Financial Planning 101 - Stocks
Updated: Jan 29, 2020
Welcome to 7th Street Financials blog on personal finance. In my last installment on investment basics I gave an introduction on investing and now will begin to delve more deeply into individual topics related to investing. The intent of these blogs is to not only provide useful financial advice but also to educate people. The focus for the next several installments will be to cover the individual types of assets that people can invest in such as stocks, bonds, real estate and others. This installment will focus on stocks and what they are and what investing in stocks means.
Stocks represent ownership shares of a company or equity. When a company is formed it issues a certain number of shares of stock. The owners of the shares own the company. Companies are either private or public. The vast majority of companies are private, meaning their shares are not available for the public to buy and sell. When a company goes public the shares of stock are made available for buying and selling on one of the stock exchanges I mentioned previously (NYSE and NASDAQ being the primary two). This allows the public to purchase shares of ownership in these companies meaning when you buy a share of Apple you own a very tiny fraction of the company.
So why would someone want to buy stocks? Well, the simple reason is that stocks historically offer a very good return on your investment. Now, when I am referring to ‘stocks’ that means in terms of the market like I discussed last installment. Since 1926 the S&P 500 has averaged roughly a 10% annual return. This is a higher annual return than almost any other traditional asset class.
10% rate of return, sign me up! Based on this rate of return why wouldn’t we all just go out and buy stocks? If you recall the principles of investing I went over in the previous installment with this high rate of return comes a higher amount of risk and investing in stocks bring that risk. As you can see in this chart of annual returns for the S&P 500 since its inception the returns are far from a smooth annual 10%.
Instead they range from almost a 50% return to a -50% loss which is indicative of the risks of stocks. In the 90+ years of the S&P 500 there has been a negative return in 29 of those years so positive returns outweigh the negative 2 to 1 and in 25 of those years the return has been at least 20%.
Again, those are returns of a market or index and not individual stock. Individual stocks are far more risky than the market or an index might be. The ups and downs of individual stocks will be much greater than an overall market which gets smoothed out by the averaging of the ups and downs of the individual stocks. Take for instance just a few of these examples.
Take the last 12 years of Chipotle which was a rapidly growing company and then ran into problems with food safety and has since rebounded. The calmest year of the stock was 2012 when it was down 12%. The following year was up 79%, then another 28%, food safety issues hit and the stock went down 30, 21 and 23% in successive years. It has since rebounded with gains of 49% and is up over 70% (going from 428 to 732) so far in 2019.
Tesla has had 30 different 20 point moves in its stock price in just the past 12 months.
In the past 12 months Facebook started at $196 per share, went to $215, dropped all the way to $127, recovered slightly to $145, dropped to $123, climbed all the way back to $197, dropped again to $164 and is now at $186.
Stocks are initially made available through an Initial Public Offering (IPO). An IPO is the sexy glamorous star of the stock trading world. Some IPOs are wildly successful and others not so much. 2019 has seen Beyond Meats (ticker BYND) which was originally priced at $25 per share for its IPO in early May and has since exploded to $200 and is currently at $167 which is an amazing 568% return in just six weeks. On the flipside Lyft (ticker LYFT) which went public in early April at $88 is now at $64.
An investment in an individual stock can be the ultimate swing for the fence move depending on the type of stock you buy.
Stocks can be classified in multiple ways. One of which is how big the company is, also known as market capitalization. Market Capitalization is calculated by taking the number of issued shares multiplied by the current share price. Large Cap companies are those with a market cap greater than $10 billion, mid-cap companies are valued between $2 -10 billion while small cap companies are less than $2 billion.
The larger the company the less risky it tends to be. The reason for this is by the time a company reaches this stage it is thought it is less likely to experience big swings either for the good or bad. That doesn’t mean large cap stocks can’t have big moves in their stock price as evidenced by the examples above though. Mid-cap stocks are thought to be less risky than small cap stocks as well.
Value vs Growth
Another way stocks can be categorized is as value or growth. Value and growth companies can be found at all market cap levels. A growth stock is one that, well, is experiencing rapid growth in their sales and/or income. These companies tend to be newer or in a rapidly growing industry or technology area. Current examples include Amazon, Facebook and Google.
