Investing: Stocks 101
who said it was common?Firms use equity and debt to finance operations. While debt represents a liability to the firm and adds financial risk, equity represents an investment in the firm by shareholders and reduces the founders' overall risk.
Equity itself can be broken into two forms:
1- Preferred shares are a hybrid between debt and common equity in that they provide a fixed dividend while providing upside potential.
2- Common stock is synonymous with a share in a firm. Each share represents ownership of the firm's equity.
When it comes to valuating a share, it helps to understand that a share is a factor of the present financial and operational strength of a firm, as well as its future potential.
pick championsStock analysis can be broken down into fundamental and technical analysis. When it comes to fundamental analysis, there are some interesting points to consider.
When stock investing it is not enough to pick just any company, it is more important to know which stock will outperform its peers. For example, the entire computing industry may have benefited throughout the 1990s, but investors would have fared much better had they invested in Dell rather than Compaq or Hewlett-Packard. After all, there can be many runner-ups, but the key is to find the champion.
top-down approachThe top-down approach is when two different approaches emerge. Such an approach makes more sense for novel investors and consists of scanning the entire economy, and pinpointing the select industries that will outperform. From there, you can examine the various firms within the industry to pick out the winner. But what do you look for when using such a top-down approach?
market capA share price is, in itself, meaningless; the firm's market value or capitalization (which is equal to share price multiplied by number of shares outstanding) is the key metric because this shows the cumulative present value of the firm's earning power.
This is what suggests whether a share is overpriced or underpriced vis-à-vis its competitors. A share price is not useless as it provides — when used with other ratios — a sense of how fast the share price will appreciate. For example, imagine the stock price of News Corporation was $24 and that of AOL Time Warner was $12.
Does this imply that AOL is worth half the value of News Corporation? Not necessarily. A closer look reveals that AOL TW's market capitalization stands at $56 billion, while News Corp's value is $25 billion. You can now use your marketing know-how, IT acumen and financial savvy to determine whether AOL TW's fundamentals justify it being worth twice as much as News Corporation. Risk arbitrageurs can then play one security off the other, but that is for more sophisticated money investors.
It's all about P/E...