Economics Kleinfelder February 2012 Introduction to the Stock Market

Transcription

1 Economics Kleinfelder February 2012 Introduction to the Stock Market WHAT IS THE STOCK MARKET??? When people talk about the Stock Market, it s not always immediately apparent what they are referring to. Is the Stock Market just one place or many? To many it is an abstract idea. Many people buy and sell stocks without ever leaving the comfort of their computer terminal some people have no idea how their money is dispersed markets, relying on others to maintain their portfolio. The world stock market is estimated at over $35 trillion (US $). The term, in general, refers to the organized trading of securities in various market exchanges. Countries including the United States, United Kingdom, Japan, India, China, Canada, Germany, France and the Netherlands all have markets that are comprised of a number of exchanges. The stock market is an auction-based market, with intermediaries who match buys and sellers of stocks. As there is no fixed price, the selling price is set by the amount a buyer is willing to pay. A stock exchange is the market place where brokers buy and sell stocks. Therefore the U.S. stock market is comprised of the NYSE, AMEX, and NASDAQ. The largest public stock market is the New York Stock Exchange (NYSE). The NYSE is a physical exchange and is comprised of specialists who match buyers and sellers of stocks. The American Stock Exchange operates in a similar fashion. And there are many smaller regional exchanges, such as the Pacific in Los Angeles, the Philadelphia, the Boston, the Cincinnati, and the Chicago. While smaller companies are only listed on regional exchanges, other companies list on regional markets, as well as the NYSE or AMEX, so to ensure greater exposure. The NASDAQ differs from the AMEX and NYSE, because all transactions are done on an electronic system. Another name for this is virtual listing. Trades for NASDAQ stocks are done using an extensive computer network between geographically dispersed investment banks and brokerage firms. The NYSE and AMEX are increasingly relying on technology that matches trades electronically, bypassing the need for human specialists. HISTORY OF THE STOCK MARKET The first brokers date back to 12 th century France when courratiers de change, on behalf of banks, managed and collected the debts of farming communities. In 1309, a group of commodity traders gathered in Antwerp, Belguim. This grop became known as the Brugse Beurse and the idea spread to Flanders, Ghent, and Amsterdam. The creation of Beursen institutionalized what had been an informal meeting of trade. By mid-13 th century, bankers in Venice began to trade in government securities. The practice spread throughout Italy by the end of the 14 th century. In 1600, the Dutch began to organize joint stock companies, where shareholders invested in large business ventures and received a share of the profit (or loss). In 1602, the Dutch East India Company issued stocks and bonds; thereby creating the Amsterdam Stock Exchange (Amersterdamn Beurs). The Amsterdam Stock Exchange grew quickly and pioneered many fundamental aspects of continuous trade. Wall Street can trace it s name back to Originally it was set up for defense and not for commerc. Settlers of Dutch descent, who were always on the look out for attacks by the American Indians or the British, built a 12 foot stockade fence. Little did they know this fence would go on the become the center of financial activity until At that point the British tore down the fence to build Wall Street. What helped Wall Street rise to pre-eminence was the emergence of two large stock exchanges in Philadelphia in Two years later a group of New York merchant met to discuss how to take command of the securities business. The 24 merchants founded what is now the New York Stock Exchange (NYSE).

2 THE STOCK MARKET HOW IT WORKS A stock market may be thought of in terms of two separate functions: PRIMARY MARKET FUNCTION \/ A PLACE WHERE COMPANIES CAN RAISE LONG-TERM FUNDS FOR THEIR OPERATIONS BY ISSUING SHARES TO INVESTORS A company wishing to set up a new business or expand its existing business can raise the capital it requires either by borrowing money or by issuing shares to investors The investors become shareholders in the company. As a result, they are part owners and, therefore, share in the profits and growth Companies wishing to have their shares traded must first be listed. To become listed the company must be large enough for there to be a market in its shares and it must agree to abide by listing rules (Ie. Informing market of activities, report profits/losses, etc.) A strong interest in shares allows the company to raise additional capital for the future SECONDARY MARKET FUNCTION \/ A PLACE WHERE INVESTORS CAN BUY and SELL THOSE SHARES AT CURRENT PRICES AS DETERMINED BY OTHER INVESTORS IN THE MARKET Once a company is listed, shares can be sold on the stock market to investors. Private individuals can buys shares of companies individually or can authorize a money manager to churn their funds The price of shares is determined by the forces of supply and demand, as private investors and fund managers decide at what price they buy or sell. Wealth is created in the form of dividends and other income/capital gains from selling the company s shares as the prices raise. The share market provides an opportunity for investors to contribute to and benefit from the wealth-creating activities of companies, and, in that way, participate in the broader economy. When you buy goods and services form listed companies, you are contributing to their growth and providing an opportunity to higher profits, which enables them to pay higher dividends to shareholders. AN INTRODUCTION TO STOCKS A share of stock is a share of a business. Many people try to gain more money by investing in stocks. Stockholders, therefore, are partial owners of the company that issues the stock. The stockholder is able to make money in the form of dividends, or their proportional share of the profit. Corporations always issue common stock, representing ownership interest in the company. People owning common stock usually have the right to vote for the directors of the company. Preferred stock may also be issued by the corporation. This kind of stock gives preferential treatment over common stock. These stockholders may receive fixed dividends before the common stock holders are paid, along with other advantages. However, they generally have no voting privileges and cannot expect to receive more than their fixed dividend. The prices of stock change often. Most active stocks change in value during a day s trading. A corporation only has a certain number of shares available to buy. The laws of supply and demand cause the prices to fluctuate. Prices depend on general business conditions, company earnings, and what people think is the future prospects of the corporation. When more people want to buy, the market in stocks will rise. When more people want to sell, prices go down. The trick is to try and guess correctly: buy when the price is low and sell when the price is as high as it is going to go! READING and UNDERSTANDING STOCKS Current stock listings are organized a little differently from source to source, but they all have the same basic information. First you have to type in the correct SFN/SYM, the abbreviation for the name of the company. You may have to look this up (see the Reference List for sources). Once you have the correct SFN, you will see the information you need: Last - the most recent trade of a stock Change change in price from previous day s closing choice Currency currency used (I.e. USD for U.S. dollar) % Change calculates the percentage change in the price of a stock from the previous day s closing price

