The ChoosaBroker Trading Academy
2.2. Stocks
Course Description
Barring a handful of notable exceptions, almost everyone on the Forbes top 100 billionaires list made their wealth by holding a large block of shares in a private or public corporation. In this guide to investing in stocks, we will explain –
- What Stocks Are?
- Why Invest in Them?
- How Stocks are Valued?
What are Stocks?
Stocks are a type of financial security that gives its holder a share of ownership in a company. They are also called “equities.” Companies issue stocks to raise capital either to expand business or pay-off existing debt. Investors buy stocks with the expectation that their price will appreciate in the foreseeable future.
Stocks are publicly bought and sold at stock markets or stock exchanges. These may be physical establishments like the New York Stock Exchange, or computer networks like the NASDAQ.
To better understand the role played by stocks in the financial ecosystem, let us look at the example of owners of a chain of retail stores in Tokyo. They want to expand their business to other cities in Japan, and are seeking capital to increase the retail footprint. They have two options – either seek a loan from a bank, or raise money by bringing in new shareholders. They opt for the latter and list the company’s stock on the Tokyo Stock Exchange. Smart investors sensing growth potential buy in to the stock. Upon listing, if the stock price gains, the investors profit, while the owners of the retail stores also fulfil their objective of obtaining funds to grow the business.
Companies offer two types of stocks – common and preferred. Both of these represent some degree of ownership of the company. However, common stockholders get the opportunity to vote while electing the company’s board of directors. Preferred stockholders don’t have any voting rights but usually receive dividend payments before holders of common stock do. They also have greater claim to the company’s assets in case it goes bankrupt and is liquidated. Common stocks live up to their name by being the most commonly traded class of stocks on any major exchange. During the course of this lesson, whenever we talk about stocks, we will be implying the common stock.
Difference Between Stock and Share
The modern financial press has somewhat blurred the distinction between the terms “stocks” and “shares.” Very often, these words are used interchangeably to commonly refer to a piece of paper that represents ownership in a particular company. However, there lies a subtle difference between the two as regards the context in which they are used.
“Stock” is a more general term in that it can be used to describe ownership certificate of any company, while “share” denotes ownership certificate of a particular company. So, if any investor says that he or she owns stocks, it usually refers to their overall ownership of certificates of more than one company. The distinction between the two terms has more to do with syntax, and as such is typically overlooked.
Why Invest in Stocks?
At its most basic level, people invest their hard-earned money to meet their financial goals. The options available are plenty. Then why do most savvy investors choose equities over other investment avenues? If you are among the stock shy, consider these four reasons to understand the overwhelming benefits of investing in the asset class.
- Highest Returns – The most compelling argument in favour of owning stocks is that they offer the maximum growth potential. Amongst the various financial assets, stocks have consistently produced the highest historical returns, easily outperforming both bonds and commodities. Consider the example of the Dow Jones Industrial Average, which over the course of the past 30 years, has appreciated by over 1200%. The price of gold, in comparison, has gained by around 300%, while the widely-tracked Fidelity Investment Grade Bond Fund has approximately returned 600%.
- Dividend Income – A large number of companies distribute their profits to shareholders by paying them a dividend. These dividend payments arrive even if the stock has depreciated in value and represent income for the investor on top of profits he or she may realize by eventually selling the stock.
- Stocks Offer Easy Diversification – An investor can choose stocks from the various industries and sectors within an economy to diversify his risk profile. Diversification can also be achieved from a geographical perspective by opting for stocks from different countries – both developed and emerging.
- High Liquidity – Stocks listed on most major exchanges can be effortlessly bought and sold. This easy liquidity gives investors the latitude to convert their stocks in to cash whenever necessary.
Basics of Buying and Selling of Stocks
The entire process of buying and selling of stocks is fairly straightforward. The key steps involved are briefly explained below:
- Open a Brokerage Account
– The easiest and the most common way to invest in stocks is through a registered broker. Setting up a brokerage account is as easy as opening a bank account. You will first need to fill out an application form, provide proof of identity and then select how you want to fund the account. Funding can either be done by transferring money electronically or by mailing a check. There is a broad choice of brokers, we have created a best online brokers and best brokers for beginners to provide a balanced view of options to suit your needs.
- Select Your Stocks
– Once you have opened and funded a brokerage account, it’s time to plunge in to the all-important task of selecting stocks. Picking stocks can become a very complicated process. Your aim should be to always keep things simple. A good place to start is by analyzing companies, whose products you have already experienced as a consumer. As the legendary Wall Street investor Peter Lynch once famously said, ““Invest in what you know.” You are liable to make fewer errors that way.
- Choose Your Order Type
– After selecting the stocks you want to buy, you can either place a “limit order” or a “market order” with your broker. A limit order is one in which you instruct your broker to buy a stock at a limited price. For example, if you want to purchase Apple’s stock at $150 a share, and the stock is currently trading at $160, then the broker would wait to buy the shares until its price hits your limit. A market order is when you request to purchase a stock at the prevailing market price.
How Stocks Are Valued?
Buying stocks that are currently trading below their intrinsic value can prove to be a very rewarding investment strategy. Let us look at the three most widely-used equity valuation techniques:
Price-Earnings Multiple
Knowing whether a stock is expensive or cheap can be a tricky business. The simplest and often overlooked measure is the price-to-earnings, or PE ratio. It is arrived at by dividing the current price of a stock with what the company earned per share over the past one year. Stocks, whose PE ratios are below their historical averages, and who also report high earnings growth, are considered as good buy candidates.
Discounted Cash Flow Model
The Discounted Cash Flow (DCF) analysis is a powerful tool to put a price tag on a company’s stock. The DCF model uses future free cash flow projections and discounts them to compute the present value. If the present value is higher than the current stock price, the stock is deemed to be undervalued.
Return on Equity Valuation
Return on Equity (ROE) is Warren Buffet’s favourite investment metric. The ROE is a gauge of a company’s profit-generating efficiency, and is calculated by dividing its net income with its shareholder equity. In general, a healthy company yields an ROE in the range of 13% to 15%. As with all valuation metrics, comparing the ROEs of companies within the same industry group can give you a better picture.
Final Few Notes
Despite the many ups and downs in the global economy, the equity market has consistently proven to be an excellent place to invest your hard-earned cash and secure your financial future. But superior returns always come laden with higher risks. A thorough understanding of how the market operates is an essential first step.
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