Before investing in stocks, you should know the functioning of the stock market. This article will serve as the beginner’s guide for stock market investing.
“Rule No.1: Never lose money.
Rule No.2: Never forget rule No.1.”
– Warren Buffett
A quick and efficient way of making money is through investment in stocks, provided you understand the business. The stock market is a crucial financial institution, which fulfills the need of capital that businesses are looking for, while letting investors profit as shareholders in companies, creating a win-win platform for both, investors and businesses.
However, making money on the stock market is another ball-game altogether. Trading stocks requires a substantial amount of study and understanding, before you put your hard-earned money on the line and begin making profits. The following article attempts to give an insight into the working of the stock market and what stock investing for dummies entails.
Stock Market Essentials
When asked what the stock market will do, J.P. Morgan replied, “It will fluctuate.”
The word stock is synonymous with the stock markets, trading, brokering and the often confusing terminology that accompanies it. One is often at a loss to explain the meaning of certain financial terms, necessary for any successful attempt at taming the stock market. For investors new to the stock market, knowing what these financial terms imply, can be the fine line between success and failure.
What are stocks
Rather than giving a detailed definition of this basic unit of trading, let’s take a look at a small example of how stocks are created. It will also be a lesson on what they are and how they function.
An entrepreneur finds an unexploited niche of the economy, an area where there is latent demand and can be fulfilled by launching certain products. To go about this, he needs to establish a company which will produce, market and sell this product. However, before he realizes his dream of becoming the next Rockefeller, he must answer a very basic question- Does he have the money to do these things? The answer, in most cases, will be in the negative.
How then does one go about raising money, or more formally, raising capital? The easiest, safest and quickest way to do this is to offer the public a stake in his enterprise, a small portion of holding for which they shall pay a particular sum. This holding is known as stock, the unit of which is a share. One may hold stocks in IBM, but buy a hundred shares of Exxon.
The entrepreneur now has sufficient money to buy equipment, rent space, hire workers, run an assembly line and market his revolutionary product. The shareholders – the people who purchased stock in his company – have limited exposure to risk, only to the extent of their holdings, if the venture suddenly folds.
A company goes public or becomes a joint-stock company, when it sells a part of its equity holding to raise capital, through an IPO (Initial Public Offering). The stocks are sold at a fixed value in this initial sale, after which they can be traded on the secondary market, which is the stock market. The price of shares depends upon several things, the company’s profitability being one of the prime factors.
If our entrepreneur can make decent profits from the word go, the price of his stock shall increase as people compete to purchase the same number of shares, however, if he runs into losses, the price will go down.
Stocks can be of the following types:
Types of Stocks
Preference stockholders are granted privileges over and above that of common stockholders. They are distributed dividend before the common stockholders, and also hold a higher claim when it comes to asset distribution, in event of the liquidation of the company.
This is the equity that a company offers its stockholders as ownership. The common stockholders have voting rights and are invited to the annual general meetings of the corporation. They can vote for selection of management and receive dividends from the payouts of the company’s profits.
Other investment vehicles
When a financial instrument derives its value from the price of the stocks that support it, it’s called a stock derivative. Most often the underlying stock is an index, which fluctuates with time, changing the values of the derivatives. The most common types of derivatives are futures and options.
Companies and governments often issue bonds to meet their working capital requirements. These bonds are issued as a form of loan, the purchaser is the lender and the issuer is the borrower. There is a fixed rate of interest to be paid on bonds and the full amount is redeemed at the end of the maturity period. The US Government issues several bonds such as US Savings Bonds, US Treasury Bills and US Treasury Notes.
“I never attempt to make money on the stock market. I buy on the assumption that they could close the market the next day and not reopen it for five years.”
– Warren Buffett
After an IPO has been made, a company’s stocks can trade on the stock exchange. A stock exchange is like a market for stocks and traders. It is a place where people willing to buy stocks meet those willing to sell them, and speculation in future prices and profits is what drives the trade. Stock trading these days is usually undertaken by stockbrokers on behalf of traders, who buy and sell shares according to market conditions.
