Stock Fundamentals: A Beginner’s Guide
At this point, all or most of your debt is paid off, you have some cash flow, and you’re looking to make some moves in the stock market.
Don’t jump in just yet. Before you go out and start buying stocks like Microsoft, Amazon, and Apple on a whim just because you know the companies and read about them often in the news, there are some basic stock fundamentals you need to learn if you want to gain a competitive advantage and protect yourself against market volatility.
Buying Stocks: An Introduction
Buying stocks is one of the most important financial decisions of your life. If you time the market and buy the right stocks, you can make a lot of money in gains and dividends.
But what exactly should you look for? It’s not as simple as examining the current price of a stock and then deciding to buy a number of shares. For example, you also need to consider valuation, future growth, the company’s earnings, profit margins, and the company’s financial statements, among a myriad of other metrics.
The good news is that you don’t have to do all of this stock analysis on your own.
How Stocks Are Ranked
Stocks are tracked and ranked through various exchanges. Altogether there are roughly 3,600 exchanges in the United States.
Of the 3,600 U.S. exchanges, there are three leading benchmarks you should know about.
The Standard & Poor’s 500 (S&P 500)
The S&P 500 tracks the 500 largest publicly-traded companies in the United States.
The Dow Jones Industrial Average (The Dow)
The Dow is a price-weighted index tracking 30 large, publicly-owned companies in the New York Stock Exchange (NYSE) and the NASDAQ.
The NASDAQ Composite
The NASDAQ Composite tracks companies primarily in the technology sector.
How to Buy Stocks
A brokerage firm enables you to place financial orders online using a digital platform. This type of firm provides access to a broad range of financial products.
When companies go public, customers can buy individual stocks or shares that give them partial ownership of the company and potential for payout down the road. The more individual stocks of a particular company you own, the more ownership stake you have.
In addition to buying individual stocks, you can also buy index funds. These are collections of securities that track market indexes. Index funds can provide broad market access to a variety of stocks.
Exchange-traded funds (ETFs) also deal with collections of securities. The main difference is that ETFs are traded throughout the day much like stocks, while index funds are bought and sold based on their market price at the end of the trading day.
Yet another type of security that you can buy is a mutual fund. This type of fund is actively managed, meaning an account manager picks and chooses the stocks that go into the fund. Because of this, they tend to have higher fees than index funds. The tradeoff, however, is that they can grow faster.
How a Stock’s Price Is Calculated
As you can see, there are many ways to buy stocks. As an investor, it’s important to have a thorough understanding of how it all fits together so that you can build a robust and diversified portfolio.
The next step is to understand how stocks are valued.
Good news: There is a massive amount of financial information that can be used to assess the market value of a stock and the value of a company. This data is necessary for guiding investments and letting you know which stocks are worth purchasing and when they should be bought or sold.
A company’s total market value—or market capitalization—is determined by multiplying its stock price by the number of outstanding shares.
In other words, once a company goes public, its shares become available to trade on the stock exchange. Share price is then determined by supply and demand. Pricing goes up if there is a high demand for shares of the company. When bad news comes out and a company’s income statement looks bleak, shares plummet as demand subsides.
What Is Fundamental Analysis?
A stock’s price and position on a market index is just the tip of the iceberg when it comes to assessing its overall value. To make the best investment decisions, you’ll need to take a much closer look.
In addition to looking at the price and ranking of a stock, you can conduct a fundamental analysis and measure the intrinsic value of a particular security, or its true value independent of other factors.
There are two types of fundamental analysis.
Quantitative analysis involves analyzing financial statements and using the information to determine a conclusion about share price.
As the name suggests, this strategy involves looking beyond pure financial data and analyzing aspects like brand value and public opinion to judge the weight of a company.
Tools for Valuing Stock Prices
There are several tools that investors can use to value stock prices.
Price-to-Earnings Ratio (P/E Ratio)
The P/E ratio is a measurement of a company’s share price in relation to its earnings per share (EPS).
Price to Sales Ratio (P/S Ratio)
Price to sales ratio (P/S ratio) is determined by dividing a company’s market capitalization—the number of outstanding shares multiplied by its share price—by its total sales revenue over the previous 12 months. Investors should generally look for lower P/S ratios to avoid buying a lemon.
Return on Equity (ROE)
ROE is determined by dividing net income by the shareholder’s equity. It’s used to determine how profitable a corporation is in relation to a stockholder’s equity.
Price-to-Block (P/B) Ratio
The P/B ratio is a comparison of a company’s book and market value. This method is often used to discover undervalued companies that can be prime investing opportunities.
If you want to understand how much a company pays in dividends over the course of a year, look at its dividend yield and compare it to its stock price.
Price-to-Earnings Growth (PEG) Ratio
A price-to-earnings growth (PEG) ratio can describe a stock’s true value. A PEG ratio of 1.0 or greater is an indicator that the stock is overvalued. A PEG ratio is calculated by taking the price/earnings ratio (P/E) and dividing it by its percentage growth rate.
Fundamental Analysis vs. Technical Analysis
In addition to conducting a fundamental analysis of a particular stock, you can also do a technical analysis to determine its true value.
A technical analysis involves observing patterns of share price movement and volume within a particular company.
Fundamental analysis is typically used to assess the quality of a long-term investment. A technical analysis is used to analyze short-term investment decisions.
Frequently Asked Questions
What is a share price?
A share price refers to the dollar amount of a single share of stocks within a publicly traded company. It is the highest price that someone is willing to pay for the stock or the lowest amount at which the stock can be acquired.
Should you buy a stock based on past performance?
Most financial experts are going to tell you that past performance cannot guarantee future results. In other words: don’t assume that an investment is going to continue to perform well in the future simply because it’s done well during a specific time period.
Instead, put your energy into calculating a stock’s future performance based on the latest data available. And instead of trying to determine short-term performance, focus on long-term projections.
Investors can get in trouble when they try to calculate performance based on limited data or insights. If you really want to determine the short-term value of a stock, consider working with a financial advisor who can give you a better perspective.
What can market share analysis tell you?
A market share analysis is an indicator of how well a company is performing in the marketplace compared to competitors. In short, market share can be determined by dividing total shares or revenue by the industry’s total sales during a fiscal time period.
What is the meaning of a blue chip stock?
A blue chip stock is a stock that comes from a leading, established corporation. Blue chip stocks usually pay strong dividends and have a demonstrated history of performance in the marketplace. Look for healthy balance sheets and cash flow and a history of increasing dividends over time.
What is a balance sheet?
A balance sheet is a financial statement that details an organization’s liabilities, assets, and shareholder equity for a specific time period. You can use a balance sheet to determine the company’s rate of return, capital structure, and financial well-being.
The Bottom Line
Deciding to enter the stock market is one thing. The next step is to take a deep dive into the individual components that make up the stock market in order to understand how stocks are valued and ranked so that you can make the smartest investing decisions.
As an investor, the trick is to get to a point where you’re no longer buying stocks based on what others are telling you but by doing your own research and knowing what to look for.
Once you get to this point, you can start to identify undervalued stocks poised for significant growth.
Of course, as a beginner with limited data, you should always compare your findings to what the experts are saying. This is the best way to avoid getting manipulated into making certain financial decisions that you might end up regretting later.
Keep reading and learning, and in time you’ll start to get the hang of how the stock market works. In the meantime, focus on building a core portfolio of low-risk, affordable stocks. Spread risk around and try to lay a strong foundation by investing in secure and profitable funds.
Remember, slow and steady wins the race. So stay the course, be patient, and you’ll make the right decisions. Good luck!