Part I of a series: A basic overview of what the stock
market involves.
Many
people have fears and apprehensions about the stock market
and investing which are mostly based on a lack of information,
understanding and research. The purpose of this article is
to help you understand how a business grows from a solely
owned company to a large blue chip company trading on the
stock market and to introduce you to some key terminology
and concepts that are needed to understand investing.
A business is usually organized
as a sole proprietorships, partnerships, or corporations.
A sole proprietorship is a business (usually a retail business
serving a local market/customer base) owned by a single person,
who is solely responsible for its success or failure. As the
business grows and the individual needs to raise more capital
for expansion a partner may be added on. The addition of a
partner changes the business from a sole proprietorship to
a partnership where the expenses/liabilities and profits are
divided between partners in a pre-arranged manner (possibly
in the same proportion as the amount of capital invested in
the business). The partnership can be a "limited partnership"
where it will be managed by a general partner who will make
all the investment decisions, but the limited partner will
have limited liability. The limited partner's liability is
limited to the amount of investment. An S corporation which
is closely related to a partnership may later be formed as
it protects assets outside the corporate shell from legal
claims. One step up from that is a private corporation. In
this type of entity the company has issued stocks that are
held by a few investors (these investors, the shareholders
keep all the profits from the corporation's business and make
all the financial decisions for the company) and it does not
have to disclose any information about business operations
to the public. The business may be doing well and still need
additional expansion.
There
are two basic means of raising capital. Money can be borrowed
in the form of a loan from a bank or other financial institution
or from other investors by issuing bonds. A bond is a formal
certificate representing a loan, the terms of which are set
by the borrower, the bond issuer. The issuer of the bond will
pay a fixed rate of interest to the investor, usually in semi-annual
payments, and guarantee the return of the investor's principal
at maturity, the due date. An investor in a bond is a lender
and has a senior position over equity (stock) investors in
the event of bankruptcy. There are two main categories of
bonds: Debentures (unsecured bonds) which are backed solely
by the good name of the company and Mortgage bonds (secured
bonds) that are issued by using property as collateral. The
other way to raise capital is for the company to sell some
of its equity by issuing shares that are available to the
general public (In going public the company makes available
shares of stock, representing ownership in that business to
anyone who wants to invest). By issuing shares the company
won't have to pay interest or pay back principal, but it will
lose some of the control over the business. (Note: It was
important to learn how a business is set up because as a shareholder
(you own a piece of the company/business, but you don't manage
the company) that determines what kind of financial responsibility
you bear. If a business is organized as a proprietorship or
a partnership, the owners have unlimited liability. If the
business fails, creditors have the legal right to seize assets
of the business and the owners). The liability of investors
in a public corporation is limited to the amount of their
investment. A public Corporation is required by law to reveal
all of its financial information to the public and its investors.
The financial data is sent to investors in the form of quarterly
statements and annual reports.
As
an investor we risk our capital for the profits we hope the
company will make. Profit is what is left after all expenses
have been paid. In the reports they are listed as net income,
net profit or earnings. The earnings belong to the shareholders.
Dividing the earnings for the company by the total number
of shares issued will give you the earnings per share (EPS).
This is the amount that each shareholder is entitled to as
result of owning shares (multiplying the number of shares
you own by the EPS will give you your earnings). The company
decides what to do with the earnings. The earnings may be
reinvested in the company to grow it by increasing the size
of its factories, hiring more people, doing research and development,
etc. The earnings, part or all of it may be distributed to
the shareholders in the form of dividends. The dividend amount
is determined by the board of directors and is paid in equal
amounts to each share outstanding, usually on a quarterly
basis. A stock is only worth what people are willing to pay
for it (supply and demand theory). One way of evaluating whether
or not a company's cost is fair is to look at its price/ earnings
(P/E) ratio. The P/E ratio is the relationship between the
cost of a share and the earning of each share. For example,
if a share of Discoverhaiti cost $10 and each share earns
$2, the P/E is 5 (10/2). That means people are willing to
pay 5 times more than earnings to get in on the action. Three
main factors which determine what investors are willing to
pay for a stock are earnings, dividends and the financial
condition of the company. If people believe that this company
has the potential to make them a lot of money they will pay
ridiculous prices for it. Note: If you pay too much for a
stock there is only so much profit you can make on it. So
you have to make sure you not only invest your money in great
companies, but that you pay a fair price for it. Individuals
make money by price appreciation and dividends. All profits
and losses are on paper and unrealized until you actually
sell your stocks.
