TL;DR: "In the short term, the market is a voting machine. But, in the long term, the market is a weighing machine". -- Ben Graham[1]
Part 1: How the stock market works
Part 2: How does one evaluate Stocks
Part 1: Basics of a Stock Market
History: A long time ago, humans ran businesses with just their money. The businesses they ran were small and they grew the businesses only with their own profits. However, not all businesses can be built with your own money. What if you wanted to build a new factory that costs more than a million dollars? Banks won't lend money for young companies and your friends won't have that much.
In the 15th-16th century as the Europeans started exploring Asia and Americas, the big explorers felt they needed a lot of money and their kings were not providing them anymore. The wealthy guys demanded a lot of interest. Thus, they felt they need to raise money from a bunch of common people. Thus, in 1602, the Dutch East Indian company became the first company to issue shares of its company in the Amsterdam Stock Exchange and get traded on a continuous basis.
What is a Stock? Stocks in a company provide you a share of the company's future profits in return for the capital invested. For instance, if you buy 1 stock of Apple now, you will be assured one-billionth of Apple's profits in the future (as there are almost a billion such stocks that Apple has issued now).
Listing: In a stock market, 1000s of companies are listed and these companies (called public companies - as they have given out their shares to common public) pay a fee to the exchanges, along with a promise to provide all important info to the markets. In return they get an opportunity to put their company in the stock market's board & have the ability to get money from people visiting the market. The first time a company's stock appears on the stock market's board is called an IPO (Initial Public Offer).
Brokers: Conceptually, a stock exchange is similar to eBay. These guys allow companies to be listed and connect the buyers & sellers. Since millions of people trade in the market and it is practically impossible for these exchanges to deal with all the individuals, they have assigned brokers who act between the exchanges and the individuals.
Part 2: How does one value a stock
Basic Terminology:
We will use a term EPS (Earnings per share) that is exactly as it sounds. It is the profits of the company divided by number of shares. For instance, Apple has $41 billion in profits and about 950 million shares, giving an EPS of about 41000/950 = $44/share. Thus, if you own a share of Apple, you are entitled to 44 bucks of Apple's profits this year.
Calculating Share price:
To evaluate how much you need to pay for that 1 Apple stock you need to do a simple addition of all the earnings you will get
Stock Price = EPS in Year 1 + EPS in Year 2 +...
Now, you know that a dollar earned 10 years from now is not the same as a dollar earned now. Because, there is an interest rate i involved and money you get in 10 years is less worthy than the money you have now. Thus, you need to adjust that formulae.
Stock Price = ((EPS in Year 1)/(1+i))+ (EPS in Year 2/(1+i)^2) +...
Now, there is a whole bunch of math involved (starting from the compound interest formula) and for the sake of simplicity, I will get you to the final results and reduce the stock price to two cases:
1. In case of a mature company that doesn't grow:
Stock price = EPS/Interest rate
The expected Interest rate is relatively easy to calculate and depends on how risky the company is, how risky the market is and the current long term interest rate of government bonds. For many mature utility companies this interest rate comes to about 10%. Thus, utility companies that doesn't grow much is generally traded at about 10-15 times the EPS. (insert in the formula above).
The stock prices of these companies are very smooth and change only when there is a change in long term interest rates, the risk profile of the company (can change when hurricanes such as Sandy hits) or when market risk changes (for instance 2008 financial crisis). But on a regular day, not much action here. Let us move to the second category of shares:
2. For a growing company:
Stock price = EPS of next year / (interest rate - expected growth rate of the company)
Let us use a simple example. If you assume Apple's next year EPS will be $48, the expected interest rate for such a risky company at 15% and an expected annual growth rate at 5%, you will get:
$48/(15%-5%) or $48/10% or $480 as the ideal stock price for the company. Where did I get this magical 5% number?
Getting the growth inputs:
Now, we need to find the growth rate of the company and figure out what the company will earn in the next year, the following year and so on. This is not an exact science and no one has a perfect answer to this question. This is why we need stock markets. Collectively, we all pool our intelligence to figure out the future growth of the company and thereby its current price.
To do this collective prediction, we constantly get new inputs and project that to future. For instance, if the company management gets hotshot new engineers, then we predict the future will be bright. What are the other news that investors typically use:
- Periodic financial results of the company that gives us a view into the company;s workings and its financial position
- Periodic results of similar companies that helps us guess this company;s results. Thus, when Apple sneezes everyone else catches a cold.
- Changes in the sector. If a new report comes that people are more inclined to using mobile phones, we predict growth of these companies will be high.
- Changes in the broader market.
- Changes in the international economy
Market Estimation:
In short, we try to use every possible information to guess the future growth of the company, plug that into our formula and find out the stock price. For instance, if Apple comes out a report saying people are buying less of iPads, we might ding Samsung too as we believe their Galaxy Tabs will sell less too.
Estimating growth rate is an art rather than a science, and is collectively done by millions of humans in a place called the stock market. Since, we need to constantly adjust the growth rate based on new information, stock prices constantly fluctuate.
Main advantages of a stock market:
1. Starting/building a business: The market lets companies get money from a large number of people. That means there are more options to get money to build a business.
2. Spreading risk: It lets you spread the risk of a business into a large number of people. Since, each person is investing only a small portion of their income in the stock of a particular company, the risk of a single company collapsing doesn't significantly affect investors.
3. Collective estimation of value.
Summary: Modern corporations require a lot of capital, which is beyond the reaches of a few individuals. Markets help companies raise money from a large number of people and together these investors value their company. The theory is that when a large number of people do their independent valuation, the company's price comes more closer to its ideal worth.
