The beginner stock market investor could be forgiven for thinking that the end of the world is nigh. With share prices having fallen dramatically the world over and the economies of most developed nations entering or already in recession things certainly do look grim. That's why I thought it was time to put together another "how to buy stocks for beginners" type of post.
So lets get back to basics. When you purchase shares in a publicly traded company, what does it mean? Well the first point I'd make is that your investment is more than just a number next to a stock symbol on the Yahoo Finance website (or whatever financial website you prefer). Your investment represents ownership of a portion of a real business. That ownership entitles you to a share of that business's future profits.
This is a very important concept to grasp. Don't be taken in by the daily fluctuations of share prices. These prices are driven by investor sentiment, by a bunch of people trying to guess what the future may hold. The rate at which these prices change belies the stability of the underlying value of your investment. The value of the business - your business - doesn't change that quickly. Sure there are times when a company makes an announcement about a fundamental change in their operations which may cause the price to plummet. But more often than not, it's just the general mood of investors pushing prices up and down.
Don't get me wrong - I'm not suggesting that we can ignore the current economic problems. But by the same token, don't let the current gloom and doom terrify you to the extent that you're willing to ignore quality companies trading at bargain basement prices just because you don't know if the stock market has bottomed yet.
That brings me nicely to my next point. I'm a firm believer in buying stock for the long term. One of the advantages of this approach is that it frees up your mind from worrying about the day to day gyrations of the stock market. By fixing your eyes firmly on a point 3 to 5 years (or even longer) down the track, you can afford not to worry about what your shares will be selling at next week or next month. You'll be able to focus on what really matters - watching the business, making sure it continues to perform as you expected when you bought it.
However, in order to do this you'll first have to put some effort into learning how to understand stock market concepts. Learn how to read a company's financial statements. Compare profitability ratios with those of it's competitors. Consider the financial strength of the company - does it have excessive debt and will it be able to make the interest payments on that debt?
There are a number of very good books available on investing in the stock market. I wrote a post some time ago about what I thought were some of the best investment books for beginners. The books mentioned in that post are all very good and well worth readying.
When To Buy Stocks
This is the essence of being a long term investor and is what I was alluding to before. If you're willing to take a long term view, you can afford to think more about the best stocks to buy rather than the best time to buy stocks. Accept that you wont pick the bottom. There's every chance that prices may go lower. However, if you're happy that you've bought stock in a good quality business who's earnings are going to grow over the long term, you'll be able to ignore the short term price movements. If it's any consolation, you probably wont pick the top either.
I think if you can remove this focus on short term results, you will remove one of the biggest impediments to beginners buying stock.
Friday, March 20, 2009
Friday, March 21, 2008
How can stock market beginners use the return on equity formula to start investing in quality companies?
In recent articles, I've discussed dividend investing, price to earnings ratios and net current asset value as ways for beginners to find value in the stock market. Today I'm going to discuss return on equity, or ROE for short. While dividend yield, price earnings ratios and net current asset value are great methods for value investors to find undervalued stocks, they don't necessarily uncover quality businesses - just cheap ones. But let's not get ahead of ourselves.
What Is Return On Equity?
The first thing we should do is define return on equity. In simple terms, ROE is just the rate of return a company earns on it's stockholders' funds. What it represents is the efficiency with which the management of a corporation is able to use its net assets (net assets are total assets less total liabilities). In other words, how much profit is generated from shareholder funds.
How To Calculate Return On Equity.
The return on equity formula or equation can be expressed as follows:
ROE = Net Income / Stockholders' Equity
Net Income, known in some countries as Net Profit After Tax is the total revenue of the company less all expenses including interest and tax. Stockholders' Equity can be calculated by subtracting the total liabilities from the total assets of the business. Because stockholders' equity changes over time, it's common to use average stockholders' equity in this calculation. This means you will need to take an average of the figures as of the start of the year and the end of the year.
Unlike dividend yields and price earnings ratios, ROE is not always published in the financial press. But some of the financial websites (like Yahoo Finance) do publish the figures. However, beginner stock market investors should definitely know how to calculate this financial ratio.
