Investing in stocks can seem complicated and overwhelming, not to mention extremely risky. There are no guaranteed returns when you invest in stocks and you could lose ten twenty, fifty percent or more of your investment overnight.
In reality, you could even lose your entire investment, all one hundred percent of it. This makes investing in stocks seem like too big of a gamble for most people. They’d rather play the lottery or go to Las Vegas once a year.
Most of those who get involved end up investing in stocks by leaving it to the professional money managers by putting their money in mutual funds instead of individual stocks.
Let’s try and change all that by starting from the beginning and taking a look at what investing in stocks really is; it’s simply investing in a business for a percentage of future profits that the business produces.
Investing in stocks is very similar to investing in your cousin Joey’s pizza shop in town. Joey doesn’t want a business loan from you that he would pay back he wants you to buy a percentage of his business and use that money to keep growing that business.
Joey would like you to purchase 10% of the business, which would entitle you to 10% of the net profits.
What would you want to know about Joey’s business? For starters, you’d want to know how much in sales the business does each year. You’d also want to know how much net profit is left over from those sales, as well as the potential for growth over the next one, three, five years or more.
Joey’s pizza shop brought in revenue of $600,000 in the last year. After all his expenses such as utilities, inventory, mortgage, advertising and employees, there was $200,000 left but this was income before taxes, which took up another $80,000. This left a net profit from the business of $120,000 last year.
Joey feels this makes the business worth $1.2 million dollars and wants you to invest $120,000 for your 10% stake in the business. This would entitle you to ten percent of the profits, which would give you $12,000 or a 10% return on your investment.
Is this a good deal? It would seem to be as a 10% return is higher than you would get with government bonds, which are almost risk free. You’re taking more risk and would want the potential to get a higher rate of return. But it’s not always that easy. The future matters, too.
It’s important to take a look at what the business, in this case Joey’s pizza shop, might do in the future when it comes to earnings.
Is there room for growth? Does Joey want your investment so he can open another pizza shop or two? Is it possible he will see more competition in town? Is Joey’s business well run? In other words, will he put your investment to good use in growing the business?
These are all important questions that need to be answered as best as they can before making the decision to invest in Joey’s pizza shop.
This is exactly what you are doing when investing in stocks. Each ‘share’ of a company that your purchase, means you own a percentage of that business. Of course, with publicly traded companies, many of whom issues millions of stock shares, your percentage of ownership will be extremely small. But the overall concept is the same.
To review, by buying that ‘share’ of stock you are purchasing a percentage of the business and are entitled to a percentage of that business’s future earnings.
An important consideration when purchasing stock is to determine of the current price of the stock is a good deal against the potential future earnings of the company. This means a bit of research and a bit of guessing. Despite all the wizards on Wall Street, no one can predict the future.
The potential earnings you will receive, in the form of the appreciation of your shares of stock, needs to be greater than the return on the 10 year U.S. Government bond, otherwise it is not worth the risk of the investment.
Boiled down to its simplest parts, these are the things you need to know about a company if you want to understand how to invest in stocks.
One very key point is to understand that you are investing in, or buying, a piece of the company, however small it may be for you. Investing is something you do for the long term.
You see, the short term price movement of stocks usually has nothing to do with the reality of the quality or profitability of the business itself.
Sometimes it’s rumors about a new product, maybe a product recall, news about the overall economy or sometimes traders sell off a stock to take profits and that causes the stock price to drop.
This is much different than trading. Traders look to buy and sell stocks by exploiting things like the above mentioned news items. They may only hold a stock for a few days, a few hours or even a few minutes and they don’t care about the overall health of the company, they are looking to exploit short term price fluctuations and profit from them.
The value of a company is based on its earnings and potential future earnings and does not change much over the short term. But stock prices do change a lot over the short term, based on many things and sometimes nothing at all.
When you are investing in stocks, you are looking for good companies at a reasonable price, one that offers the potential for a yearly rate of return higher than the 10 year U.S. Government bond.
This is known as value investing, originally made famous by Benjamin Graham and then later by one of his followers, billionaire investor Warren Buffett.
Graham looked at it this way. You can do three things with a stock. You can buy it at the current price the market is offering, sell it at the current price the market is offering (if you own it, of course), or you can do nothing at the current price.
What Graham and Buffett recommend is investing in the stock of a company when the stock price being offered by the market is lower than the value of the company, known as investing with a margin of safety.
With value investing you need to know two crucial things; are you getting a good price and is the business you are investing in a good business or a bad business?
In order to understand this as best you can without being able to predict the future, we need to look at two simple tools when deciding to purchase a specific stock.
So how do you figure that out? Great question! Let’s go back to Joey’s pizza shop.
We’ll turn Joey’s example into stock shares. Joey issues 100,000 shares at $12 per share ($1.2 million which is what Joey valued the business), which would total half the business.
Joey keeps 50,000 shares himself, giving him 50% of the business going forward. Your ten percent investment is 10,000 shares (10% of the total 100,000 shares) times $12 per share, or $120,000.
The business netted $120,000. With 100,000 shares issues, that’s an earnings of $1.20 per share. The earnings yield of the business would be ten percent ($1.20 profit per share at a share price of $12).
Now, what if the share price was still $12 but the earnings per share was $2? What if the earnings per share was $3? Which would you rather have? Yes, it’s the $3, then the $2 and then the $1.20.
A key criteria for stock investing is the earnings yield. It helps determine if the price of the stock is a good price. But we also need to know if it’s a good business. The price of a stock may seem like a great bargain but if the company itself is struggling, it’s a very risky investment.
A very good indication of whether the business behind the stock is a good one is what is known as return on capital.
Let’s say Joey used the $600,000 he raised from selling the 50,000 shares of stock to open another pizza shop and the shop earned $200,000 the first year. That’s a one third return (roughly 33%). This is usually referred to as a return on capital.
Let’s say the shop earned only $6,000, or just a measly one percent return on capital. Which is better? Obviously the 33% return on capital.
A business with a one percent return on capital probably won’t last very long and you could invest your money most anywhere else and get a better return on your investment.
Here’s what we know. You want to buy a business at a good price, a business that earns more relative to the price of the stock, one that has a high earnings yield.
You also want to purchase stock in a good company, one that is good at putting its money to work. In other words, one that has a high rate of return on capital. A company that is good at getting a return on its money, is usually a very well run business.
A good company at a good stock price.
While there are many ways to invest in stocks, probably as many ways as there are investors, by looking for stocks that have both a high earnings yield and a good rate of return on capital, you have a good chance at purchasing a quality stock at a reasonable price.
And while there are no guarantees at all while investing in the stock market and you could lose all your money, this gives you a fighting chance at earning a decent rate of return on your investment over the long term.