Introduction to Stocks

Introduction to Stocks Basic Stock Information to Get You Started Some Stock Terms:      Earnings per Share – EPS Price to Earnings Ratio – P/E Projected Earning Growth – PEG Price to Sales – P/S Price to Book – P/B Some Stock Terms:  Bear Market A market in which stock prices are falling.  Blue Chip Stocks Stocks of leading and nationally known companies that offer a record of continuous dividend payments and other strong investment qualities.  Bonds Promissory notes issued by a corporation or government to its lenders, usually with a specified amount of interest for a specified length of time. Some Stock Terms:    Bull Market A market in which stock prices are rising. Commodities Products used for commerce that are traded on a separate, authorized commodities exchange. Commodities include agricultural products and natural resources such as timber, oil and metals. Commodities are the basis for futures contracts traded on these exchanges. Common Shares or Common Stock Securities that represent part ownership in a company and generally carry voting privileges. Common shareholders may be paid dividends, but only after preferred shareholders are paid. Common shareholders are last in line after creditors, debt holders and preferred shareholders to claim any of a company's assets in the event of liquidation. Some Stock Terms:  Distribution The portion of the issuer's equity paid directly to the security holders. It is generally paid to security holders of trusts, partnerships, and funds. The issuer or its representative provides the amount, frequency (monthly, quarterly, semiannually, or annually), payable date, and record date. The exchange that the issue is listed on sets the ex-dividend/distribution (ex-d) date for entitlement. Some Stock Terms:  Dividend The portion of the issuer's equity paid directly to shareholders. It is generally paid on common or preferred shares. The issuer or its representative provides the amount, frequency (monthly, quarterly, semi-annually, or annually), payable date, and record date. The exchange that the issue is listed on sets the ex-dividend/distribution (ex-d) date for entitlement. An issuer is under no legal obligation to pay either preferred or common dividends.  Dividend Yield Equal to the indicated annual dividend rate per share divided by the security's price. For example, if the indicated dividend rate is $1.00 and the closing price is $50.00, $1 divided by $50.00 equals 2%. Basic Stock Information to Get You Started  The first step for you to understand the stock market is to understand stocks.  A share of stock is the smallest unit of ownership in a company. If you own a share of a company’s stock, you are a part owner of the company.  You have the right to vote on members of the board of directors and other important matters before the company. If the company distributes profits to shareholders, you will likely receive a proportionate share. Basic Stock Information to Get You Started  One of the unique features of stock ownership is the notion of limited liability. If the company loses a lawsuit and must pay a huge judgment, the worse that can happen is your stock becomes worthless. The creditors can’t come after your personal assets. That’s not necessarily true in private-held companies. Basic Stock Information to Get You Started There are two types of stock:  Common stock  Preferred stock Most of the stock held by individuals is common stock. Common Stock  Common stock represents the majority of stock held by the public. It has voting rights, along with the right to share in dividends.  When you hear or read about “stocks” being up or down, it always refers to common stock. Preferred Stock  Despite its name, preferred stock has fewer rights than common stock, except in one important area – dividends. Companies that issue preferred stocks usually pay consistent dividends and preferred stock has first call on dividends over common stock.  Investors buy preferred stock for its current income from dividends, so look for companies that make big profits to use preferred stock to return some of those profits via dividends. Liquidity  Another benefit of common stocks is that they are highly liquid for the most part. Small and/or obscure companies may not trade frequently, but most of the larger companies’ trade daily creating an opportunity to buy or sell shares.  Thanks to the stock markets, you can buy or sell shares of most publicly traded companies almost any day the markets are open. Stock Sectors - How to Classify Stocks Stock Sectors - How to Classify Stocks  One of the ways investors classify stocks is by type of business. The idea is to put companies in similar industries together for comparison purposes. Most analysts and financial media call these groupings “sectors” and you will often read or hear about how certain sector stocks are doing.  One of the most common classification breaks the market into 11 different sectors. Investors consider two of there sectors “defensive” and the remaining nine “cyclical.” Let’s look at these two categories and see what they mean for the individual investor. Defensive  Defensive stocks include utilities and consumer staples. These companies usually don’t suffer as much in a market downturn because people don’t stop using energy or eating. They provide a balance to portfolios and offer protection in a falling market.  