Advantages Of Return On Equity?
As I said at the start of this article, return on equity differs from the value investing types of financial ratios I've discussed in recent articles (P/E, dividend yield, etc) in that ROE is a useful measure of the quality of a company's business. Companies with low P/E ratios and high dividend yields are normally trading at relatively low prices and this is part of what value investors should be looking for. But this doesn't give any indication as to the quality of the company. In fact, often the stock price is cheap because the business is just an average one. That's not to say there may not be value there. I tend to think that there is value in the stock of most corporation if the price is low enough.
By using return on equity, you should be able to find good quality businesses. The theory goes that a superior business is able to achieve and maintain higher returns on its stockholders' funds. A company with a consistently high ROE probably has good quality management or operates a business in an industry with high barriers to entry or both.
Things To Consider When Using Return On Equity.
One of the things to keep an eye on, especially when first starting out in the stock market, is the level of debt. Because of the how return on equity is calculated, high levels of debt can inflate the figures. I wont go into great detail on the maths behind this, but by being more highly leveraged a company can generate higher returns for shareholders given the same level of stockholders' funds. And while these higher returns are good up to a point, you will need to make sure that the company's debt levels are not excessive. I will write more about this in a future article, but using a gearing ratio of 50% makes sense - that is stay away from stock where the gearing ration is greater than 50% if you want to maintain a conservative investment stance - even if the ROE is high.
You may also want to look at return on equity vs return on capital. Return on capital essentially uses total assets instead so it will account for debt levels. I'll write more on this in the future.
Another thing to consider is the industry in which a business operates. I noticed that Wikipedia made the point that consulting businesses which have very low capital requirements tend to have high return on equity ratios. They also note that because of the low barriers to entry they are much more susceptible to competition than companies operating in capital intensive industries. I think another thing to consider here is whether the company has some other intangible asset (think of brand name or intellectual property) which may make it's position more defensible. I'm thinking of a company like Coca Cola which I believe has relatively low capital requirements but which is in a very strong position because of both brand and intellectual property. I think the main point is to compare ROE of companies in the same or similar industries.
Return On Equity And Growth.
ROE in isolation wont necessarily identify growth companies. You will need to have a look at what a company does with its profits. If a corporation has a high rate of return on equity but it pays out all of its profits in dividends, then it's unlikely to be a growth company - that's not to say it's not a good business. But if it's paying out all of it's profits in dividends it probably doesn't have any way in which it can reinvest its profits to grow the business. This may be because it's in a mature industry, or it may be the dominant player in it's industry with no room to grow it's market share. The fact that it earns high returns on its shareholders' funds probably means its a good business - just not a growing one. At the right price, it may still make a good investment though.
If we now look at the opposite situation, where a business earns high return on its equity and pays little of its profits out as dividends, this is a candidate for a growth stock. If it can consistently reinvest profits back into the business and consistently generate a good return on this expanded equity (reinvested profits add to shareholders' equity) then this is most likely a growth stock. Companies like these tend to trade at higher multiples because of the compounding effect of having profits reinvested in the business.
But there are a couple of things to watch out for with growth stocks. A business wont stay in this high growth phase forever. At some point growth will start to slow. Markets and not infinite in size. It will reach a point where the market is saturated, or a competitor may enter the market. So look at the trend of ROE over time. A falling ROE may indicate it's nearing the end of its growth phase.
And this is the other thing to watch out for. As the stock market gets a sniff that growth is slowing, the price will normally be discounted. Stock market participants tend to be very future-focussed. They will try to anticipate when a company will go ex-growth then move on to find the next big thing. Stock market beginners need to make sure they don't pay too much for a growth stock nearing the end of its growth phase.
I've written more than I intended on this subject, so if you've made it this far - well done. There's just one more thing I wanted to mention before I finish up, so bear with me. Joel Greenblatt (I always find that name amusing - like a character out of The Hitchhikers Guide To The Galaxy - no offense intended to Joel) wrote a book called The Little Book That Beats The Market. Joel seems like a pretty smart guy and in the book he advocates using a variant of return on equity along with a kind of modified price to earnings ratio as a way of ranking stocks. I think there's a lot of merit in this idea as it brings together a measure of quality with a measure of value. I'll need to re-read Joel's work to refresh my memory, but I think that was the gist of it. I will write more about Joel Greenblatt's Magic Formula in a future article.
