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Stock Market Guide

Types of Stock    How Stocks Trade    Analyzing Stocks

Buying Stocks    Notes

The modern stock market exists as a way for entrepreneurs to finance businesses using money collected from investors. In return for financing the company, the investor becomes a part owner of the company. That ownership is represented by stock -- specialized financial "securities," or financial instruments -- that are "secured" by a claim on the assets and profits of a company.

Types of Stock

Common Stock. Common stock is aptly named, as it is the most common form of stock an investor will encounter. It is an ideal investment vehicle for individuals because anyone can own it. Common stock is more than just a piece of paper; it represents a proportional share of ownership in a company -- a stake in a real, living, breathing business.
Shareholders "own" a part of the assets of the company and part of the stream of cash those assets generate. As the company acquires more assets and the stream of cash it generates gets larger, the value of the business increases. This increase in the value of the business is what drives up the value of the stock in that business.

Because they own a part of the business, shareholders get one vote per share of stock to elect the board of directors. The board is a group of individuals who oversee major decisions made by the company. Far from being a perfunctory collection of do-nothings, the board wields a lot of power in corporate America. Boards decide how the money the company makes is spent. Decisions on whether a company will invest in itself, buy other companies, pay a dividend, or repurchase stock are all the purview of the board of directors. Top company management -- who the board hires and fires -- will give some advice, but in the end the board makes the final decision.

Different Classes of Stock. When companies find it necessary for various reasons to concentrate the voting power of a company into a specific class of stock where the majority is owned by a certain set of people. For instance, if a family business needs to raise money by selling equity, sometimes they will create a second class of stock that they control that has 10 votes per share of stock and sell a class of stock that only has one vote per share to others. Does this sound like a bad deal? Many investors believe it is and routinely avoid companies where there are multiple classes of voting stock. This kind of structure is most common in media companies and has been around only since 1987.

When there is more than one kind of stock, they are often designated as Class A or Class B shares. For instance, Berkshire Hathaway Class A shares trade as BRK.A, whereas Berkshire Class B shares trade as BRK.B. On the Nasdaq stock market, the class of stock becomes a fifth letter in the ticker symbol. For example, Bel Fuse trades under the tickers BELFA (the Class A shares) and BELFB (the Class B shares).

How Stocks Trade

Probably one of the most confusing aspects of investing is understanding how stocks actually trade. Words such as "bid," "ask," "volume," and "spread" can be quite confusing.

Listed Exchange. The New York Stock Exchange (NYSE) and the American Stock Exchange (AMEX, composed of the Boston, Philadelphia, Chicago, and San Francisco Exchanges and now merged with the Nasdaq stock market) are both "listed" exchanges, meaning that brokerage firms contribute individuals known as "specialists" who are responsible for all of the trading in a specific stock. Volume, or the number of shares that trade on a given day, is counted by the specialist and reported to the exchange along with information on the price and size of each trade.
NYSE trades still take place face-to-face in the trading pit where buyers and sellers physically converge on the specialist who matches buyers with sellers, but computers play a big part in the process these days. All trades are "auctions." There is no set price, although the last trade is often considered to be the "price" of a stock. In reality, the price is the highest amount any buyer is willing to pay at any given moment. When demand for a certain stock is high, the various buyers bid the price higher to induce sellers to sell. When demand for a stock is low, sellers must sell at lower prices to attract buyers and the price drops.

Over-the-counter Market. The Nasdaq stock market, the Nasdaq SmallCap, and the OTC Bulletin Board are the three main over-the-counter markets. In an over-the-counter market, brokerages (also known as broker-dealers) act as "market makers" for various stocks. The brokerages interact over a centralized computer system managed by the Nasdaq.

Market makers may match up buyers and sellers directly, but mostly they maintain an inventory of shares to meet the demands of the market. So when you want to sell 100 shares of ABC stock, you don't have to wait for someone else to place an order to buy 100 shares of ABC; the market maker steps in, buys them from you immediately, then sells them when a buyer comes along. Market makers and specialists keep the markets "liquid" each in their own way. You are assured that, except in extraordinary circumstances, you can always buy or sell your shares if the market is open.

