Part 12: Understanding Stocks

Stocks are a fundamental component of many investment portfolios, offering the potential for significant growth and income. In this chapter, we will explore what stocks are, the different types of stocks, how the stock market works, key metrics and strategies for investing in stocks, and the risks and rewards associated with stock investing. 

What are Stocks?

Definition of Stocks Stocks, also known as shares or equities, represent ownership in a company. When you purchase a share of stock, you become a part-owner of that company. This means you are entitled to a portion of the company's assets and earnings. Companies issue stocks to raise capital (money) for growth, expansion, and other business needs.

How Stocks Work When you buy a stock, you are essentially buying a small piece of the company. As a shareholder, you have a claim on the company's profits, which can be distributed in the form of dividends. You also have the potential to benefit from capital appreciation if the value of the stock increases over time. Stocks are bought and sold on stock exchanges, and their prices fluctuate largely based on the supply and demand of the stock (i.e. how many people want to see and how many people want to buy), and company performance (i.e. if the shareholder’s equity - Assets minus Liabilities) is increasing. 

Example: Imagine you own a lemonade stand. You need money to buy more lemons, sugar, and cups to expand your business. You decide to sell shares of your lemonade stand to your friends. Each share represents a small ownership in your business. If your lemonade stand becomes very popular and makes a lot of money, the value of the shares increases. Your friends, who bought shares, can benefit from the profits and the increased value of their shares.

Types of Stocks

Common Stock

• Definition: Common stock is the most widespread type of stock that investors purchase. It represents ownership in a company and provides shareholders with voting rights, typically one vote per share, on major company decisions, such as electing the board of directors.
• Advantages:
• Voting Rights: Common shareholders have a say in important company decisions.
• Dividends: Common stockholders may receive dividends, though they are not guaranteed.
• Capital Appreciation: Common stock offers the potential for significant capital gains if the company's value increases.
• Disadvantages:
• Volatility: Common stock prices can be highly volatile, leading to potential losses. This is why volatility is one of the key metrics to consider when conducting the quarterly review of your portfolio. 
• Subordinate to Debt: In the event of liquidation, common shareholders are paid after debt holders and preferred shareholders. i.e. If the company declares bankruptcy you are the last person to be paid any money.

Example: If you own common stock in a company like Apple, you can vote on important matters at the company's annual meeting. If Apple does well and its stock price goes up, the value of your shares increases. However, if Apple performs poorly, the stock price may drop, and you could lose money.

Preferred Stock

• Definition: Preferred stock is a type of stock that provides shareholders with a higher claim on assets and earnings than common stock. Preferred shareholders typically receive fixed dividends and have priority over common shareholders in the event of liquidation. However, preferred stockholders usually do not have voting rights.
• Advantages:
• Fixed Dividends: Preferred shareholders receive regular, fixed dividend payments.
• Priority in Liquidation: Preferred shareholders are paid before common shareholders in the event of liquidation.
• Less Volatility: Preferred stock tends to be less volatile than common stock.
• Disadvantages:
• Limited Capital Appreciation: Preferred stock generally has less potential for capital gains compared to common stock.
• Lack of Voting Rights: Preferred shareholders typically do not have voting rights.

Example: If you own preferred stock in a utility company, you might receive a fixed dividend payment every quarter. If the company goes bankrupt, you would be paid before common shareholders. However, you wouldn't have a vote in company decisions.

Growth Stocks

• Definition: Growth stocks are shares in companies expected to grow at an above-average rate compared to other companies. These companies often reinvest their earnings into expansion, research and development, and other growth initiatives rather than paying dividends.
• Advantages:
• High Growth Potential: Growth stocks offer the potential for substantial capital appreciation.
• Market Leadership: Growth companies are often industry leaders, driving innovation and capturing market share.
• Disadvantages:
• High Volatility: Growth stocks can be highly volatile and may experience significant price fluctuations.
• Limited Dividends: Growth stocks typically do not pay dividends, as companies reinvest earnings into growth.

Example: A company like Tesla is considered a growth stock. Tesla reinvests its earnings into new technologies and expanding its production capacity. Investors buy Tesla's stock, expecting the company to grow rapidly and increase in value.

Value Stocks

• Definition: Value stocks are shares in companies that are considered undervalued based on fundamental analysis. These stocks are often characterized by low price-to-earnings (P/E) ratios, high dividend yields, and strong fundamentals.
• Advantages:
• Potential for Appreciation: Value stocks offer the potential for capital appreciation as the market recognizes their true value.
• Dividends: Many value stocks pay dividends, providing a steady income stream.
• Disadvantages:
• Slower Growth: Value stocks may have slower growth compared to growth stocks.
• Market Risk: Value stocks can still be subject to market risk and may underperform during certain economic conditions.

