but it’s something you can’t forget if you plan on doing well.
A good example of this is that Buffett himself missed out on the tech bubble of 2000 as he didn’t understand technology companies.
As you probably know, by 2001, many of those tech company lost over 70% of their share prices while others went bankrupt. You should look for companies with a strong brand image.
Businesses like coca cola or McDonalds are known across the world and have a stable customer base.
These are the types of companies that are deemed safer than the average and that can present tremendous value.
Next is to look at earnings.
Again, Coke and McDonalds have seen increasing earnings over a long period of time, which is what fueled their stock prices to move higher.
Last but not least is management.
The reason why management is so important is that whoever leads the company also determines how it will perform financially.
A good CEO can make a business prosper during an entire lifetime and can even rescue a company during tougher times.
Just remember, when you invest in a business, you are also investing in the management team.
Alright so how do you determine whether a company is overvalued or undervalued.
There are two main ways to do this: either by relative or absolute valuation.
For the purposes of this video, we will focus on relative value.
Basically, relative valuation involves comparing a company to its competitors in the same industry and we mainly do this using ratios.
There are many metrics you can apply but one of the most important ones is the price to earnings ratio, or PE ratio.
You get the figure by dividing price by earnings.
The rule of thumb is that the higher the PE ratio compared to competitors in the same industry, the more overvalued the stock is, while the lower the ratio, the more undervalued it is.
Let’s say Apple is trading at a PE of 20, which we get by dividing the stock price of $200 by earnings of $10 per share.
On its own, we can’t really understand its value but if we compare it to Microsoft, whose PE is 25, we can determine that Apple is undervalued relative to its peer.
Another important metric is the Price to Book ratio.
In general, book value is a rough estimate of how much a company is worth.
The abbreviation for this is P/B and is calculated by dividing price over book value.
If Apple’s PB is 14 and Microsoft’s is 16, Apple is undervalued in terms of book value relative to Microsoft.
Finally, the last crucial metric that I like to look at is the debt to equity ratio.
As we saw from some of the legendary investors, they warn against investing in companies that carry too much debt, so businesses that have taken out lots of loans.
The debt to equity ratio looks at the amount of debt in relation to a company’s shareholder equity, which if you remember is calculated by subtracting liabilities from assets, and is the net worth of a company.
The lower the ratio, the better.
If Apple has a debt to equity ratio of 0.31 and Microsoft is at 0.33, then Apple is more
attractive as it carries less debt.
Now let’s look at another way of figuring out value.
This one’s a little bit more tricky and can be incredibly complex, so I’ll simplify it as much as possible.
Remember how we talked about the intrinsic value of a stock?
If you don’t remember, the intrinsic value is the true value of a stock and value investors try to buy when the current market price is below the intrinsic price.
Right now we’ll try to figure out a form of intrinsic price for Apple using random numbers.
Let’s say Apple sells 100 million products per year at an average price of $1000 each, making $100 billion in sales.
To make those 100 million products, they have to spend $800 dollars which are the costs.
This means they are personally making $200 per device, so $20 billion.
Obviously, Apple is a business and businesses want to grow.
Let’s say that Apple sells 5% additional product each year at the price of $1000.
So next year they make $22 billion, and the year after they make $24.2 billion.
For the next 39-40 years, we predict they will make 337.5 billion.
If you divide that by the total number of shares, we get a value of $55 dollars per share.
That is the intrinsic price.
If we were to say the current market price is $40, that represents upside of 37.5%.
This means that Apple is undervalued.
As you can see, the most important factor for a business is growth and growth in earnings.
if a business can consistently grow its profits, higher stock prices will follow.
That’s pretty much it for value investing.
If you’re just starting out, I advise you focus on relative valuation and figuring out how a company compares to competitors in the industry.
Its not only an easy way of valuing a business but it can give you a very precise indication
of what investors are willing to pay for peers in the industry.
Absolute valuation is also very useful but at the same time much more complex, and requires you to forecast free cash flow and determine things like the weighted average cost of capital.
These are things that you will learn with time and as you look at more companies.
In the end, as Warren Buffett himself said, only by investing time in your research, will you be able to do well as an investor.
The Next Steps
Congratulations on completing Stock Market Investing for Beginners! You should be very proud of yourself.
There are many directions you can take from here and it varies according to your interest in finance.
Have a read of a real financial report. Don’t worry if you don’t understand everything. Most of this stuff comes with time and experience. Just know that you are well on your way as it is.
Word of advice: financecompanies should become your best friend from here on out.
First of all, I suggest you begin by opening a virtual investing account (for free) through financecompanies‘s stock simulator. Here is the link: financecompanies Stock Simulator Link. Begin experimenting by buying and selling different stocks. Over time, you’ll start to notice that some will perform better than others. Your job will be to figure out why this is going and determine a correct investing strategy for you. Do you prefer value investing like Warren Buffet and Benjamin Graham, growth investing like Philip Fisher or a mix of both like Peter Lynch? The key here is to understand your taste as every strategy requires a different approach.
Keep up with the news! This is very important if you want to keep up with the investment world. Again, financecompanies will be your friend here. Ta! Da!