However, for all their safety, defensive stocks usually fail to climb with a rising market for the opposite reasons they provide protection in a falling market: people don’t use significantly more energy or eat more food.  Defensive stocks do exactly what their name implies, assuming they are well run companies. They give you a cushion for a soft landing in a falling market. Cyclical stocks  Cyclical stocks, on the other hand, cover everything else and tend to react to a variety of market conditions that can send them up or down, however when one sector is going up another may be going down. Here is a list of the nine sectors considered cyclical:          Basic Materials Capital Goods Communications Consumer Cyclical Energy Financial Health Care Technology Transportation Cyclical stocks  Most of these sectors are self-explanatory. They all involve businesses you can readily identify. Investors call them cyclical because they tend to move up and down in relation to businesses cycles or other influences.  Basic materials, for example, include those items used in making other goods – lumber, for instance. When the housing market is active, the stock of lumber companies will tend to rise. However, high interest rates might put a damper on home building and reduce the demand for lumber. How to Use  Stocks sectors are helpful sorting and comparison tools. Don’t get hung up on using just one organization’s set of sectors, though. MorningStar.com uses slightly different sectors in its tools, which let you compare stocks within a sector.  This is extremely helpful, since one of the ways to use sector information is to compare how your stock or a stock you may want to buy, is doing relative to other companies in the same sector. How to Use  If all the other stocks are up 11% and your stock is down 8%, you need to find out why. Likewise, if the numbers are reversed, you need to know why your stock is doing so much better than others in the same sector – maybe its business model has changed and it shouldn’t be in that sector any longer. Conclusion  You never want to be making investment decisions in a vacuum. Using sector information, you can see how a stock is doing relative to its peers and that will help you understand whether you have a potential winner or loser. What Market Indexes Tell Us What Market Indexes Tell Us  The Dow is up (or down) so the market is great (or terrible).  If you read or listen to the popular media, you might get the impression that the Dow Jones Industrial Average, usually just the Dow, is the pulse of the market.  Other stock indexes like the S&P 500 or the Nasdaq Composite get play also, often in hushed or excited tones depending on numbers.  However, what do these and the other reported indexes really tell us and how should we use them? What is an Index?  First, let’s look at what an index number represents. Although there are different ways to calculate index numbers, it is important to remember the numbers represent a change from an original or base value.  The number is not important. What is important is the percent change over time. This movement up or down gives you and idea of how the index is performing.  Is the Dow up or down? The index is calculated “on the fly” during trading to give investors a sense of direction to the market it represents. What is an Index?  Notice, I said the index reflects “the market it represents,” not “the market.”  Most stock indexes, even those quoted as representing the total market, only reflect a portion of the actual market.  Here are the most popular indexes and the markets they reflect. The Dow  The Dow Jones Industrial Average is the oldest and most widely known index. It is also the most widely quoted index and, mistakenly, considered the market barometer.  Originally, it was a simple average of the stocks in the index, but thanks to stock splits, spin offs and other transactions, more sophistication is now required.  The Dow currently has only 30 stocks. However, each of these stocks represents one of the most influential companies in the U.S. and all have annual revenues in excess of $7 billion. The Dow  The Dow is the only major index that is price weighted, which means if a stock’s price changes by $1, it has the same effect on the index regardless of the percent change for the stock. In other words, a $1 change for a $30 stock has the same effect as a $1 change for a $60 stock.  The Dow stocks represent about one quarter of the value of the total market, so in that sense it is a factor and big changes indicate investor confidence in stocks, however it does not represent small or midsize companies at all. S&P 500  The S&P 500 is the most frequently used index by financial professionals as a representative of “the market.” It includes 500 of the most widely traded stocks and leans towards the larger companies.  It covers about 70% of the market’s total value, so in those terms it is much closer to representing the true market than the Dow.  