Example: Imagine a well-established company like Johnson & Johnson. Its stock might be undervalued if the market hasn't fully appreciated its strong fundamentals and potential for future growth. Investors might buy its stock, expecting its true value to be recognized over time - but usually a much longer timeline than growth stocks. 

Dividend Stocks

• Definition: Dividend stocks are shares in companies that regularly pay dividends to shareholders. These companies typically have stable earnings and a history of distributing a portion of their profits as dividends.
• Advantages:
• Regular Income: Dividend stocks provide a steady income stream through regular dividend payments.
• Stability: Companies that pay dividends are often financially stable and well-established.
• Disadvantages:
• Limited Growth: Dividend stocks may have limited growth potential compared to non-dividend-paying growth stocks.
• Dividend Risk: Dividends are not guaranteed and can be reduced or eliminated if a company faces financial difficulties.

Example: Coca-Cola is known for paying regular dividends. If you own Coca-Cola stock, you might receive a quarterly dividend payment, providing a steady income. However, the stock may not grow as quickly as a growth stock like Tesla.

How the Stock Market Works

Stock Exchanges Stock exchanges are platforms where stocks are bought and sold. The two primary stock exchanges in the United States are the New York Stock Exchange (NYSE) and the Nasdaq. In Canada, the primary exchanges are the Toronto Stock Exchange (TSE) and the TSX Venture Exchange. Other international exchanges you may have heard of are The London Stock Exchange, Euronext or the Shaghai Stock Exchange. The New York Stock Exchange is by far the largest in the world in terms of both market capitalization (the total value of a company's outstanding shares) and often in terms of monthly trade volume. Stock exchanges facilitate the trading of stocks by matching buyers and sellers, providing liquidity, and ensuring fair and transparent transactions. Some companies, particularly large multinational companies like Unilever, may be listed on more than one exchange, allowing them to reach a broader investor base, and increase their presence in multiple financial markets. This is know as dual-listing or cross-listing.

Example: Think of a stock exchange like a farmers' market where farmers (sellers) bring their produce, and customers (buyers) come to buy. The market provides a place for these transactions to happen smoothly.

Initial Public Offering (IPO) An initial public offering (IPO) is the process by which a private company becomes publicly traded by issuing shares to the public for the first time. Companies use IPOs to raise capital for growth and expansion. Once a company goes public, its shares are listed on a stock exchange and can be bought and sold by investors.

Example: Imagine your lemonade stand is doing so well that you need a lot of money to open more stands all over the city. You decide to go public, meaning you sell shares of your lemonade stand to the public. This helps you raise the money you need to expand.

Stock Prices and Market Capitalization

Stock Prices Stock prices are determined by supply and demand in the market. Factors that influence stock prices include company performance, earnings reports, economic data, industry trends, and investor sentiment. 

Factors Influencing Stock Prices

Several things can influence whether people want to buy or sell a stock:

Supply and Demand

Supply: This is how many shares of the company's stock are available for people to buy.

Demand: This is how many people want to buy those shares.

Example: If a lot of people want to buy a stock (high demand) but there aren't many shares available (low supply), the price goes up. If many people want to sell a stock (high supply) but not many want to buy it (low demand), the price goes down.

Company Performance: How well the company is doing. If a company is making a lot of money or releasing a popular new product, people may want to buy its stock, pushing the price up. If the company is struggling, the price might go down.

Example: If Apple releases a new iPhone that everyone loves, more people might want to buy Apple stock, so the price goes up.

Earnings Reports: Every quarter (three months), companies tell everyone how much money they made in that quarter. If they made more money than expected, the stock price can go up. If they made less, the price can go down.

Example: If Netflix announces it has a lot more new subscribers than expected, its stock price might increase.

Economic Data: This includes information about the overall economy, like how many people have jobs or how much things cost. If the economy is doing well, stock prices can go up. If the economy is doing poorly, stock prices can go down.

Example: If there is news that more people are getting jobs, stock prices might rise because people think the economy is getting better.

Industry Trends: This is about what's happening in the specific area or sector a company operates in. For example, if technology is advancing rapidly, tech company stocks might go up.

Example: If there's a new trend in renewable energy, companies that make solar panels might see their stock prices increase.

Investor Sentiment: This is how people feel about the market. If investors are feeling positive and optimistic, they are more likely to buy stocks, pushing prices up. If they are feeling negative or scared, they might sell stocks, pushing prices down.