Well that's definitely enough now. I think this is the longest post I've written so far. Hopefully stock market investing beginners have gained a decent grounding in return on equity after that.
Monday, March 17, 2008
Stock market investing beginners need to understand the difference between price and value.
In my last post Stock Market For Beginners I discussed the basics of what the stock market is and how it works in simple terms. Hopefully those wanting to get started investing in shares will have got a good grounding buy reading the post. If you haven't read it yet, I suggest you go and read it now.
In the article I briefly discussed price and value - two very important investment concepts. I didn't go into the difference in any great detail, except to say that the price of a stock may differ greatly from what the underlying value in the company. Today I want to discuss this concept in greater detail.
The price at which a stock trades is a function of normal market forces - that is supply and demand. Regardless of the underlying value (or lack thereof) in the corporation whose shares are being traded, the price will only be what someone is willing to pay. Human emotions, both fear and greed frequently seem to have a large bearing on the price at which a company's stock changes hands.
We've seen it again and again through the history of stock market investing. The market booms and then it crashes. Think the dot com boom, the crash of 1987 and so on. For those that aren't familiar with these events, the prices of shares increased by a large amount in a relatively short period of time to reach unsustainable levels. As the prices increased, more and more investors (or perhaps more accurately speculators) bought in hoping to make a quick buck. This caused prices to keep rising which in turn led to more buying.
Eventually investor sentiment changed and nobody wanted to buy the shares anymore. Even worse, everyone panicked and tried to sell at the same time. If you'll recall earlier, I said that the price of a share will be whatever someone is willing to pay for it. When nobody wanted the buy the shares, sellers had to drop their price a great deal before anyone was willing to buy.
This brings me the the value of a share as distinct from the price. The value of a stock is dependent on the underlying value of the company which issued it. How much cash can it generate? What are it's assets and liabilities? And so on...
During many past stock market booms, the underlying value of companies didn't increase by very much, yet the price of the stock increased by a great deal. Similarly, when the stock prices of some companies dropped by more than 50% in a matter of days, the value of the companies themselves hadn't changed by anywhere near that much (if at all).
Typically, while the value of a company changes relatively slowly over time, hopefully for the better (but sometimes for the worse), the price of a company's stock changes much more quickly. The stock price of some companies can differ greatly from the underlying value, both on the upside and the downside. This a very important investment concept - the price and value of a stock are not necessarily the same.
This is where value investors like Benjamin Graham used things like Dividend Investing and Price To Earnings Ratios to try to exploit these differences between price and value. Graham believed that if he could buy shares which were at a steep enough discount to their underlying value, he would profit when the share price increased and the gap between price and value closed.
The main thing stock market beginners need to remember is that the price a company's share trades at is based on market forces - the perception that people collectively have of a company. And while this consensus view is mostly correct, there are times when the market get it wrong - but on an individual stock level, but also with regard the stock market as a whole.
You have a choice as to whether to buy or sell at a particular price. Don't take the stock market at face value. Make sure a high-priced stock is worth what is being asked - look at its fundamentals. Exercise some skepticism. Similarly, don't pass over the market pariah until you're sure there is no value there. If the market isn't interested in a particular company and marked its price down, this is a good place to start looking for value. But again, be sure of the fundamentals.
If stock market beginners keep this difference between price and value in mind, they will be well on the way to a successful investing career.
Friday, March 14, 2008
An introduction to investing in the stock market for beginners.
In this article I will explain the basics of the stock market. Those first starting out in investing need to grasp the basics of what it is and how it works. Who are the participants and how does an ordinary investor fit into the picture? The first thing we need to do is understand some of the basic concepts.
What Is A Stock?