With the advent of the Internet in the business sphere, the virtual trading terminal has become the accepted norm of stock investing. Here, traders working on computer terminals bid through computers within a network, and provide investors with online accounts to buy and sell stocks. One does not need to go to the stock market to know the stock prices and quotes, it can be done from the home or the office with the help of a laptop and an Internet connection.
Every stock market has an Index, which is based on statistical calculations and gives an idea about how listed stocks are performing. Examples are Dow Jones, NASDAQ and the S&P 500. The value of the index is calculated through the performance of a bunch of blue-chip benchmark stocks. Stock exchanges may have specific requirements for companies who want to list their stocks on them.
A highly recommended guide on stock investing is the book The Intelligent Investor, by Benjamin Graham, a venerable Wall Street master, whose students include the legendary financier Warren Buffett.
Let’s look at a few stock market terms.
Stocks can be bought on the stock exchange with the help of a broker, or they may be purchased directly from the company. Most stockbrokers are listed with the stock exchange, giving them the authority to buy stocks on behalf of a trader, however one can purchase a company’s stocks directly as well.
One may buy stocks against money already owned, or it can be arranged through a margin purchase, when a trader purchases stock against the value of those very stocks. Stocks can be purchased when their prices are low, so as to make a profit when prices rise, or they can be purchased at a premium when there is speculation that the company, or even the economy in general is experiencing phenomenal growth and the prices will rise further.
Selling is much the same as purchasing, except that one may have to pay the capital gains taxes on the proceeds earned by the way of sales, if these come within the limits of the taxation law. Selling can be done when the seller is anticipating further losses or maybe when the prices have reached a peak, from which there is a chance of a decline, and the seller wants to short-sell to make a good profit.
Traders gather and communicate their individual stock quotes on the exchange floor, a process called bidding where the stock price changes with every bid and stops only when a bid is singled out as the highest. Traders aim to Buy stock cheap and sell dear, to make profits for their investors and themselves.
Another question most beginners come up with is, how are these stock prices determined? A stock exchange is the perfect example of the Law of Demand and Supply in action. At any given point in time, the total number of shares on offer, called float, is in equilibrium with the total demand, the number of shares traders wish to buy. This is what the term market capitalization refers to, the demand and supply equilibrium of any corporation listed on the stock exchange, the total value of the company’s stock at that point in time.
Investing for Beginners: Planning your Investments
“One of the funny things about the stock market is that every time one person buys, another sells, and both think they are astute.”
– William Feather
Now that you have a basic idea of what the stock market is all about, we can move on to the next step, knowing how to go about investing. Although one can commission a stock broker to undertake trading on one’s behalf, if you are going the solo route to investing, it’s always better to be armed with the latest information and the tools and techniques of investment analysis.
Once you have decided the amount of money you are willing to invest, it is time to make a comparative analysis of some popular stock options. One can go for the traditional blue-chip companies, which provide regular dividend and maintain a good share pricing, the nexus of software, oil and manufacturing, or try a selection of smaller companies with lower stock prices and market capitalizations, but functioning in areas of the economy which are headed for a boom.
It is important to identify companies that have a reliable consumer base and are market leaders, they face healthy competition yet innovate to stay on top of their game. Whatever your ultimate decision may be, it can be helpful to take a look for the following characteristics, in a company you have targeted for investment.
Is it a Brand?
GM, Coke, McDonald’s and Apple are some of the giants of their respective industries, companies which play the market on the strength of their brand names and the loyalty of their customers. Pricing and marketing is relatively easier for these companies as they have huge capital reserves, and as a result, their stock prices too, tend to be high.
The advantage of investing with these companies is that they are stable organizations with a global reach and their stock price fluctuations tend to be less, also, they provide good dividend income.
Does it possess economies of scale?
Large corporations like Walmart, Dell and Lego operate all over the world. They have achieved certain competitive advantages in production which allow them to reduce prices and secures them a large chunk of the demand. Such advantages are known as economies of scale and allow the companies to create profits from the sheer volume of sales they generate.
China is an example of an international economy working on this principle to capture large swathes of the global consumer demand. It is not just large companies which have competitive advantages, even smaller firms, such as the Solo Paper Cup Company have achieved these economies. Investing in such companies reduces risk to a great extent as they have global exposure and won’t tank up anytime soon.