What is the Stock Market?
The
stock market is nothing more than a place and a system where
people assemble in person and sometimes electronically to
buy and sell stocks. As stated above each company has an authorized
number of shares that it is issued and these shares are bought
and sold (exchanged) on the market. Shares may be traded via
the exchanges: two-way auction trading such as NYSE (New York
Stock Exchange (the largest in the world)), AMEX (American
Stock Exchange) and regional exchanges (ex. Philadelphia,
Pacific, Midwest etc.) or through the nationwide network of
broker and dealers- Over the Counter (OTC) such as NASDAQ
(National Association of Security Dealers Automatic Quotation
System), a virtual market. A stock is listed on an exchange
when it is accepted for trading. The company must meet listing
requirements and can be de-listed if it falls below the requirement
(each exchange has its requirements).
How can individuals participate in the market?
Individuals can participate in
the stock by trading, speculating and investing. Trading - attempts to take advantages of small price changes,
ownership is unimportant and stock certificates are treated as paper
to be bought and sold for a profit within a short time. Speculating - investors bear great risks for great rewards,
ownership is unimportant and time is not really considered. Investing - Mostly the most successful approach, time horizon
is long and is used to the investor's advantage and investors become
part owner and get sufficient return on investment for the risk
taken.
The Bear vs. the Bull
Many of you have heard analysts
or newscasters speak of a bull or bear market, and may be
confused by these terms. A bear market is a time period of
generally falling stock prices, usually lasting several months
or years. (The name derived from the way a bear attacks its
prey by pushing his paws downward.) A bull market on the other
hand is a time period of generally rising stock prices, usually
lasting several months or years. (The name was derived from
the way a bull attacks it prey by lifting it up with its horn.)
The stock market cycles between these two markets. There is
always a bull or a bear market somewhere as each industry
operates in different cycles. (It is important to diversify
your portfolio so that all your stock holdings are not in
the same market cycle.)
What are the Indexes and Averages?
The Dow Jones Industrial averages (DJIA) - is made up of
30 blue chip companies which are selected on the basis of being
leaders in their industry. The changes in DJIA are a market barometer,
computed by the mathematical average, of the changing prices of
the 30 companies.
The Dow Jones Composite Average - is made up of 65 stocks,
a combination of the stocks in the Dow Jones Industrial average
(30 stocks representing all types of businesses), the Dow Jones
Transportation Average (20 railroad, airline and trucking stocks)
and the Dow Jones Utilities Averages (15 utility stocks).
The S & P 500 - is a collection of 500 stocks from the New
York Stock Exchange & NASDAQ. It is value-weighted because the closing
price of each company in the index is multiplied by its number of
shares outstanding. The index is used to compute the average of
the total "market value" for each of the 500 companies.
The NASDAQ Composite Index - represents the NASDAQ market
and is heavily weighted with technology stocks.
Russell 2000 Index - represents small-cap companies
Wilshire 5000 Equity Index - It is composed of almost 7000
actively traded companies that are not included in the S&P 500 and
is the broadest of the most frequently quoted market indexes.
Whether you are watching an average
or an index, the importance of the resulting computation of
that market indicator is not the number itself, but its relative
change over a period of time. For example if the DJIA was
at 10000 and it went up 1000 points then you know that the
market was up 10% (10000/1000 = 10). Each type of company
belongs to a certain index be sure you're following the appropriate
index so your not comparing apples to oranges. Therefore if
you own a small-cap company you should follow the Russell
2000 Index as a comparison among similar companies.
Why invest in the stock market?
Since
1926, stocks have returned on average 10.6 % a year which
is higher than any other type of investment. The market has
survived the crash of 1929, the Vietnam War, recessions, etc.
and it has always rebounded. Does the market have risk? Yes,
but some level of risk is involved in everything that we do.
It is up to you as an individual to know what level of risk
you can handle and to cater your investment style towards
that. As an investor you have to know what risks are involved
and to try to minimize those risks. This can only occur by
doing research and having a concrete understanding of the
market and how it works.
Look forward to Part II of this Series - How to Invest
in the Stock Market.