"Volume" numbers under the Nasdaq system are often inaccurate. Since most trades are in and out of the market makers accounts, what would be one trade on the NYSE (where buyers and sellers are matched directly) is usually two trades on the Nasdaq.

Bid, Ask and Spread

Handling all those orders is very valuable service, and market makers (and specialists) are appropriately rewarded. Suppose you want to sell ABC and the last trade was at $6.25. When your "market" order (an order to sell at the going price) goes out on the Nasdaq system, the companies that make a market in ABC will bid for the right to buy your shares. If they see a lot of orders for ABC, they might bid $6.50 for your shares, because they know that they can turn around and ask $6.60 to sell them. If they see a slackening of demand for ABC, they might only bid $6.00 and ask $6.10. On the NYSE, specialists won't match orders for the exact same price. They will match buy orders for slightly more than the seller is asking.

Investors can set their own bid or ask prices, too, by placing orders to sell or buy only at a specific price. Market makers and specialists keep a close eye on these "open" orders, executing them when conditions are met, and using them to gauge demand for the stock.

Analyzing Stocks

Fundamental Analysis - Buying a Business (Value, Growth, Income, GARP, Quality)
When you buy a share of stock you are buying a proportional share in a business. As a consequence, to figure out how much the stock is worth, you should determine how much the business is worth. Investors generally do this by assessing the company's financials in terms of per-share values in order to calculate how much the proportional share of the business is worth. This is known as "fundamental" analysis by some, and most who use it view it as the only kind of rational stock analysis.

Value. An investor's purpose should be to know both the price and the value of a company's stock. The goal of the value investor is to purchase companies at a large discount to their intrinsic value - what the business would be worth if it were sold tomorrow. In a sense, all investors are "value" investors - they want to buy a stock that is worth more than what they paid. Typically those who describe themselves as value investors are focused on the liquidation value of a company, or what it might be worth if all of its assets were sold tomorrow. However, value can be a very confusing label as the idea of intrinsic value is not specifically limited to the notion of liquidation value. Novices should understand that although most value investors believe in certain things, not all who use the word "value" mean the same thing.

The value investors tend to have strict rules governing how they purchase a company's stock. These rules are usually based on relationships between the current market price of the company and certain business fundamentals. Some examples include:

Growth. Growth investing is the idea that you should buy stock in companies whose potential for growth in sales and earnings is excellent. Growth investors tend to focus more on the company's value as an ongoing concern. Many plan to hold these stocks for long periods of time, although this is not always the case. At a certain point, "growth" as a label is as dysfunctional as "value," given that very few people want to buy companies that are not growing.

Growth investors look at the underlying quality of the business and the rate at which it is growing in order to analyze whether to buy it. Excited by new companies, new industries, and new markets, growth investors normally buy companies that they believe are capable of increasing sales, earnings, and other important business metrics by a minimum amount each year. Growth is often discussed in opposition to value, but sometimes the lines between the two approaches become quite fuzzy in practice.

Income. Although today common stocks are widely purchased by people who expect the shares to increase in value, there are still many people who buy stocks primarily because of the stream of dividends they generate. Called income investors, these individuals often entirely forego companies whose shares have the possibility of capital appreciation for high-yielding dividend-paying companies in slow-growth industries. These investors focus on companies that pay high dividends like utilities and real estate investment trusts (REITs), although many times they may invest in companies undergoing significant business problems whose share prices have sunk so low that the dividend yield is consequently very high.

GARP. GARP is an acronym for growth at a reasonable price. The world according to GARP investors combines the value and growth approaches and adds a numerical slant. Practitioners look for companies with solid growth prospects and current share prices that do not reflect the intrinsic value of the business, getting a "double play" as earnings increase and the price/earnings (P/E) ratios at which those earnings are valued increase as well.