A stock or share represents part ownership in a company or corporation. When you buy a stock you become part owner of a business - it may only be a small fraction of the business, but it's still important to consider yourself an owner. Ownership of the stock entitles you to all of the rights and responsibilities a business owner normally enjoys. You're entitled to share in any profits the company makes. You'll receive the benefits of any success the company has. This could be through share price appreciation, stock dividends, capital returns and so on.
When you buy stock, it's important to understand that you are buying a piece of the business, not just lending the company some money. If you lend a company money (by buying a bond or debenture) you're entitled to receive regular interest payments and a specified rate. Anything the company earns in excess of that amount becomes the property of shareholders. This means that as an owner you can receive potentially unlimited benefits if the company does well.
However, if the company does poorly and doesn't make much money, the creditors (people who decided to lend money to the company) will normally be paid their interest payments before shareholders receive any dividends. And in the worst case, where a company goes out of business and gets wound up, the shareholders stand last in line. Everybody else must be paid in full before shareholders receive a cent. This means employees, other secured and unsecured creditors, the government - everybody gets paid before stock holders. Only if there are excess funds after paying all of these other people and institutions do the owners of the company's stock receive anything.
What Is The Stock Market?
The stock market is an institution which facilitates the buying and selling of shares. It provides a mechanism for owners of listed companies to sell their stock to those interested in buying. The price of a stock at any given time is a basically what someone is willing to pay for it. This is an important concept to grasp and I will explain it more fully in a future post. But for now you just need to understand that price and value are 2 different things. The underlying value of a stock may be vastly different to the price at which it trades.
Where was I? That's right, the stock market is a place where people can buy and sell shares. When (and if) you decide to invest in shares, the stock market is the institution which will facilitate this. Whether you're investing on the NYSE, the NASDAQ, the LSE (London Stock Exchange) or the Bombay Stock Exchange (Indian market), the principles are the same.
What About The Dow, S&P 500 and the FTSE?
When you hear commentators saying things like "...the market was up by 25 points today..." what are they talking about? Normally they're talking about stock market indices. A stock market index is kind of like an average representation of a particular market (or segment). The stock prices of a group of companies is averaged out (it's actually more complex than a simple average but that will do for now) and presented as a single number. That number is then used to give an indication of the direction the market moved on a particular day - ie. up or down - and its relative level over time.
The most well known market index is probably the DJIA (Dow Jones Industrial Average) often just called The Dow. The DJIA is comprised of the 30 largest and most widely held companies in the United States. The index is currently comprised of companies like IBM, Microsoft and General Electric. I say currently because the composition of the index changes from time to time. As companies grow and shrink, or merge with other companies, the top 30 companies can change so the index is altered to reflect this.
Other stock market indices include the following:
- S&P 500 - The S&P 500 is made up up 500 large capitalization corporations in the US. It's maintained by Standard and Poors and is a broader based index than The Dow. This means it should give a better indication of the broader activity of the market.
- FTSE 100 - The FTSE 100 idex is comprised of the largest 100 companies listed on the London Stock Exchange.
- SENSEX - The top 30 on the Bombay Stock Exchange.
- Hang Seng - 40 largest companies listed on the Hong Kong Stock Exchange.
- DAX - 30 large cap companies listed on the Frankfurt Stock Exchange.
- Nikkei - An index of stocks on the Tokyo Stock Exchange.
- CAC 40 - 40 of the top 100 stocks on the French Stock Exchange.
So why would you want to invest in stocks? The fundamental reason is to generate wealth (or put more bluntly, to make money). But this can be accomplished in two main ways.
The first method could be called stock market trading (others may call it speculation). This normally entails buying a stock to take advantage of short term price movements. The underlying value of a company is sometimes of secondary importance. The buyer is normally more interested in whether the price of a company's stock will go up in the short term. People engaged in this sort of activity may only hold the stock for a matter of days (sometimes even hours).
The second method can more properly be called investing. It entails buying stock in a company because you believe in the long term prospects of the company and because the stock can be bought at a reasonable price. Determining a fair price to pay is another article (or articles) in itself, but you can do worse than starting with fundamentals like price to earnings ratios and dividend yield for investing. Having bought the stock you would normally hold onto to it, bank the dividends when they arrive and only sell it when it becomes overvalued or a better opportunity arises.