Example: If investors hear good news about trade agreements between countries, they might feel positive and buy more stocks, causing prices to rise.

Market Capitalization Market capitalization, or market cap, is the total market value of a company's outstanding shares of stock. It is calculated by multiplying the current stock price by the total number of outstanding shares. Market cap is used to classify companies into different categories:

• Large-Cap: Companies with a market cap of $10 billion or more.
• Mid-Cap: Companies with a market cap between $2 billion and $10 billion.
• Small-Cap: Companies with a market cap between $300 million and $2 billion.
• Micro-Cap: Companies with a market cap between $50 million and $300 million.

Example: If your lemonade stand has 1 million shares outstanding and each share is worth $10, the market cap would be $10 million (1 million shares x $10 per share).

Stock Market Indices Stock market indices are benchmarks that track the performance of a group of stocks. They provide a snapshot of the overall market or specific sectors. Common stock market indices include:

• Dow Jones Industrial Average (DJIA): Tracks 30 large, publicly traded companies in the United States.
• S&P 500: Tracks 500 of the largest publicly traded companies in the United States.
• Nasdaq Composite: Tracks over 3,000 stocks listed on the Nasdaq exchange, including many technology and growth-oriented companies.
• Russell 2000: Tracks 2,000 small-cap companies in the United States.

Example: Think of a stock market index like a report card for the stock market. If the index goes up, it means that, on average, the stocks included in the index are doing well. If it goes down, it means they're not doing as well. You can use these indices to to establish an expected rate of return for your portfolio. Earlier in this book we used the fact that the S&P 500 has produced an average rate of return of 10% for the past 40 years to establish a benchmark for your portfolio. 

Key Metrics for Evaluating Stocks

Price-to-Earnings (P/E) Ratio

• Definition: The P/E ratio is a valuation metric that compares a company's stock price to its earnings per share (EPS).
• Formula: P/E Ratio = Stock Price / Earnings Per Share
• Interpretation: A high P/E ratio may indicate that a stock is overvalued, while a low P/E ratio may indicate that a stock is undervalued. However, the P/E ratio should be compared to industry averages and historical P/E ratios for context.

Example: If a company's stock price is $50 and its EPS is $5, the P/E ratio is 10 ($50 / $5). If another company's stock price is $50 but its EPS is $10, the P/E ratio is 5. The second company might be considered a better value.

Price-to-Book (P/B) Ratio

• Definition: The P/B ratio compares a company's stock price to its book value per share. The book value is the value of a company's assets minus its liabilities.
• Formula: P/B Ratio = Stock Price / Book Value Per Share
• Interpretation: A P/B ratio below 1 may indicate that a stock is undervalued, while a P/B ratio above 1 may indicate that a stock is overvalued.

Example: If a company's stock price is $50 and its book value per share is $25, the P/B ratio is 2 ($50 / $25). This might suggest that the stock is overvalued compared to its book value.

Dividend Yield

• Definition: The dividend yield measures the annual dividend payment as a percentage of the stock price.
• Formula: Dividend Yield = Annual Dividend Payment / Stock Price
• Interpretation: A high dividend yield can indicate a strong income-generating stock, but it may also signal potential risks if the yield is unusually high compared to peers.

Example: If a company pays an annual dividend of $2 per share and its stock price is $40, the dividend yield is 5% ($2 / $40). This means you earn 5% of your investment back in dividends each year.

Earnings Per Share (EPS)

• Definition: EPS is a measure of a company's profitability, calculated by dividing the company's net income by the total number of outstanding shares.
• Formula: EPS = Net Income / Total Outstanding Shares
• Interpretation: Higher EPS indicates greater profitability, but it should be considered in the context of the company's industry and historical performance.

Example: If a company has a net income of $1 million and 1 million shares outstanding, its EPS is $1 ($1 million / 1 million shares). If another company has a net income of $2 million and 2 million shares outstanding, its EPS is also $1.

Return on Equity (ROE)

• Definition: ROE measures a company's profitability by comparing net income to shareholders' equity.
• Formula: ROE = Net Income / Shareholders' Equity
• Interpretation: Higher ROE indicates more efficient use of equity capital, but it should be compared to industry averages and historical ROE for context.

Example: If a company's net income is $1 million and its shareholders' equity is $5 million, its ROE is 20% ($1 million / $5 million). This means the company generates 20 cents of profit for every dollar of equity.

Strategies for Investing in Stocks

Buy and Hold

• Description: This strategy involves purchasing stocks and holding them for an extended period, regardless of market fluctuations. It is based on the belief that the stock market will generate positive returns over the long term.
• Advantages:
• Reduces trading costs and capital gains taxes.
• Takes advantage of long-term market growth.
• Disadvantages:
• Requires patience and discipline.
• May not capitalize on short-term market opportunities.