Does it sell?
A company with a dedicated consumer base, will tend to weather the storms of economic uncertainty much better than one that cannot hold its customers for too long. Much of this depends upon the type of products it has to offer, a company like Walmart sells everything under the sun, but so do Target and Marks & Spencer, however, the customers of BMW swear by it and will not go for any other car brand. It is important to invest in a diverse range of companies, so as to spread risk and create buffers for your investments.
How heavy is the competition?
An industry with too many players can be a difficult one to invest in, as a beginner may not understand which companies are bound to do well and which fail in the long run. Sectors like software, food and consumer durables are filled with several large, medium and small cap companies which have their own niches and markets. Investing in such companies calls for extensive analysis and a constant monitoring of investments.
Differentiating between price and value
This is probably the most important factor when one considers investing in stocks. There is often a marked difference between the price at which a share might trade and the value that is actually has. Stock value is an amalgamation of several factors which are more micro-economic and related to the company rather than to outside variables.
They can be along these lines:
- Profits over time, past present and speculated.
- Sales volume.
- Credit ratings by reliable agencies.
- Current competitors and future probables.
The price of stocks, on the other hand, are influenced by the law of demand and supply operating on the exchange floor, during the session of trading. A number of buyers and sellers come together and agree on a specific price, which in turn may be hugely inflated or deflated depending on the current economic conditions and general mood of the investing community. This may be due to several macro factors such as:
- National and international news
- Economic forecasts
- Scandals or scams
One must be careful while buying or selling stocks and take into account not just the price of the stocks but also their value, which may often be completely at odds with each other. Trading sense is often overtaken by herd behavior, when a rumor or irrational speculation pushes or lowers prices of the stocks in a drastic manner.
“In the business world, the rearview mirror is always clearer than the windshield.”
– Warren Buffett
All talk and no work makes Jack a poor chap. We have been discussing some theoretical concepts thus far in our attempt at making some sense of the stock market, it’s time we looked at some actual valuation techniques used in the real world to gauge the potential of a company, and the value of is stock.
Stock valuation is the method used to calculate values for company stock, and thereby predict a movement in these values, or in the short term, the stock prices, so as to profit from the change. Stocks considered undervalued – whose true value has not yet been recognized by the larger market – are purchased, and the overvalued ones are sold, in the anticipation of a drop in prices.
There are several mathematical techniques of stock valuation, let us discuss some of them.
Discounted Cash Flow technique
The most popular and frequently used method of valuation is the DCF or the Discounted Cash Flow technique of stock valuation. Like the name suggests, this method discounts the future cash flow expected from an investment and presents it in terms of their present values.
When taken in totality, the future total outflow and inflow of cash is termed as the Net Present Value (NPV) of the investment. It is based on the principle of Time Value of Money, considering the simple fact that a particular sum of money in the future is not of the same value as the same amount in the present, accounting for the interest it accumulates over time.
DCF = CF1/(1+r)1 + CF2/(1+r)2 + CF3/(1+r)3 …+ Cfn/(1+r)n
CF1, CF2, CF3 are cash flows in the 3 years under consideration
CFn = cash flow in n number of years
r = internal rate of return
The formula might look intimidating but only as far as it is not understood. In simple terms, the formula tries to approximate the cash generated by the investment in the stocks of a company with regards to the time-frame. The element of risk undertaken by the investor is factored in (also called internal rate of return or r), this is the rate at which he would have been compensated had he chosen to invest the same sum in a different instrument, such as a Treasury bond. The amount is then discounted in reverse, to its value in today’s dollars.
Earnings Per Share (EPS)
Another very popular method of valuation of company stock is the Earnings per share formula, which gives you the net income of a company in relation to every unit of stock it holds.
The simplest way to calculate this is to divide the net income of a company during a given period by the number of shares outstanding during that period. EPS is helpful because it gives a platform for comparison between stocks of different companies, an exercise which is difficult when comparing just the profits these companies might declare.
