Saturday, October 17, 2009

Stocks: Owning Part of a Company


Buying stock makes you a partial owner of that company. You're basically betting that the company will be successful. This can be exciting, especially if you're really interested in what the company does. But the most common, and best, advice about buying stocks is that you can't put all your eggs in one basket. In other words, do not, no matter how great the company is, put all your money into that one stock. The risk is just too much. It's generally advisable to diversity your portfolio, which means investing in many different companies and industries. To diversify a portfolio, an investor should own at least ten different stocks in different industries.

Unless you have loads of cash and are able to buy millions of dollars of diversified stocks, by nature owning stock directly carries a higher risk than investing in a mutual fund. The advantages are in the lack of management fees (because you do it yourself) and direct control over your investments.

How they work
When you buy stock, you become a part owner of the company and are known as a stockholder, or shareholder. Stockholders can make money in two ways--receiving dividend payments and selling stock that has appreciated. A dividend is an income distribution by a corporation to its shareholders, usually made quarterly. Stock appreciation is an increase in the value of stock in the company, generally based on its ability to make money and pay a dividend. However, if the company doesn't perform as expected, the stock's value may go down. There is no guarantee you will make money as a stockholder. In purchasing shares of stock, you take a risk on the company making a profit and paying a dividend or seeing the value of its stock go up.

Day-trading and other short-term stock holding techniques make for some very risky investments. The best way to minimize risk and maximize potential is to become a long-term investor. Plan on holding your stocks for years--at least five and preferably many more. The idea is that if you choose the right companies, over the years they will grow and continue to be successful and their stock will appreciate. The longer the investment term, the more the risk decreases since you're allowing time for any spikes in performance to even out to a slow growth.


Why Some Investments Make Money and Others Don't
You can potentially make money in an investment if:
  • The company performs better than its competitors.
  • Other investors recognize it's a good company, so that when it comes time to sell your investment, others want to buy it.
  • The company makes profits, meaning they make enough money to pay you interest for your bond, or maybe dividends on your stock.
You can lose money if:
  • The company's competitors are better than it is.
  • Consumers don't want to buy the company’s products or services.
  • The company's officers fail at managing the business well, they spend too much money, and their expenses are larger than their profits.
  • Other investors that you would need to sell to think the company's stock is too expensive given its performance and future outlook.
  • The people running the company are dishonest. They use your money to buy homes, clothes, and vacations, instead of using your money on the business.
  • They lie about any aspect of the business: claim past or future profits that do not exist, claim it has contracts to sell its products when it doesn't, or make up fake numbers on their finances to dupe investors.
  • The brokers who sell the company's stock manipulate the price so that it doesn't reflect the true value of the company. After they pump up the price, these brokers dump the stock, the price falls, and investors lose their money.
  • For whatever reason, you have to sell your investment when the market is down.

Buying Stock: How to Pick 'Em
Before investing in a company, learn about its past financial performance, management, products, and how the stock has been valued in the past. Learn what the experts say about the company and the relationship of its financial performance and stock price. Successful investors are well informed.

Where do you find all that information? You could go to the company's website and try to find its financial statements and annual reports, then visit a bunch of financial news sites or get a free subscription to Investor's Business Daily. But if you're short on time, websites like Morningstar, TDAmeritrade, Scottrade, and Yahoo! Finance make the basic information you'll need easier to find. Each of these sites let you search stocks by ticker symbol and access profiles of that company and its stock. Most include of these sites include in each company's profile organized financial stats, analyst commentary, relevant news, and helpful charts. If you don't have a certain company in mind, all of the above sites have free customizable stock screeners which let you search stocks by various criteria.

No set of criteria will guarantee you a winning stock, but here are some tips:
  1. Look for companies with high cash to debt ratios. Then look for mid-level payout ratios; too high could be dangerous because it could mean that the company is overreaching. You don’t want a company that pays out more than it can afford. A good average is around 40%.
  2. Also avoid stocks with high dividend yields (for the market at the time). By nature of its definition, a stock's dividend yield falls when its price goes up, and vice versa. A yield above 6% could mean that share price is plummeting. Furthermore, high yields tend to indicate mature companies with little opportunity for growth.
  3. This one might seem obvious, but it's important so it's getting listed anyway: profits. Look for companies with high profits, and more specifically high profits relative to revenues. If Company A and Company B both have 1-year profits of, say, $2 million, but Company A's revenue is lower, all else being equal, Company A's stock would be more desirable. Why? Because a higher percentage of the money it brings in directly benefits its shareholders by increasing the company's net worth.
  4. Look for a high P/E (above 30). This tends to indicate a better growth rate and expectation of future profits. Particularly avoid stocks with low price-to-earnings ratios (below 15) because they tend towards slower growth and lower profit expectations.
Once you've found some stocks you're interested in, you can create a watchlist for them. A watchlist allows you to monitor stock prices, company news, etc. See the bottom of this page for step-by-step instructions on creating a free watchlist at Morningstar.com. Some of the above websites also let you set alerts to notify you when a stock price reaches or falls to a specified amount.

If you're serious about learning the details about a company, it's time to check out their financial statements and reports. Most of these you can access from the company's website and/or from the monitor/broker sites listed above.

Your first stop: the income statement. The income statement contains the following information:
  • Revenue: how much money the company has earned
  • Expenses: how much money the company has spent
  • Gross profit: how much money the company has left after sales to pay its operating expenses (revenue − cost of sales)
  • Net income: how much money is left after all expenses are paid, i.e. actual profit. Also called earnings, profit, "bottom line."
  • Earnings per share (EPS): net income ÷ number of shares outstanding
  • Equity aka stockholder's equity aka net assets aka net worth: how much more the company owns than it owes
  • Market capitalization: a company's market value (stock price × shares outstanding)
  • Gross margin: gross profits ÷ revenues
  • Operating margin: operating profits ÷ revenues
  • Net margin: net profits ÷ revenues
  • Price to earnings ratio (P/E): very roughly, how expensive or cheap a stock is at the moment (stock price ÷ earnings per share). One way to gauge how a stock is valued relative to the market is to compare its P/E with the average S&P 500 P/E.
  • Return on equity (ROE): net income ÷ equity
  • Dividend Yield: annual dividends per share ÷ stock price
How to set up a free watch list on Morningstar:
(from the Morningstar.com website)
  1. Go to Morningstar.com and click on the tab labeled "Portfolio."
  2. In the Portfolio Manager window, under "Create a Portfolio," click "New Portfolio."
  3. You'll see a box labeled "Step 1." It's automatically set up to build a watch list, so click "Continue."
  4. Pick a name for your portfolio, or just call it "watch list." Then, plug in the ticker symbols of the companies you want to watch. Click "Done."
  5. In the following window, you'll see a list of updates, alerts, and tips that Morningstar will send you daily for the companies in your watch list. Click "Done" again.
  6. Now you have a watch list that you can visit anytime by clicking the Portfolio tab on Morningstar.com.

See also:
Bonds: The Basics

Funds: Mutual Funds, ETFs, Closed-end Funds, Hedge Funds, Oh My!

Annuities: What Are They? How Do They Work? And How Do I Find the Right One For Me?

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