One of the most common GARP approaches is to buy stocks when the P/E ratio is lower than the rate at which earnings per share can grow in the future. As the company's earnings per share grow, the P/E of the company will fall if the share price remains constant. Since fast-growing companies normally can sustain high P/Es, the GARP investor is buying a company that will be cheap tomorrow if the growth occurs as expected. If the growth does not come, however, the GARP investor's perceived bargain can disappear very quickly.

Quality. Most investors today use a hybrid of value, growth, and GARP approaches. These investors are looking for high-quality businesses selling for "reasonable" prices. Although they do not have any shorthand rules for what kind of numerical relationships there should be between the share price and business fundamentals, they do share a similar philosophy of looking at the company's valuation and at the inherent quality of the company as measured both quantitatively by concepts like Return on Equity (ROE) and qualitatively by the competence of management. Many of them describe themselves as value investors, although they concentrate much more on the value of the company as an ongoing concern rather than on liquidation value.

Company Size. Some investors purposefully narrow their range of investments to only companies of a certain size, measured either by market capitalization or by revenues. The most common way to do this is to break up companies by market capitalization and call them micro-caps, small-caps, mid-caps, and large-caps, with "cap" being short for "capitalization." Different-size companies have shown different returns over time, with the returns being higher the smaller the company. Others believe that because a company's market capitalization is as much a factor of the market's excitement about the company as it is the size, revenues are a much better way to break up the company universe. Although there is no set breakdown used by all investors, most distinctions look something like this:

  • micro-caps - $100 million or less
  • small-caps - $100 million to $500 million
  • mid-caps - $500 million to $5 billion
  • large-caps - $5 billion or more

The majority of publicly traded companies fall in the micro or small categories. Some statisticians believe that the perceived outperformance of these smaller companies may have more to do with "survivor" bias than actual superiority, as many of the databases used to do this performance testing routinely expunged bankrupt companies until pretty recently. Since smaller companies have higher rates of bankruptcy, excluding this factor helps "juice" up their historical returns as a result. However, this factor is still being debated.

Screen-Based Investing. Many quantitative analysts use "screens" to select their investments, meaning that they use a number of quantitative criteria and examine only the companies that meet these criteria. As the use of computers has become widespread, this approach has increased in popularity because it is easy to do. Screens can look at any number of factors about a company's business or its stock over many time periods.

While some investors use screens to generate ideas and then apply fundamental analysis to assess those specific ideas, others view screens as "mechanical models" and buy and sell purely based on what comes up on the screen.

Momentum. Momentum investors look for companies that are not just doing well, but that are flying high enough to get nose bleeds. "Well" is defined as either relative to what investors were expecting or relative to all public companies as a whole. Momentum companies often routinely beat analyst estimates for earnings per share or revenues or have high quarterly and annual earnings and sales growth relative to all other companies, particularly when the rate of this growth is increasing every quarter. This kind of growth is viewed as a sign that things are really, really good for the company. High relative strength is often a category in momentum screens, as these investors want to buy stocks that have outperformed all other stocks over the past few months.

As "fuzzy" as fundamental analysis might be, there are often times that knowing even a little about the company you are buying can help a lot. For instance, if you are using a high-relative-strength screen, you should always check and see if the companies you find have risen in price because of a merger or an acquisition. If this is the case, then the price will probably stay right where it is, even if the "screen" you used to pick this company has generated high annual returns in the past.

Buying Stocks

Use a Brokerage. The most common way to buy stocks is to use a brokerage. You can either use one of the many way-too-expensive full-service (or full-price) brokers, or use a discount broker to execute your trades. When you use a brokerage, you can have a cash account or a margin account, meaning you can borrow money to buy stocks.

In order to buy shares of stock, you need a stockbroker to help you with the transaction. The broker is the link between you and the stock exchange. He is employed by a brokerage house to facilitate your transactions and, in the case of full-service brokers, to advise you in making your investment decisions.