How To Buy Shares On The Stock Market.
An ordinary investor normally can't participate directly in the stock market. You will need to engage a stockbroker to do your buying or selling for you, for which you will be charged a fee or commission. The stockbroker holds a license to buy and sell shares on your behalf. I wont go into the mechanics of it here, but you basically call your broker and ask him to buy or sell stock on your behalf. Most stockbrokers now have only share trading facilities which allow you to buy and sell over the internet, normally for much lower fees.
There is obviously a lot more to investing than I've been able to cover in one article. However, in a nutshell, this is the stock market for beginners.
Tuesday, March 4, 2008
What is a dividend yield and how can beginners use it in their stock market investing?
Dividend yield is one of the handy fundamental analysis tools we can use when scanning the stock market for good value stocks to buy. It simply measures the cash return an investor can expect in the form of dividends on in investment in any particular stock. In my last post I discussed price to earnings ratios as a way to value stocks and dividend yield can be used in conjunction with the p/e ratio. In fact Benjamin Graham was a proponent of both of these measures.
How To Calculate Dividend Yield.
Like the price earnings ratio, the dividend yield of most stocks is published in financial newspapers and online on websites like Yahoo Finance. However the dividend yield formula is very simple and easy to calculate yourself. Here is the formula:
Dividend Yield = Dividends Per Share / Share Price
As an example, if a company pays an annual dividend of $2.00 and the current share price is $100 then the dividend yield calculation would be as follows:
Dividend Yield = 2 / 100 = 0.02 or 2%
So in the above example, you could expect a cash return of 2% on the hypothetical company at the price quoted. Of course as the price of a company's stock fluctuates, so does it's dividend yield. A higher stock price pushes the yield down and a lower price will raise it. You will notice that I said cash return above. By this I mean the income you will receive from the investment each year. On top of that, you would expect the capital value of the stock to appreciate. That is, you want the stock price to go up so that ultimately you will make a capital gain when you sell the stock.
So How Can You Use Dividend Yield In Your Stock Market Analysis?
The simplest method to do this would be to just buy a group of stocks with the highest dividend yield as listed in your local financial press. In doing so, you should end up buying the best value stocks on offer at a given time and receive a handy annual income from your stock market portfolio at the same time. But what might the pitfalls be with this method?
One of the first things you might like to check is the payout ratio or times covered figures. The dividend payout ratio is the percentage of annual profits paid out by a company as dividends. Check for companies with payout ratios over 100% - this means they are paying out more in dividends than they are earning. There may be a legitimate reason for doing this in the short term, but over the long term it's not sustainable. Dividend times covered is simply another way of expressing this ratio. It indicates how many times a company's profits cover their dividend. In this case a measure of less than 1 again indicates that they are paying out more than they're earning.
Another thing to consider is what the average dividend yield is. While the return may look good in the most recent year, you will need to look at what was paid out in years past? It could be that the company has paid a larger than normal amount in the most recent period and that this is not expected to continue. This will sometimes explain an unusually high dividend yield.
The main problem with high dividend yields is that it usually means the market doesn't think much of the company's stock. This could be because the company is not expected to exhibit very high levels of profit growth in the years ahead. Or it could be because the company is experiencing financial difficulties and is therefore considered to be a high risk proposition. Whatever the reason, it is usually a result of negative market sentiment.
But this is the type of situation in which value investors may be interested. A value investor may see the high dividend yield (and therefore relatively low share price) as a buying opportunity. A value investor may see the company's difficulties (whatever they may be) as temporary in nature. They may expect to see considerable share price appreciation once the uncertainty is passed.
Another option in dividend investing for beginners is to find high dividend yield mutual funds. Some funds specialize in this area and as such can be well suited to investors looking for income but who don't have the capital, the confidence or the time to enter the stock market directly.
When Is A Low Dividend Yield Good?
