Investing Unit 4: Common Stocks

Personal Finance January 05, 2017 Print Friendly and PDF

 


 

When a company wants to raise money, it offers investors a share of ownership in the company in the form of stock in exchange for that money. As a partial owner of the company, each investor shares in the success or failure of the business. There is no guarantee of return on the investment. Investors become part owners of a business and have no guarantee that they will receive any income for the use of their money or that they will get back any or all of their money in the future.

However, historically, common stocks have outperformed all other investments. According to the Chicago investment research firm Ibbotson Associates, the average annual return on U.S. large company stocks from 1926 to through 2015 was 10.0% versus 12.0% for small company stocks, 5.6% for long-term government bonds, and 3.4% for U.S. Treasury bills.

If a company makes money in a given time period, its board of directors may decide to reward its owners by distributing dividends or may choose to reinvest the money in the company. If you own a stock that pays dividends, you may have the option of reinvesting them in more stock instead of receiving a cash dividend. The dividends are still taxable but dividend reinvestment plans (also known as DRIPs) are an easy way to increase your investment holdings.

As owners of the business, stockholders elect directors who select the people who manage the company on a day-to-day basis. Depending upon the business and the way in which it is set up to operate, stockholders may have the opportunity to influence other decisions as well. Typically, this happens at an annual business meeting and stockholders can cast proxy votes if they are unable to attend the meeting in person.

There are many companies that offer stock investments. If you are interested in purchasing stock, you should learn about the industry and the particular business in which you are considering investing. There are many ways to learn. Magazines such as Kiplinger’s and Money are one. Newspapers, especially those that focus on economic topics, like the Wall Street Journal, and those in large cities, such as the New York Times are good sources. Companies such as Value Line produce materials to specifically rate stocks. These are typically carried in the reference section of larger libraries.

The Internet is full of Web sites that offer information. Scrutinize each site to determine the source and note whether written material is produced by a person or business that may gain profit from the information provided. One place to look for such Web sites is in the money section of the site at http://www.consumerworld.org/. There, you will find a link to the American Association of Individual Investors at http://www.aaii.org/, as well as a link to a stock market simulation for learning about how the market works.

By law, a company must provide a prospectus, which describes information such as its management and financial situation when it first issues stock. If you are interested in purchasing new stock in a company, you can request a prospectus. You may also find prospectuses on line at the Securities and Exchange Commission Web site at http://www.sec.gov. Some annual reports are available online from the Public Registers Annual Report Service at http://www.prars.com.

 

Generally stocks are classified by category.

  1. Growth stocks are those of companies that are expected to increase in value. They may have high P/E (price to earnings) ratios. This means that the price of the stock is high compared to the forecasted earnings. A high ratio tends to indicate a more speculative situation. A low ratio tends to indicate a more conservative investment.
  2. Income stocks are expected to pay regular, relatively high (compared to other companies) dividends.
  3. Speculative stocks are those that have potential for the future. They generally do not pay much in dividends and their prices may be relatively volatile.
  4. Value stocks currently have relatively low prices compared to their historical earnings and the value of the company’s assets.
  5. Blue chip stocks are those of established companies with relatively stable stock prices and relatively predictable earnings. Since the end of World War II, dividends have accounted for about 40% of the stock market’s total return, price increases for the remaining 60%.
  6. Penny stocks are sold for $5 per share or less. They may be initial offerings with prices set intentionally low or stocks of companies that are experiencing difficult financial times. In either case, they are speculative stocks; if you invest in them, you should be prepared to lose all of your money.

 

It is important to consider your goals and your needs when you invest in stocks and to select ones that are most likely to match your situation.

Investors use indexes to assess the general activity of the stock market. They are widely reported in newspapers, on television and radio, and via the Internet. The Dow Jones Industrial Average is the most widely followed gauge of daily market activity. Indexes also help show trends in market behavior. Investors use Beta as a measure of a stock’s price volatility–how much it changes. The average Beta for all stocks is +1. However, the Beta for an individual stock can be either positive or negative. The larger the Beta figure (e.g. +2 versus .50), the more speculative–and thus risky–a stock.

A "must read" for all equity investors is a company’s annual report. Along with other investor resources, such as Value Line and professional advisors, annual reports provide important clues to company performance. To obtain a company’s annual report, call its "shareholder relations" department or request a copy online from the company Web site.

The first part of a company’s annual report is the letter to shareholders. Here, company management explains significant changes in company operations (e.g., new products, decreased earnings) and in the report’s financial statements (balance sheet and income statement).

Like a personal net worth statement, the balance sheet in an annual report lists a company’s assets and liabilities (debts) at a particular time (usually the end of a company’s fiscal year). Assets are things owned by a company, such as product inventory and accounts receivable (money owed by customers). Liabilities are company obligations to pay for goods and services or to repay borrowed funds (e.g., interest and principal on company bonds). The name balance sheet reflects the fact that figures must "balance;" the value of a company’s assets must equal the sum of its liabilities and shareholder equity (the total value of all shareholders’ investments in a company.

Various financial ratios can be used to determine the financial health of a company. A common one is the current ratio, which is current (less than a year) assets divided by current liabilities. A 2:1 ratio ($2 of assets for every $1 of debt) is considered adequate. Another helpful ratio is the debt-to-equity ratio, a company’s total liabilities divided by shareholder equity. It should be less than 1:1.

Income statements in an annual report describe a company’s net income (or loss) per share. A common ratio used to analyze income statements is earnings per share: net income divided by the number of outstanding shares. Another is the price/earnings (P/E) ratio, which is calculated by dividing the share price by earnings per share (e.g., $24 per share and $2 earnings per share = P/E of 12).

Stocks can be bought and sold on one of several major exchanges. Current information about stock prices and sales is available in most newspapers. An example of a newspaper report of the New York Stock Exchange is shown in Figure 2.

Figure 2 - NYSE

52-week Abbr. Sales    
High Low   (000s) Last Chg
96.13 48.38 AT&T 12728 85.56 -2.44
51.25 22.94 Compaq 21938 32.75 -1.63
  8.50   3.44 Ethyl       66   4.69 - 0.13
68.00 47.44 Litton       53 56.94 +0.07

Terms used in Figure 2:

52-week High-Low–These numbers tell the highest and lowest prices at which the stock has sold in the last year. Prices are in dollars and decimals of dollars. For example, highest price the AT&T stock sold for in the last year was $96.13 and the lowest price was $48.38.

Abbreviation–Standard abbreviation of the stock’s name. For example, AT&T.

Sales (000s)–The number of shares traded yesterday. It is multiplied by 1,000. Thus, AT&T sold 12,728,000 shares the previous selling day.

Last–Price at closing yesterday. For AT&T it was $85.56 per share.

Chg–The difference in the closing price yesterday and the day before. The price today was $2.44 lower than yesterday’s.

Note: The nation's stock exchanges converted stock prices from fractions to decimals in 2001.

When stock is purchased or sold, a fee is generally charged. The cost will vary, depending on where the stock is purchased (e.g. discount broker, direct purchase, online). Comparison shop to determine available costs and services and to get the best deal.

Many investors use a specific strategy, dollar cost averaging, to invest in stocks. They regularly invest the same amount (e.g. $50) at regular intervals (e.g. monthly)–regardless of the price of the stock.

When investors use the buy and hold strategy, they purchase stocks and keep them for a number of years, not worrying about the changes in the market. Investors refer to times when prices are very low as a bear market and times when they are high as a bull market . The goal of successful equity investing is to buy when prices are low and sell when prices are high. You can learn more about these strategies in Unit 2, Investment Basics.

 

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