3 Open price at which a stock opens the trading day Day Low lowest price the stock has traded at during the day Day High highest price the stock has traded at during the day Volume daily number of shares of a stock that changes hands between a buyer and a seller; given in hundreds or thousands Avg Vol average Daily Volume, or monthly average of the cumulative trading volume during the last 3 months divided by 22 days Dividend annual per share cash payout investors should expect Div Date Dividend Pay Date, or date on which the dividend was last paid, or date when the next one will be paid Div/Shr Dividend Per Share, or annual dividend per share of stock as reported by the company Yeild annual dividend per share divided by the previous closing stock price as a percentage (multiplied by 100) EPS Earnings Per Share stated for the most recent 12 months and calculated by dividing earnings by the average number of shares of common stock outstanding during the period P.E. (Price-to-earnings ratio) ratio of market price per share to the earnings per share Ask price price you will pay to buy a stock Bid price price you will get if you sell your stock Spread difference between the bid price and ask price Last trade time and price of the last trade made for the stock (date is reported if stock has not been traded that day Net change price difference from current price to the last trade price Bid size/ask size number of shares a buyer is willing to purchase for the bid or ask price Previous close closing price for the trading day prior to the last trade reported EVALUATING STOCKS No matter how the exchange is organized, there are potential winners and losers. Your task is to tell them apart. In order to do that, you need to be able to evaluate risk factors inherently represented in both the industry and in the balance sheet of the company. There are many questions to ask about a company before buying its stock. The answers to these questions will help you to judge the likelihood of that company s ability to repay your investment with short term returns. Some key questions to ask are discussed below. Is the company financially strong? A company s financial strength is crucial to its long term survival and growth. Start by looking at a firm s debt level. Some analysts suggest looking for a 2-to-1 ratio of the firms assets to liabilities. A falling below this line may be unable to invest in new plants and equipment or develop new products. It could even be forced in to bankruptcy. What is the company s dividend history? A firm that has been paying out positive dividends

4 consistently for the past 20 years is probably on solid financial ground. It is even more advantageous if the dividends have grown consistently over 5 years or longer. However, a company may pay out dividends to it s own detriment. For example, if it should be saving capital to revitalize itself in the industry. Understand the company s assets and liabilities. Is the stock priced fairly? Investors do not always get what they pay for. Many highly touted stocks of excellent companies that trade at high prices suffer sharp declines. Likewise, some neglected or unpopular stocks of struggling firms eventually turn around. It is not enough to buy stock in a good company. You must also buy when it is reasonably priced, based on the company s underlying prospects. How can you judge a stock s price? One key indicator is the PE ratio, which is calucated by dividing a stock s current price by its earnings per share. The PE ratio indicated how much investors are willing to pay for a given level of earnings. The higher the ratio, the more investors are paying for earnings; because they are betting on higher earnings in the future, they are willing to pay more now. Many investors use the PE ratio as a type of price tag to tell them when a stock is trading at an extremely high price or an attractively low price. That does not mean you should only buy shares with low PE ratios. Be sure to identify the industry s average PE ratio. When you identify a PE ratio well below the industry average, you will want to research why it is so inexpensive. If it is financially sound and its earnings prospects are strong, you may have found a quality investment. Alternatively, if a stock s PE ratio is especially high when compared to the industry average, you should be wary as you are paying a premium that could be excessive, unless the company meets the most optimistic expectations. Are the company s earnings growing? When you invest in a growth stock, you should have reason to believe that the company will continue to post higher and higher profits. It s important to look at the company s earnings and sales history. Look for steady annual profit and sales growth over the past 5 years or more. Also consider analysts earnings projections for the next 3-5 years. What could go wrong? Is the company s success dependent only on one product? Is this product a staple in the market? Is it only seasonally popular? Could it turn out to be a fad? Is the company well entrenched in a variety of growing domestic and international markets? Is the firm engaged in a highly competitive market? Are sales and profits closely linked to outside factors, such as the overall health of the economy or government regulation? Does the balance sheet reflect a weakness in the company s financial manageament? Does the balance sheet reflect an awareness of risks the company faces? What are the economic trends of the market, sector, industry, and company? Look at short term and long term. Compare and contrast with similar businesses. What business events occurred through the financial press and news that may cause the market to react? WHAT ARE SECURITIES? What they have in common is this: a security is a tradable financial asset that represents ownership of a company or a loan to a company or a government. While stocks are the most common security people trade in, you will asked to trade in other securities as well. The following are other types of securities: BONDS~ Bonds are IOUs that companies and governments sell when they borrow money. If you buy a Dell Computer bond, you get an IOU from Dell that pays periodic interest. The company must also repay the loan when the bond matures. You don t buy bonds directly from Dell, however. Bonds are bought from other investors in the bond market. Like the stock market, the bond market is a secondary market where investors trade securities (in this case, bonds) with one another. 2 When a bond matures and is repaid, a company pays the investor owning the bond at that time.

