Sure, you might think you know what a stock is, but do you know what a P/E ratio, or Beta is? I promise the big gun’s at the office do. Planning to invest is a noble start, but now it’s time to get serious and figure out the basics of what, how, and when to invest.
Investing is a constant source of conversation in the corporate world. Almost everyone invests in some capacity, from simple savings accounts to leveraged trading in highly risky securities. Investing in publicly traded companies through the stock market is very common, and the topic is likely to arise in conversation with co-workers, supervisors, and friends. Some basic knowledge on the fundamentals of corporate finance will enable you to easily navigate your way through a conversation that might have once seemed puzzling.
First, what is a stock?
Companies want to make money. In order to make money, they must first have money to invest in projects, purchase equipment, make payroll, etc. One way of raising money is by issuing equity, a.k.a. shares of common stock. A share of common stock is partial ownership of a company. Yes, your share of XYZ stock means you are one of the many owners of that company. You are fully entitled to vote for directors of the board, receive profits that the company distributes as dividends, and receive your tiny little portion of the company if it liquidates and closes.
However, common stock holders get paid last, after all other creditors, so don’t get too excited about the last option. Furthermore, complete ownership is usually split among many millions of shares, so the small number of shares that most investors own is inconsequential to the actual functioning of the company, and merely serves as an investing tool for the investor.
The company issues stock, raises a buttload of money, and they’re happy. After stock is sold from the company to investors on the primary market, thereafter it is traded among investors on the secondary market, such as the New York Stock Exchange (NYSE).
Why would you want to purchase a stock?
Two reasons: a belief that the value of the stock on the secondary market will increase, and dividends. The former is pretty conceptually simple. You can buy a stock in hopes that its future price will be higher than its current price so that you can profit from its sale.
Dividends, however, are cash payments made from the company to shareholders. Every quarter a company can decide to keep all of its profit to re-invest in expansion, or distribute a portion of that profit to shareholders as dividends. Dividends are optional at the discretion of the company’s management. Some companies pay high dividends, some little, and some have never paid a dividend. Dividends are usually declared quarterly on a “per share” basis. If you own 1000 shares and the company declares a dividend of 10 cents per share, then you get a check for $100.
Another way to raise money for operations is to issue debt in the form of bonds. Companies, cities, and even the federal government issue bonds to finance spending. Here’s the proposed deal: you give the bond issuer the purchase price today (usually close to $1000). In return, the bond issuer will give you periodic coupon (i.e. interest) payments for the term of the bond (perhaps semi-annually for five years) plus repay the face value of the bond (usually $1000) at the end of that term. When you factor in the purchase price, interest payments, maturity date, and face value of a bond you can come up with its “yield to maturity” (YTM) or simply “yield.” This is the overall return you will receive for investing in the bond.
U.S. Treasury securities, a.k.a. “T-Bills,” are considered risk-free investments and offered with terms from one month to 30 years. The yield on T-Bills is the starting point for all other bonds of the same term. For example, on May 5th 2009 the YTM of a ten-year Treasury note was 3.20%. This security is the primary competitor to mortgages. While most mortgages have a term of 30-years, the mortgaged house is usually sold or refinanced within about ten years. The best rate for a 30-year fixed rate mortgage in my area on the same day was about 4.75%. See the correlation? Mortgages are riskier than T-Bills, so in order to sell a mortgage as a security, the lender must charge more interest.
Publicly traded companies are required to publish their financial statements each quarter. These include the balance sheet, income statement, and statement of cash flows. Investors often examine these statements for information about the company and have created several ratios and measurements to objectively compare stocks. One that you will hear often is the price to earnings ratio or P/E ratio (pronounced “Pee Eee Ratio”). This is the stock’s current price per share divided by annual earnings per share. In simple terms, P/E ratio measures the price of a stock compared to the company’s actual profit. A high P/E ratio means the stock is expensive compared to the company’s earnings. A low P/E ratio means the opposite.
You can’t really just take two stocks at random and compare their P/E ratios as apples to apples.
However, P/E ratio will quickly tell you two things:
- Is the company focused on growth (high P/E) or value (low P/E)?
- How is the stock priced compared to other similar companies? (compare P/E ratio to P/E ratio)
Another useful metric is Beta. Beta is calculated using some fancy statistical math that compares a stock’s historical returns to a standard (usually the S&P 500). Beta measures how closely a stock’s price follows the standard. For example, the Beta of the S&P 500 is defined as 1.0. A stock that generally follows the S&P 500 but is more volatile might be 1.5. A stock whose price still generally follows the up/down swings of the S&P 500 but is less volatile might have a Beta of 0.5. Finally, a negative Beta indicates that a stock generally performs opposite of the S&P 500 (i.e. the price of the stock rises as the price of the S&P 500 falls).
Beta quickly answers two important questions:
- Does the price of the stock follow the market as a whole? (Is Beta positive or negative?)
- How volatile is the stock’s price? (How positive or negative is Beta?)
Google Finance makes researching stocks particularly easy, and can assist in understanding some of these concepts. For example, go to Google Finance and enter “GE” in the “get quotes” search box. The profile for General Electric will appear. From there you can see P/E ratio, Beta, and access GE’s financial statements. You can use the chart to look at GE’s historical price and easily compare it to major market indices like the Dow and S&P 500. You can use Google Finance to track an entire portfolio if you wish.
A plethora of information is available online if you wish to learn more about the inner workings of markets. This information is merely a starting point that will orient you in conversations with your peers and enable you to ask intelligent questions. While the jargon can be confusing, every word you don’t understand has a Wikipedia entry to explain it. Finance is a vastly interesting topic that inspires opinions and ideas that are debated almost like politics. Educate yourself on the basics and you’ll find a source of meaningful conversation that could be an important step in climbing the corporate ladder.
You can read more from Jeff at his blog, The Midnight Hour.