The S&P 500 is a market capitalization or market cap weighted index, as are almost all of the major indexes. S&P 500  Weighting by market cap gives more importance to larger companies, so changes in Microsoft stock will have a greater impact than almost any other stock in the index.  Even though the S&P 500 is weighted toward larger companies, it is a more accurate gauge of the broader market than the Dow is.  Even though some of the talking heads on TV may emphasize the Dow, you will get a clearer picture of the market by focusing your attention on the S&P 500. The Nasdaq Stock Market Composite  The Nasdaq Stock Market Composite is composed of all the stocks on the Nasdaq market – more than 5,000.  Although broad in coverage, the Nasdaq is heavily weighted to technology stocks. This is because it is a market cap weighted index and stocks like Microsoft and some of the other big technology companies influence the index.  Their influence and the population of small, speculative companies in the Nasdaq make the index more volatile than either the Dow or the S&P 500.  The Nasdaq obviously is not designed to represent “the market,” however it does give you a good idea of where technology investors are going. Other Indexes  There are a number of other indexes that measure larger or smaller sections of the market. Mutual fund investors can find a number of funds that track almost any index they want.  However, the major three indexes above will serve most investors well. Should you want to look at other indexes for comparison, make sure you understand how the index is weighted (most, if not all will be market cap) and how stocks are selected. What’s Good about Indexes Indexes provide useful information including:  Even with their limitations, indexes show trends and changes in investing patterns.  They give us snapshots, even if they are out of focus.  Indexes provide a yardstick for comparison. Making Money with Dividends Making Money with Dividends  One of the ways you make money with stocks is by investing in companies that pay dividends.  Dividends are profits the company distributes to shareholders. The companies don’t do this out of the kindness of their hearts – this is what a company is all about; making money for the owners.  Dividends usually don’t represent all of a company’s profits. The company retains some portion for future use - in acquisitions or to retire debt, for example. Making Money with Dividends  Most companies pay dividends in the form of cash, although you may hear of occasions when a company uses stock instead. Many investors are attracted to stocks with a good history of paying dividends. These companies are usually well established and profitable, but may not offer much in the way of growth potential.  The company’s board of directors sets the dividend at a quarterly meeting. Making Money with Dividends  It is important to note that they are under no obligation to pay a dividend. If the company is hurting financially or the board is concerned about future prospects, it can forego the dividend.  The board sets the dividend rate at a per share basis. For example, the board may declare a quarterly dividend of $0.50 per share. This means if you own 100 shares of stock, you will get a check for $50 for that quarter. Important Dates There are four important dates to remember about dividends:     The Declaration Date This is the date the board sets the dividend and announces when the stockholders will get their checks. The board also announces the Ex-Dividend Date, which is a very important date to know. Record Date This is the date when the company sets the list of shareholders to receive the dividend. You must own the stock before this date to get the dividend; however, it is the Ex-Dividend Date that is more important. Ex-Dividend Date This date usually falls 2 – 4 days before the Record Date. This date allows for the completion of all pending transactions, since it usually takes three days to settle a regular stock sale. The Ex-Dividend Date is the most important date as far as owning the stock if you want to receive the dividend. Payment Date This is the date the company mails the checks, often two weeks or so after the record date. Important Dates  On the Ex-Dividend Date, the market discounts stock’s price since the dividend is no longer available to buyers. Types of Dividends  Dividends come is two types: fixed and variable. Dividends that pay at a fixed rate go to owners of preferred stock, while variable dividends go to common stock holders.  Dividends offer investors another way to make money, especially if your goal is current income. Many investors find that buying and holding companies with a good history of paying dividends makes good sense for financial goals. What You Should Know about Different Share Types What You Should Know about Different Share Types  Not all shares of stock are created equally. Authorized, restricted, float, outstanding and treasury shares all have different attributes. Investors need to know these terms to make informed decisions.  You will hear these terms and see some of them used in financial ratios, so it is important to understand how these types of shares differ.  