Example: If you buy shares of a strong company like Apple and hold them for 10 years, you might benefit from significant growth in the stock's value over time.

Dollar-Cost Averaging

• Description: This strategy involves investing a fixed amount of money at regular intervals, regardless of the stock price. It helps reduce the impact of market volatility and lowers the average cost per share over time.
• Advantages:
• Reduces the risk of investing a large sum at an unfavorable time.
• Encourages disciplined investing.
• Disadvantages:
• May result in missed opportunities if the stock price rises significantly.

Example: You decide to invest $100 in a stock every month. Sometimes you buy shares at a higher price, and other times at a lower price, averaging out your investment cost.

Growth Investing

• Description: This strategy focuses on companies expected to grow at an above-average rate. Growth investors seek companies with strong revenue and earnings growth, innovative products or services, and competitive advantages.
• Advantages:
• Potential for significant capital appreciation.
• Often involves investing in innovative, market-leading companies.
• Disadvantages:
• High volatility and risk.
• Limited dividends and income.

Example: Investing in a company like Amazon, which has consistently grown its revenue and expanded into new markets, hoping the stock price will rise as the company grows.

Value Investing

• Description: This strategy involves identifying undervalued stocks based on fundamental analysis. Value investors look for companies with strong fundamentals, low P/E and P/B ratios, and high dividend yields.
• Advantages:
• Potential for capital appreciation as the market recognizes the stock's true value.
• Often involves investing in financially stable companies.
• Disadvantages:
• May require a longer time horizon to realize gains.
• Can be challenging to identify truly undervalued stocks.

Example: Finding a company with a low P/E ratio and strong financial health that the market has overlooked, and buying its stock with the expectation that its value will increase over time.

Dividend Investing

• Description: This strategy focuses on stocks that pay regular dividends. Dividend investors seek companies with a history of stable or growing dividend payments and strong financial health.
• Advantages:
• Provides a steady income stream.
• Often involves investing in financially stable companies.
• Disadvantages:
• Limited capital appreciation compared to growth stocks.
• Dividends are not guaranteed and can be reduced or eliminated.

Example: Investing in a company like Procter & Gamble, known for paying reliable dividends, to receive regular income from your investments.

Risks and Rewards of Investing in Stocks

Rewards

• Capital Appreciation: Stocks offer the potential for significant capital gains as the value of the stock increases over time.
• Dividends: Many stocks pay dividends, providing a regular income stream.
• Ownership: Owning stocks means having a stake in a company and benefiting from its growth and success.
• Liquidity: Stocks are easily bought and sold on stock exchanges, providing liquidity and flexibility.

Example: If you bought shares of Microsoft 20 years ago and held onto them, the value of your shares would have increased significantly, and you might have received dividends along the way.

Risks

• Market Risk: Stock prices can be highly volatile and influenced by various factors, including economic conditions, company performance, and investor sentiment.
• Company Risk: Individual companies may face financial difficulties, leading to declines in stock prices or bankruptcy.
• Sector Risk: Certain sectors may underperform due to changes in industry trends or economic conditions.
• Interest Rate Risk: Rising interest rates can negatively impact stock prices, particularly for companies with high debt levels.
• Inflation Risk: Inflation can erode the purchasing power of investment returns, particularly for stocks with low growth potential.

Example: If you invested in a company that goes bankrupt, you could lose all your investment. Or if you invested heavily in technology stocks, a downturn in the tech sector could negatively impact your portfolio.

Investing in stocks offers the potential for significant growth and income, but it also comes with risks. Understanding the different types of stocks, how the stock market works, key metrics for evaluating stocks, and various investment strategies can help you make informed decisions and build a diversified portfolio. By carefully selecting stocks that align with your financial goals, risk tolerance, and investment strategy, you can achieve your investment objectives and build long-term wealth.

As you continue your journey to becoming your own financial investment manager, remember that investing in stocks is an ongoing process that requires continuous learning and adaptation. Stay informed about market trends, remain disciplined in your approach, and be willing to adjust your strategy as needed to navigate the ever-changing financial landscape. With the right knowledge and a well-crafted investment plan, you can achieve your financial goals and build a secure and prosperous future.

 

Empower Your Wealth: Become Your Own Financial Investment Manager is a 20 part series that teaches readers how to self-manage their investments. It covers basics to advanced strategies, emphasizing the importance of financial independence, diversification, risk management, and technology