Although a broker may do his own research, he is NOT a research analyst. Research analysts are other folks who work for brokerages, and it is they who do that sort of enlightening, in-depth research of a company's business and industry.

Full-Service vs. Discount

Full-Service. These brokers tend to offer a wider variety of financial products, as well as investment advice and research, than do discount brokers, and they charge considerably higher fees. They may offer stocks, bonds, derivatives, annuities, and insurance. A full-service broker solicits business and is paid mostly by commissions. This means that he is compensated not according to how well your portfolio does, but by how often you trade.

Discount. Discount brokerages do not offer any advice or research - they simply transact your trades with no frills. Because they manage fewer products than their full-service counterparts, discounters charge considerably lower fees. They also often offer online computer order entry services. Live brokers at these brokerages are usually paid a fixed salary to execute your trades. They don't solicit, and they aren't paid commissions. Discount brokerages make money by doing business in volume, competing mostly on price and "reliability" of the service: if they have the lowest prices and the best service, they get the most trades.

Online Trading. Online trading has exploded over the past year as investors are becoming more self-sufficient and comfortable using their computers for investing. That's great for all the technically inclined folks, but is it right for you? It's wonderful to be able to access your account information at a moment's notice and to place trades 24 hours a day. We like the idea of using an online brokerage account, but we also realize that some people prefer to deal with a real person when they are placing trades. Many discount brokers offer both options and, in general, the price of transacting a trade with a real live human being will be somewhat higher than if you conduct it on the Internet.

When shopping around for an online discount broker, you should ask plenty of questions about its customer service department. Sure, online brokerage accounts are becoming easier to use and are providing more and more information, but you need to know how you can access your account information if you can't get online for some reason and need to make a transaction. Will a "live" broker be accessible to you if you need to place a trade? What if you need a copy of your latest monthly statements for the IRS and the web site is down?

If you're comfortable with your computer and you don't really need to hear that voice on the other end of the phone, we recommend that you go with a discount broker and trade online. If you need to hear a voice, the solution is simple: Choose a discount broker that offers trading over the telephone.

Placing an Order

Buy order. The order you place when you want to buy shares. Simply tell the broker how many shares you want to purchase.

  • Buy at market. You instruct the broker to buy a specified number of shares at the prevailing market price.
  • Buy at a limit. You instruct the broker to buy a specified number of shares, but only at a specified price or lower. For example, you might say: "Buy 100 shares of IBM at a limit of $80." In this case, you are only willing to purchase shares of IBM if you can do so at $80 or less.

Sell order. An order you place when you want to sell shares.

  • Sell at market. An order to sell your shares at the prevailing market price.
  • Sell at a limit. An order to sell your shares only at the price that you specify or higher.
  • Sell at a stop limit. You instruct your broker to sell your stock if it falls to a certain price. For example, you buy IBM at $80 and you instruct your broker to sell if it falls to $70. This would be a Sell Stop at $70.

Notes

Cash vs. Margin. If you invest in stocks just with the money you have in your brokerage account, you are using a cash account. If you borrow money from the brokerage to invest in stocks, you are using a margin account. If you borrow money in a margin account to buy stocks, keep in mind that this is not at all "free" money. Your collateral for borrowing the money is the marginable securities in your account, which means they are forfeit if you cannot otherwise repay the margin loan. You also have to pay a fixed amount of interest on the borrowed money on a monthly basis, which can reduce your overall returns. Because IRAs and other retirement accounts are cash accounts, you cannot use margin in them.

Book Value. The current value of an asset on a company's balance sheet according to its accounting conventions. The shareholders' equity on a company's balance sheet is the book value for that entire company. Many times when investors refer to book value, they actually mean book value per share, which is the shareholder's equity (or book value) divided by the number of shares outstanding. As the book value is theoretically what a company could be sold for (liquidation value), this book value number is sometimes used as a rough guide as to whether or not the shares are undervalued.

Capital Appreciation. One of the two components of total return, capital appreciation is how much the underlying value of a security has increased. If you bought a stock at $10 and it has risen to $13, you have enjoyed a 30% return from the appreciation of the original capital you invested. Dividend yield is the other component of total return.

