Stocks are a type of security that represent an ownership stake in a publicly traded company. They can be bought and sold on stock exchanges, and are typically issued in the form of shares.
When you buy stocks, you become a shareholder in the company and are entitled to a portion of its profits (if any) that are issued in the form of dividends.
Introduction to Stocks
There are two main types of stocks: common stocks and preferred stocks.
Common stocks are the most widely traded type of stock, and give shareholders voting rights and entitles them to a share of the company’s profits (if any).
Preferred stocks, on the other hand, do not typically entitle holders to voting rights, but they may have preference in terms of dividends or assets in the event of liquidation.
Stocks are often used as a way to generate income, either through dividends or by selling them at a higher price than the price at which they were purchased (known as capital gains). Certain companies are more consistent as dividends paying stocks than others.
Stocks are a foundation of almost all portfolios. The financial markets can be tricky to navigate, so it helps that each instrument has it’s on set of rules and guidance to help even the most novice of beginners.
These rules are not just guidance, but are often set out in the law for investor protection. You will recognise some of the major stock regulators such as the securities and exchange commission (SEC) in USA.
Valuation Difference By Instrument
With Forex, each you have many different factors that govern the prices and fluctuations. Each country has their own economy, own laws, and defining factors such as interest rates, and central bank policies.
Commodities differ as they are heavily influenced by supply and demand, and stocks, an entirely different kettle of fish altogether.
Stocks are undoubtedly influenced completely on the performance of the company itself, but it also draws in wider factors such as global economies, local economies, and pandemics (very apt for recent times unfortunately).
When considering how to value stocks, you would also be well served to know how to value other assets, seeing as most of these have an impact on overall markets.
Internal and External Stock Valuation influences
There are many types of stocks which can often have different rights. We will be focusing on common stocks in this article, as the name suggests it is the most common, and therefore the stock type that dominates the market by traded volume.
“A stock is a security that identifies the buyer’s ownership of a particular company, that allows a claim on that company’s earnings and assets”. In basic terms, when you own some stock in a company, you own part of that company. However large or minute your position may be, you become a part owner, and are entitled to vote, and receive dividends if they are offered.
If you are investing in electronic vehicle stocks, or automakers in general, you may well want to keep a close eye on what Tesla and other competitors or industry leaders are up to. What is moving in important competitors in your industry will likely spread across the sector.
External factors can also affect a particular sector, like extreme weather events. Hurricanes for example could negatively affect oil or energy companies, having to cease offshore activities.
The same extremes in weather can also impact usage of other fossil fuels and cause spikes in prices which also feed into companies that profit from goods in the related sector.
Geopolitical instability, sustainable energy agendas, travel restrictions and and general consumer behavioral trends are also worth bearing in mind.
Company financial health
The company’s financial situation could play quite a strong hand in how the stock price performs.
The financial crisis of 2008 has shown just how volatile a company’s financial situation can be and how rapidly things can change. This has large ramifications for the trust in the company and the investor sentiment in the business.
The debt load that a company has can also be looked at differently depending on what is going on externally. Interest rates moving upwards as a result of central bank policy can have different ramifications depending on how well the underlying company is capitalised. One laden with debt will end up having to pay more out of their balance sheet to service the same debt with an increase. Shareholders will not look at that positively.
Those companies that are sitting on huge piles of cash on the balance sheet inversely will begin to be looked at more favourably with interest rate rises, as their profitability on that same cash can be expected to grow.
Wider economic Conditions will impact markets and stock prices
The overall economic conditions can affect how well your company’s stock is doing also. It is not enough to tunnel vision your research to the how the company is doing on the inside, but also look at the external economic conditions of the country, and also globally.
As mentioned previously, the dot-com boom in the 2000s, and the 2008 financial crisis were all external conditions that have had a knock on effect. Recessions in the market your company operates in can affect your stock negatively as this usually indicates less capital in the markets as a whole which filters down to relative stock prices. Conversely, positive economic effects can lead to growth within the market, and a potential rise in share prices.
There is however no exact science to this as we have seen throughout the Covid pandemic that huge swatches of the globe were shutdown and in economic retreat (albeit forced), but US stock markets bounced and have continued to reach record highs.
Stock price ratios (EPS and P/E)
Financial stock ratios are an easy way to simplify the overwhelming and sometimes arduous task of looking through a company’s financial statements and earning forecasts, industry conditions and overall economic climates.
Although this type of research is imperative, and should not be overlooked, financial ratios can strengthen your outlook on a chosen stock. This can also help you make an informed decision on the initial investment, and to consider when to enter or exit a trade.
The most commonly used ratios that are evaluated are the EPS and PE ratios;
Earnings per Share (EPS)
An EPS rating is a common ratio that calculates the amount of net income for every issued share.
In short, this ratio depicts the amount of profit that can be earned if the net income for the entire company is divided equally between all the shares issued.
The higher an EPS rating is, the higher the profit is supposed to be, making stocks with higher EPS’ more attractive. This is an easy way to identify how profitable a particular company is, and gives you an idea of how much you are likely to earn if you own one share.
Price to Earnings Ratio (P/E)
Price to earnings ratio, is another popular financial ratio that is used to gauge how much value a company’s current share price has in comparison to its per-share earnings.
PE Ratios effectively indicate how much more you would need to pay to secure today’s earnings. A high number in this ratio is not a good thing, and indicates that the investor would need to pay more for what the earnings are today, making the investment unattractive.
On the other hand, a lower ratio would suggest that the stock price has become cheaper, and due to other factors may rise again in the future.
Now you now the basics of stocks, and stock valuations, you need to know the difference between buying and trading stocks with our leveraged stocks guide.