Earnings per Share (EPS) = Net Income − Dividends on Preferred Shares ÷ Number of Common Shares Outstanding
In order to understand EPS better one must compare it over the valuations of several years or quarters. Companies are legally bound to release the EPS data along with their annual income statements, so this data can be easily obtained.
Price to Earnings (P/E)
The P/E ratio is simply dividing the current price per share of a company by its EPS. The P/E ratio helps in determining how profitable the investors consider a company, a high P/E ratio suggests a favorable view of earnings from particular company, whereas a low P/E could be a negative indicator. It is advisable to only use this measure for comparison, and preferably for companies in the same industry, or for evaluating a single company over a time-line.
Market Value per Share ÷ Earnings per Share (EPS)
Price Earnings to Growth (PEG) Ratio
The Price Earnings to Growth Ratio is similar to the Price Earnings Ratio, with a crucial addition. It also takes into calculation the growth in the earnings over a period of time. Stocks with PEG ratios of over 100% are considered overvalued. Once again only a comparison between companies will be beneficial while using the PEG ratio.
P/E ÷ Annual EPS growth in %
There are other analysis techniques such as the Return on Invested Capital (ROIC) and the Price to Sales (P/S) ratio and Return on Assets (ROA) method which can be used to value the stocks of companies and arrive at sound investment decisions.
Some Important Tips
“Experience taught me a few things. One is to listen to your gut, no matter how good something sounds on paper. The second is that you’re generally better off sticking with what you know. And the third is that sometimes your best investments are the ones you don’t make.”
– Donald Trump
Before you take investment decisions, ask yourself the following questions:
- Am I investing from disposable income, or rainy-day savings?
- Do I have additional money to invest if another opportunity arises or am I locked into one stock?
- Should I consider investing in something that has less volatile price movements?
- Is my current portfolio the optimum utilization of my finances?
These introspective questions are necessary to keep you on the right track and focused on market movements. Intelligent investing is about picking solid stocks with earning potential. Let logic and pure technical analysis of a stock guide you.
Stay for a while
Trading in stocks gives solid returns in the long term, do not expect to blaze a trail in your first week, the stock market is not a Hollywood flick, no matter how exciting the connection seems. Quick trading is fun, you can buy and sell on the go, study economic trends and change your portfolio accordingly and also make a profit.
However, it may not always be the way to go with stocks of blue-chips, or large cap companies with strong businesses. Stay with the stocks of premium companies, they pay well in the long run.
Invest in what you understand
The multi-faceted corporation that is involved in deep sea drilling and polar exploration may sound like an amazing prospect, but stick closer to home when starting out for the first time. Think of yourself as a pioneer on the way to the frontier, invest in companies you understand, whose business-models make sense and who offer products that add value to life.
Don’t fear fluctuations
The market moves in mysterious ways, and price fluctuations can be numerous and sudden. Although the pricing mechanism in stock markets works extremely well, it is often prey to sentiment and investor emotion. Bearish trends can deflate stocks very quickly, just as bullish sentiment can take them to pinnacles of over-valuation.
It is best not to panic in such circumstances but make an informed decision. Buying undervalued stocks requires a good judgment of future stock movements, similarly knowing when to sell has its own benefits, as over-valued stocks soon return to earth and its clever to book profits when one has the chance.
Keep a margin of safety
Keeping a margin of safety helps you reduce potential losses in the long run. Despite all the research you may have done, the future is uncertain and it’s always prudent to keep a margin of 15 – 20 % on the stock price. This buffer will help you tide over sudden corrections the market may experience.
Stay true to your plans
Once you have chartered an investment route for yourself, by deciding the amount you will invest, choosing your stocks and the time you plan to hold on to them, its best to stick to it as you begin investing. Think independently, do your own research and make informed decisions, rather than trading on impulse and risking your investment.
Stock investing for beginners can seem a challenge, but with a clear investment strategy in mind, one can go about it in a profitable manner. Patience and a cool-headed approach toward investment decisions will definitely return profits in due time. The working of the stock market, its pulse, is something one can grasp only after spending some time being part of the great machine of stock trading.
There will be failures in the beginning, hasty investments which may incur losses, but it’s important to remain focused and to keep working on improving your portfolio of stocks. With time and experience one can make stock trading a profitable enterprise.