Dividend Yield. A ratio of a company's annual cash dividends divided by its current stock price. To get the expected annual cash dividend payment, take the next expected quarterly dividend payment and multiply that by four. For instance, if a $10 stock is expected to pay a 25 cent quarterly dividend next quarter, you just multiple 25 cents by 4 to get $1 and then divide this by $10 to get a dividend yield of 10%.

Many newspapers and online quote services will include dividend yield as one of the variables. If you are uncertain whether the current quoted dividend yield reflects a recent increase in the dividend a company may have made, you can call the company and ask them what the dividend per share they expect to pay next quarter will be.

Earnings Per Share (EPS). Earnings, also known as net income or net profit, is the money that is left over after a company pays all of its bills. For many investors, earnings are the most important factor in analyzing a company. To allow for apples-to-apples comparisons, those who look at earnings use earnings per share (EPS).

You calculate the earnings per share by dividing the dollar amount of the earnings a company reports over the past 12 months by the number of shares it currently has outstanding. Thus, if XYZ Corp. has 1 million shares outstanding and has earned $1 million in the past 12 months, it has an EPS of $1.00.

Market Capitalization. The current market value of all of a company's shares outstanding. To calculate market value, you take the number of shares outstanding and multiply them by the current price of each share. You can find information about shares outstanding from the company's last quarterly report or any online quote service.
For instance, if a company has 10 million shares outstanding and trades at $13 per share, the market capitalization is $130 million.

Price/Earnings Ratio (P/E). Earnings per share alone mean absolutely nothing. In order to get a sense of how expensive or cheap a stock is, you have to look at those earnings relative to the stock price. To do this, most investors employ the price/earnings (P/E) ratio. The P/E ratio takes the stock price and divides it by the last four quarters' worth of earnings.
If XYZ Corp. is currently trading at $15 a share with $1.00 of earnings per share (EPS), it would have a P/E of 15.

Relative Strength. Relative strength, also known as relative price strength, rates the performance of a stock versus the performance of the market as a whole over a given time period. The rating system gives a numerical grade - just like the ones Mr. Spicer used to scrawl in bright red ink on your algebra quizzes - to the performance of a stock over a given period, normally the past 12 months. Thus, relative strength is a momentum indicator.

The most popular form of relative strength ratings are those published in Investor's Business Daily, which go from 1 to 99. A relative strength of 95, for example, indicates a wonderful stock, one that has outperformed 95% of all other U.S. stocks over the past year. However, given that relative strength is only a mathematical relationship between the stock's performance and an index's performance, many others have created their own relative strength measures.

Revenues. Also known as sales, revenues are how much the company has sold over a given period. Annual revenues would be the sales for a given year, whereas quarterly revenues would be the sales for a given quarter.

Sales. Also known as revenues, sales are literally how much the company has sold over a given period. Annual sales would be the sales for a given year, whereas quarterly sales would be the sales for a given quarter.

Utilities. A business that provides a service essential to almost everyone is called a utility. These businesses are almost always under some form of regulation by the government and normally have a monopoly position in a certain region. Electric companies, natural gas providers, and local phone companies are often referred to as utilities.

Volume. The number of shares traded on a given day is known as the volume. Many investors look at volume over a month or a year to come up with average daily volume. Market watchers will say a company has traded at a certain number of times the average daily volume, giving the investor a sense of how active the stock was on a certain day relative to previous days. When major news is announced, a stock can trade as much as 20 or 30 times its average daily volume, particularly if the average daily volume is very low.

The average number of shares traded gives an investor an idea of a company's liquidity - how easy it is to buy and sell a particular stock. Highly liquid stocks trade easily in large batches with low transaction costs. Illiquid stocks trade infrequently and large sales often cause the price to rise or fall dramatically. Illiquid stocks on the Nasdaq also tend to carry the largest spreads, the difference between the buying price and the selling price.

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