I don't think our next guest needs any introduction. They have been a featured part of many extraordinary lives such as Warren Buffet, Peter Lynch, and yes, even your ordinary neighbor who unsuspectingly has hoards of wealth.
Stocks. They are tiny pieces of ownership in a company. Also known as equity, owning stock means you are a part owner of said company. Now for a little complicated part; if you own 10% of a company's stock it does not mean you own 10% of the company. You own 10% of the stock which is a part of the company. Stock is sold as a way for businesses to raise money and grow the business.
Note there are two different types of stock; preferred and common. Common is the most common (imagine that) and allows for voting rights at shareholder meetings and to receive dividends, which are when a company pay the stockholders a portion of their earnings, typically once a quarter (4 times a year). Each share of stock gets a specified dividend amount as decided by a company's board of directors. The amount is typically calculated as a percent of the stock price known as the Dividend Yield.
Dividend Yield= Yearly Dividend $/Price Per Share
Analogy time! Dividends are similar to a bonus an employee would get because the company is performing well except the company pays them to each owner of their stock. Preferred stock does not get voting rights but takes priority over common stock on receiving dividends and they receive priority if the company files for bankruptcy and is liquidated (if the company goes bankrupt and sells all of their assets but can't reimburse all the stockholders, they pay all the preferred shares first). Whew! We made it through that. Now on to more interesting parts.
So why do stocks have value? Because the company issuing them has value and they represent a portion of ownership in the company. Why do companies have value? Because of their ability to sell products and generate profit. So by the Transitive Property (don't worry, I had to look up what it was too), we can say that a stock's value is based on a company's ability to produce profit.
Everyone with me? Good, on to the confusing part! How do we evaluate a company's ability to generate profit and thereby know if it is a good value to buy? Logic would tell you to look at the past performance of a company and from their financial reports identify how much profit they have generated in their history. You could also take into account how much of a dividend they pay out. Absolutely, these are perfectly fine and acceptable ways of valuation but here's the thing; some don't value a company on their past performance but rather on what we expect them to do in the future. It makes sense because we all know of once great companies that went bankrupt (Blockbuster, Kodak, Toys R Us) and all companies had to start from somewhere and had little to no profit to begin with. Analogy time! You wouldn't invest into a house based on what it was worth a year ago. You buy it in the hopes that it will increase in value and you can sell it later on to make a tidy profit. You see the potential and it is no different with stock.
So what is the best way to find the future value of a stock? There is not a definitive way to value a stock. No different than asking someone what is the best dessert, opinions can differ on the matter (peanut butter pie is the correct answer). Probably the most common metric people will point to would be the Price to Earnings Ratio.
Price to Earnings Ratio = Current Stock Price / Earnings Per Share (Net Profit/# of total shares of the stock)
I am not going into a ton of detail around the ways to value a company's stock but if you're feeling frisky, take some time to research Fundamental Analysis, Technical Analysis, Dividend Discount Model (for stocks paying out a dividend), Discounted Cash Flow Model (typically for well established companies), and The Comparables Model (for companies that don't fit the other models).
In lesson 3, we will learn more about stock's little brother, bonds.