Value stocks on the other hand tend to be more stable in their growth, older and in more established industries. Current examples include Johnson & Johnson, Exxon Mobil and Proctor & Gamble. These companies are less likely to see the big swings in their stock price but that stability may be very attractive to certain investors. Also, value stocks are more likely to pay a dividend back to their shareholders. A dividend is when the company sends back a portion of their profits. This can make the stock more attractive to potential buyers since the returns may not be as a high as those for growth stocks. Growth stocks are less likely to pay a dividend as they tend to reinvest all of their profits to grow the business.
Valuing a stock
How do you know if a stock is a good deal? The short answer is you really don’t. By its definition the price of a stock should reflect the future cash flows the investor can expect to receive in the form of dividends and/or rate of return on stock price. The truth is that it is much messier than that. Stock prices are really driven by the collective mindset of buyers on where they think the stock price is headed. What makes it messy is that people reach different conclusions about the same stock and arrive at those conclusions at different times so while one person may think the stock has peaked another may think it has a long way to go yet.
That being said, there are multiple things that people look at to help them determine where they think a given stock price will go. One is to look at the fundamentals of the company. This involves looking at the company’s financial statements to see how healthy a company is. The overly simplistic logic is that a healthier company can support a higher stock price and if the future outlook is good then the stock price can reasonably be determined to increase as well. Factors that people will look for are sales growth, profit growth and keeping expenses and debt in line. If sales and profits are increasing that is a good sign and if people buy into that growth the price will go up. People may also look at the fundamentals of an industry or the entire economy as well. For instance even if a company’s financials look positive if that company’s industry is in a downturn the expectation may be made that eventually that company will suffer as well which may drive more people to sell the stock driving down the price as a result.
There are a number of ratios people will look at as well. One of the most popular of these are Earning Per Share (EPS). This measures the stock price divided by the number of shares or, in other words, how much of the company’s profit is yours if you own the stock. Generally the higher the number the better the outlook for the company.
Another very popular ratio is the Price/Earnings Ratio (PE) which measure the stock price divided by the EPS. In other words how much are you paying for a dollar of that shares profit. As a general rule the S&P trades at about a 16-17 PE ratio meaning you are paying $16 per dollar of profit associated with that share of stock. The conventional thought is when the PE ratio is higher than this level the stocks are priced too high given the profit they are generating which would be an indication prices are due to fall. Likewise, if the current PE is at 14 that might be an indication the stock prices are too cheap. But, individual companies will have wildly different PE ratios and doesn’t necessarily mean the price is too high or low as much of that is speculation around where the company can go. For instance, a relatively new company that is growing may have a very high PE ratio because people are buying into the growth and future expected profits even though current profits may be very small or possibly negative. A current example is Pinterest (ticker symbol PINS) which has a PE ratio of 1345 which is very high due to very small expected profits but reported sales growth of 57% over last year which is phenomenal growth. Time will tell if this company can continue to grow and with increased sales achieve the right amount of profitability to support a higher stock price.
Publicly traded companies will issue guidance on where they think the company’s financial future is headed. Analysts who work for financial firms follow these companies and will also come up with their own predictions on sales and profitability numbers. These predictions become a target and each quarter when the company releases their financial results the actual results are compared to the targets and future guidance. If actual results outperform the targets and guidance says this should continue this indicates the company is performing better than anticipated and a bump in stock price may follow. The reverse happens when estimates miss target or guidance is lowered.
Another method people will use to determine where a stock price is headed is to perform a technical analysis of the stock price and the trading of that stock. This method doesn’t really look at how the company is actually performing at all but instead looks at the historical trading of the stock to predict the future. For instance, as companies bounce around with their prices a trend may develop for a given stock that it tends to get to $100/share and then drops again creating a ceiling of support. If the stock were to ever crack the $100 barrier that would be a sign to buy as something has changed and the stock has established a new higher ceiling. These types of evaluations can be done to predict also when a stock price will head lower. Another factor in technical analysis is looking at the volume of stock traded in an up or down move of the price. For instance if the stock heads lower on light trading there might not be much to read into it but if it goes lower on heavy trading that might be an indication that something has truly changed with the outlook of the stock and could indicate a further dive in price.