"In the short term, the market is a voting machine. But, in the long term, the market is a weighing machine". -- Buffett
Stocks
Stocks are issued by companies, public and private, to denote ownership. For instance, by owning one share of General Electric (Ticker: GE) you own a small slice of General Electric. The more shares you own, the more of the actual company you own. If a company is doing well, more people will want to own part of the company, and therefore they'd be willing to pay more. That is what drives the price of stock. Would a business want to become a public company, they would sell stocks on the public market. The process of becoming a public is called an Initial Public Offering, (IPO). By issuing stock to the general public, the company is giving up some power over the company, as more people are able to vote.
In the structure of a company, the shareholders elect the board of directors, who then elect the executive officers. So you can see how there could be a desire to hold on to power.
IPO
There's a lot of buzz around IPOs, ie Facebook. IPOs are tricky to trade. There's generally a lot of excitement about large IPOs, and the price usually shoots WAY up in the beginning inflating the price to unsupported levels, before regulating itself back to a realistic price, ie Groupon, Shutterfly. When it comes to investing in IPOs, you can usually find a calendar or sorts of upcoming IPOs. For example: http://www.renaissancecap
Quarterly Reports
Once a company becomes public, they issue quarterly reports. These are essentially like their report cards. You can also find calendars of which companies are releasing their quarterly reports, and when. Companies commonly try to predict what their report cards will look like, and independent analysts do the same. These predictions generally come in the form of revenue, profits, and earnings per share.
Companies can decide when their fiscal year starts. Some companies arrange it so it's based on what their sales trends are. For example, stores like Macy's will have strong holiday sales that are disproportionate to their normal operations. Same with UPS.
Revenue is the amount total brought in, as dictated by sales.
Profit is the amount the company has left over after reducing all their costs from the revenues. This is seen in a company's income statement. Here's a sample income statement:http://www.lega
Companies can increase profit in two ways: One, they can make sales; Two, they can control overhead and costs. The less a company spends, the less their costs chip away at revenue, the more profit they make.
Earnings per share is a big one for investors. It basically divides these numbers by the total amount of stock shares held by investors. It's a measure of confidence.
Mutual Funds
Mutual funds are essentially a collection of stocks that have similar characteristics. Some Mutual funds focus primarily on growth, so they'll feature stocks that show strong growth trends. Some focus on dividends, and will contain companies that issue high dividends.
Mutual funds are pretty common in retirement plans.
Dividends are basically a distribution of the company's profits to their shareholders. For example, Pfizer (PFE) issues dividends of 2.2%, meaning by the end of the year, they'll issue about 2.2% of the share price to investors. Dividend mutual funds, AKA income funds, are common in retirement because they offer a steady income for people who don't work.
Steve Jobs sold Pixar to Disney for millions of shares of Disney stock. Disney pays dividends, not exactly sure what their rate is (honestly he probably got some special stock option not available to smaller investors, a la Warren Buffet and his recent investment in Bank of America (BAC)). Therefore, Steve Jobs got a dividend payout of about $43 million from Disney per year. His salary from Apple was only one dollar.
ETFs
ETFs, or Exchange Traded Funds, are conceptually similar to Mutual funds, in that they are a collection of stocks based on various categories and managed by various investment firms. They differentiate in that ETFs, by definition, can be traded on the Exchange.
For ETFs and Mutual funds, think of it as investing in the performance of a select portfolio. A portfolio is basically the stocks that you hold. I own shares of GE, Google (GOOG), PFE, therefore my portfolio consists of GE, PFE, GOOG.
ETFs to watch are SPY and QQQ. Both are designed to follow the S&P 500.
When reading about the economy you'll see things like Dow Jones, S&P 500 and NASDAQ.
These are weighted indices of stocks, and are designed to be an overall indicator of how stocks did on that day. If most stocks on the NASDAQ (typically a very technology heavy index), go up, the NASDAW will go up by their weighted average. This will make more sense as you keep following it.
Bonds
Bonds are also issued by a companies and governments, but unlike stocks, are classified as a liability on the company's/government's balance sheet, because bond holders must be paid back. They incur no ownership in the company. The benefit of bonds is they are held by a contract to pay certain amounts of interest as stated in the contract. They also get priority during a company's unfortunate liquidation.
Brokerages
A brokerage house is a company licensed to buy and sell stocks or securities. Acting as an intermediary between buyers and sellers, Broker services are usually provided on a commission basis which vary with each brokerage house.
Often, the price per trade is indicative of the level of service the firm offers. For example, a brokerage house that charges fees on the lower end of the scale may not execute trades as quickly as one that charges higher fees. Likewise, a firm that charges higher commissions usually offers more personalized service.
In addition to commissions, a brokerage firm may charge various other fees.
Stock Market Principles
Human beings have always invested for the future
And they have always made the same mistakes!
The Six Success Rules
The rules for successful stock market investing are not complicated. However, one must avoid the 'learning too much' syndrome. Learning too much is dangerous because in doing so our future judgement is clouded
Rule of Expected Returns
- investors need to be realistic about the sort of returns they can expect. the first lesson to learn from market history is to be realistic
Rule of Staying Calm
- all investing involves a degree of risk. Market volatility is inevitable, it goes with the territory. History shows that’s almost invariably prices eventually recover
Rule of Timing the Market
- although it’s very tempting to try to time the market, in fact it’s virtually impossible to do it successfully
Rule of Avoiding Complex Products
- investors should try to keep things simple, and the simplest way to invest in equities is via index funds
Rule of Diversification
- the one lesson that screams from every page of market history is to diversify 'The Golden Rule'
Rule of Excessive Trading
- despite the constant temptation to trade, the best thing that investors can do once they've built a portfolio that matches their attitude to risk is… nothing
Learn more about the Six Investing Principles by watching a few short videos which describe each principal in detail. In the videos, leading academics and financial experts explain Stock Market Principles.