First, let’s define the terms, and then I’ll explain why it is important to understand the difference. What You Should Know about Different Share Types  Authorized Shares – These shares represent the total number of shares of stock authorized when the company was created. Only a vote by the shareholders can increase this number of shares. However, just because a company authorized a certain number of shares doesn’t mean it must issue all of them to the public. Most companies retain shares for use later called treasury stock or shares.  Treasury Shares – Shares a company retains in its treasury and not issued to the public or to employees are treasury stock. What You Should Know about Different Share Types  Restricted Shares – Restricted shares refer to company stock used for employee incentive and compensation plans. Restricted stockowners need permission of the SEC to sell. There is a waiting period after a company first goes public where insiders’ restricted stock is frozen. When insiders want to sell their stock, they must file a form with the SEC declaring their intention. Even insiders of established companies must file with the SEC before selling their restricted stock.  Float Shares – Float refers to the number of shares actually available for trade on the open market. You and I can buy these shares.  Outstanding Shares – Outstanding shares includes all the shares issued by the company, which would be the restricted shares plus the float. Here’s a simple example with numbers to illustrate the relationship of these different shares:      Authorized Shares – 100 Treasury Shares – 20 Restricted Shares – 10 Float – 70 (100 – 20 – 10 = 70) Outstanding Shares – 80 (10 + 70 = 80) Why is this Important? Here are several key bits of information you can determine from looking at how these different share types stack up in relation to each other: Why is this Important?  Look at the relationship of treasury shares and restricted shares to float for where controlling interest of the company will reside. Many companies retain a large percentage of the authorized shares in their treasuries or in the hands of management through restricted shares. Companies do this to make sure no other company can seize control in an unfriendly takeover. They may also want to have stock handy for future issue instead of using debt to buy another company or for another major expenditure. Controlling interest held in treasury stock means outside shareholders will have little influence over the decisions of the company. Why is this Important?  If the float of a company is very small and the stock attracts attention of investors it can become volatile because of supply and demand imbalances. More buyers will drive the price up, which is not a bad thing if you own the stock. However, it may make the stock over priced relative to its earnings or other fundamental measures. Likewise, if the stock falls out of favor, sellers may have trouble unloading their shares, which would tend to force the price down further and more rapidly than fundamentals might indicate. Why is this Important?  Watch what restricted shareholders do. You can get this information from a variety of online sources. If you use MSN Money’s insider trading search function. Just enter a stock symbol and it will return the most recent sales or planned sales by insiders or major shareholders. Most of the time, these sales signal nothing of interest to investors. When a large number of insiders, especially in young companies, file plans to sell major blocks of stock it could signal trouble.  Notice when reading financial ratios whether they are using float or outstanding shares in the calculation. It can make a big difference in the outcome. Conclusion  Understanding the terms used to describe various shares will help you get a better handle on analyzing companies Use R&D Spending in Evaluating Stock This is Where new Products and Services are Created Use R&D Spending in Evaluating Stock  There are number of factors to consider when deciding whether a stock is a worthy candidate for your investment dollars.  Growth in earnings, revenue, market share and other markers are important factors. They should be considered on their surface and be used to compare the company to its peers.  Comparing a company’s numbers to industry averages gives you a perspective on the numbers, since different industries will register different levels of debt, for example. Different Stock Number  One number that usually doesn’t show up on most comparisons is how much the company invests in research and development (R&D).  Obviously, in technology companies this number will be higher in absolute terms and as a percentage of revenue than in other industries.  However, all companies should be involved in some level of R&D to create new products for future growth.  Most popular Web sites report income statements and you will find the R&D expenses listed in the Cost of Goods sold area, which is always the first section of expenses. Stock Sector Information  Yahoo! Finance has detailed information on sectors and the companies that make up each sector.  If you are considering a company for investment, you should take a quick check of its R&D spending in terms of absolute dollars and as a percentage of revenue.  If the company isn’t at least spending the sector average for R&D, you should ask yourself where does management plan to find new products and services to fuel future growth?