There is a school of thought that says that high dividend yields are an indication of a poor quality business. If management have adopted a dividend policy which sees the bulk of profits distributed to shareholders, it means they don't have any more profitable ways in which to reinvest it in the business. I think Warren Buffett is an advocate of management retaining earnings within the business when they can continue to generate high returns on invested capital. He believes that shareholders will benefit more in the long run from growth in the business than they would if earnings where distributed. And I read somewhere that Berkshire Hathaway has only paid 1 dividend under Warren Buffett's leadership.
Measuring Stock Market Strength.
Dividend yields may also be used as an average to measure the relative strength of the stock market over time. The dividend yield of the Dow Jones Industrial Average or the S&P 500 has been used as an indicator of the overall value of the market. At market peaks, the average sinks below 2%, whereas during extreme lows it's been known to creep into double figures. Just keep in mind when comparing figures that payout ratios tend to be lower now than they've been in years gone by.
Hopefully this article has given you some useful background to another tool you can use in your fundamental analysis. Beginners in stock market investing can now add dividend yield to their fundamental analysis toolkit.
Tuesday, January 29, 2008
Learn how to start investing in the stock market.
Beginning investors tend to approach the stock market with great trepidation. It seems so complex. There is so much to learn. So much new terminology - dividend yield, price earnings ratio, net tangible asset backing, short selling, bull market, bear market and the list goes on.
But you want to get started. The guy next door doubled his money in a couple of months. A colleague at work doubled her money in less than a week. Everybody's making money and you feel like you're being left behind.
So where do you start? Well, first I would suggest you make sure that direct stock market investing is for you. Some people just aren't suited to it. There's nothing wrong with that. There are plenty of other options which will give you exposure. Find a good mutual fund for example.
How do you know if you're well suited? I plan on writing a more thorough article on this in the near future (see Stock Market Investing - Is It For You?) but you could start by asking yourself some of these questions. Are you willing to put in the time? Are you comfortable with the volatility you will undoubtedly experience? What is your time-frame (the longer the better)?
Once you've answered these questions and assuming you still want to proceed here are the steps I suggest you follow.
Get Educated In Investment Fundamentals:
If you're going to manage your own portfolio, even with the assistance of a professional, you will need to understand what you are doing. Read some books. Read the financial press - but don't worry too much about what the market is doing from day to day. There are some great resources available on the internet as well. Start noticing the companies around you. Where do you shop? What are you buying for Christmas? Peter Lynch (a very successful fund manager and author of a number of investment books) is a great advocate of this. Apparently a number of his best investing ideas came from observing consumer trends at the grass roots level.
Don't get me wrong - there is no substitute for actually getting in there and doing it. But the more background information you have the better prepared you will be. And this education should be ongoing. There is always more to learn.
Find A Stock Market Mentor:
Find someone you trust who has some investing experience. This could be a friend or a relative or anyone else you feel comfortable with. A mentor can be a great resource. You can get a second opinion for some of your ideas. You may get confirmation that your reasoning is sound or you may get some feedback about things you hadn't considered. It will be a great benefit if you don't have to make your investment decisions in isolation.
Take A Long Term View:
Once you feel comfortable enough to make your first investment, start small and take a long term view. Don't bet the farm your first time out. Even if you've saved up a lump sum to invest, buy stocks a little at a time. This has a couple of advantages.
Firstly, you wont be putting all of your money into the market at the top. What does this mean? Over time the stock market will go up and go down. There are many reasons for this. Investor sentiment, the state of the economy and lots of other external factors all play their part. It's notoriously difficult to predict the direction that prices will take. Very few professionals get it right even the majority of the time so amateurs like us have no chance. But over time if we assume that the market will rise over the long term, which it has historically, then these short term gyrations shouldn't matter to us - provided we didn't put all of our money in at the top.
The other advantage to investing a little at a time is that we will make mistakes. And we will learn a lot from them. But we need to make sure that if we completely mess up our first foray into the market, we'll still have some capital in reserve so we can regroup and try again. Then over time we should build up a solid portfolio diversified not only by company and industry but also by the point in the market cycle at which we made our purchase.
I know this article hasn't covered yet any of the specifics of choosing a stock to invest in - I will cover that in upcoming articles - but hopefully it has given you some things to think about.
How to start investing in the stock market...