How to buy a stock
So now whether you have done your research or not you have decided to buy shares of a given stock. How do you actually do it? You can work with a number of different professionals such as a stock broker, investment manager or financial planner or try it yourself. If you work with a professional it will require establishing a relationship with them and opening an account that they would oversee. These professionals will probably be the ones recommending the stock picks to you but they will execute the trade on your behalf. In exchange for doing this they will charge you a fee. A broker will likely charge a commission while an investment manager and financial planner will charge you a fee based on the relationship you have and not so much for any specific transaction they perform for you.
Now, let’s say you want to go on your own. To do this you will need to open an account at a brokerage firm like Fidelity, Vanguard, Charles Schwab or TD Ameritrade which are the largest (in fair disclosure, I use TD Ameritrade as my custodian for investments). Each stock has its own symbol used for trading like the ones I mentioned previously in this article. When purchasing a stock you will be presented with several options like this example for purchasing Apple (ticker symbol AAPL):
You will be asked to provide the number of shares you wish to purchase and an order type. A market order will process the order at whatever the current price, a limit order will allow you to enter a price and once the market price is at or below that price it will trigger the transaction. You will also have options for how long the order stays in place. This is only an issue for a limit order as it might take time for the order conditions to be met. You can select the order to expire at the end of the day or in after-hours trading as these platforms will let you buy and sell stocks 24 hours a day.
You have probably seen the ads on tv for these forms touting their services and their low prices. When they refer to $4.95 to $6.95 that is the price they will charge you for executing the transaction on the stock. For example, if you purchase $1000 shares of a stock and the fee is $4.95, you will actually end up buying $995.05 of the stock with the rest having gone to pay the fee. The fee is the same regardless of the amount of the stock you buy or sell.
I will quickly mention there can be multiple classes of stock issued by a company. By far the most common type is type A common shares which are the shares that are traded on open market most frequently and have voting rights. Companies may issue class B stock as well that have lesser voting rights. Companies may also issue preferred stock which may not have the price fluctuations but tends to get paid a dividend and will get paid out before the common shares.
By buying a stock that you intend to hold in hopes the stock price will go up and/or receive income via dividends you are going ‘long’ on the stock. This is by far the most common way to get into stocks and will be the only method I cover here. You can also short a stock, buy or sell options, or trade on margin. These are all a little more in depth and not really for investing 101.
Now that you own a stock how do you get taxed? There are two ways to get taxed when you own stocks. The first is when you sell stocks. When you sell a stock you will generate a capital gain or loss depending on if the stock is worth more or less than when you purchased it. If you sell the stock after owning it less than one year than it will be considered a short term gain or loss and is treated just like ordinary income and taxed just like your wages. If the stock has been held for more than one year than the gain or loss is considered long term. This is important because long term capital gains are taxed at lower rates, usually 15%, depending upon your income. If you sell multiple stocks during the year the gains and losses are netted against each other to determine if you have a gain or loss and whether it is short or long term or both.
The second way to be taxed with stocks is through receiving dividends. Not all stocks pay dividends but if you own one that does and you have held the stock for more than 60 days before the dividend was declared it will be considered a qualified dividend which will be taxed much like long term capital gains, usually 15%, depending on income. Unqualified dividends will be treated as ordinary income and taxed like your wages.
Stocks are risky but have a high historical rate of return. When investing long term it is hard to generate the returns needed without a portion of your portfolio dedicated to stocks. Stocks help provide a hedge against inflation due to the higher return. Investing in the market is one thing but picking individual stocks can be especially risky.
This should provide a solid introduction to stocks for you which will carry through on future installments. The next installment will cover bonds.
As always, if you have any questions about this topic or any other personal finance issues reach out to 7th Street Financial at email@example.com or visit the website at www.7thstfinancial.com.
Disclosure – Jeff Burke personally owns shares of Facebook, Apple and Pinterest in his own portfolio.
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