5 Bond prices rise and fall in the bond market, just as stock prices do in the stock market. One of the most important reasons for these ups and downs is a change in current or expected interest rates. If interest rates rise, bond prices usually fall. If interest rates fall, bond prices usually rise. CORPORATE BONDS~ Corporate bonds generally are less risky than stocks because companies are legally obligated to pay the bonds interest and to repay the loans when the bonds mature. In contrast, companies aren t required to pay back the money people invest in stocks, nor are they required to pay dividends to stockholders. While bonds are less risky than stocks, they still have some risk. As the example above shows, higher interest rates can reduce bond prices and inflict losses on their holders. Specific bonds also have their own particular risks. A given company might have financial problems that prevent it from making some or all of its interest payments. It might also be unable to repay the bond when it matures. Investors can appraise such risks by checking bond ratings from companies like Moody s and Standard & Poor s. TREASURY BONDS, BILLS, and NOTES~ U.S. Treasury bonds are backed by the full faith and credit of the federal government, so they re much safer than corporate bonds. The Treasury can then sell bonds at lower interest rates than corporations that must offer higher rates to offset their greater risk. Treasury securities come in different flavors. Treasury bills are short-term debts that come due in 90 days to one year. Treasury notes have maturities from 2 to 10 years, and Treasury bonds have maturities ranging from 10 to 30 years. Securities with maturity dates further in the future are usually riskier because investors must wait longer for repayment. Consequently, these securities usually pay higher interest rates than those with shorter life spans. FUNDS~ All investors must decide if they want to manage their investments themselves or have professional managers do it for them. Many people choose the latter. They d rather not sort through thousands of companies and hundreds of industries in search of good investment prospects. They d rather not spend hours monitoring the investments they finally pick, and they may doubt their ability to tackle these tasks in the first place. As a result, many investors choose securities called funds over individual stocks or bonds. A fund pools the money of many savers and invests it in many different stocks or bonds. This enables investors to diversify their holdings. Diversification reduces risk by combining different investments whose prices aren t likely to move in step with one another. If the price of one stock in a fund falls, the price of another might rise and offset the loss. Investors aren t putting all their investment eggs in one basket, so funds reduce their risk of losing money. Investors have many choices of funds. Some invest only in stocks, while others invest only in bonds. Still others mix or balance both stocks and bonds. When selecting a fund, investors can pick among three general types of funds as shown belo Mutual Funds Exchange Traded Funds (ETFs) Closed-End Funds Most have professional managers who actively buy and sell stocks or bonds based on what they think is best for shareholders. A few are index funds, which are not actively managed. Instead, these funds closely follow indexes of stocks or bonds. Investors trade with the fund, not with one another. So the number of shares held by investors is open-ended, not fixed. Orders can be placed any time during the day but are completed only at closing prices after the market closes at the end of the trading day. A share s price equals the fund s net asset value (NAV), which is the total value of the fund s investments (less liabilities) divided by the number of shares investors hold. ETFs are not actively managed but are index funds that closely follow indexes of stocks or bonds. There are very few bond ETFs. The fund issues a fixed number of shares, which investors trade with one another, not with the fund. However, the fund can increase or decrease this fixed number of shares. Shares trade just like stocks. They can be traded at any time during the market s trading hours. A share s price rises and falls according to investors supply and demand. These funds are actively managed, just like most mutual funds. The number of shares issued by the fund remains fixed. Investors trade these shares with one another, not with the fund. Shares trade just like stocks. They can be traded at any time during the market s trading hours. A share s price rises and falls according to investors supply and demand.