Understanding Stock Market Fundamentals – Ecologic America

Understanding Stock Market Fundamentals

If you’ve ever watched investment shows on television, you’ve probably heard commentators mention fundamentals — but without ever explaining what stock fundamentals are and why they might matter to investors. Fundamentals are metrics for individual stocks that provide insight into the value of a stock.

Among Warren Buffet’s famous investment quotes is: “Price is what you pay, value is what you get.”

The seemingly simple quote is worthy of the attention it has received over the years because it points to a possible disconnect between the way a stock is priced by the market in the short term and the real, long-term value of the stock. Investors like Warren Buffet have built their fortunes, in part, by finding these discrepancies between price and value — and then waiting for time to prove them right.

As an interesting example, Class-A shares in Buffet’s Berkshire Hathaway investment company currently trade at over $300,000 per share. Based on price alone, this price might seem outrageous. However, the company has earned nearly $38,000 per share when you look at the trailing twelve months of earnings. There are other considerations when choosing stocks based on fundamentals, but considering just the earnings per share, Berkshire Hathaway begins to look like an investment opportunity worth a closer look.

Price is what you pay, value is what you get — and they aren’t always the same thing.

What is a stock?

A stock represents an ownership share in a company, commonly called shares. The term stock is generally used to refer to more than one share — but buying stocks, as a plural, usually refers to buying shares in more than one company. Stocks are a way for companies to raise money to help grow the business. Partial ownership is sold, which helps fund growth. That ownership, the shares, can then be resold. This buying and selling activity is what we refer to as the stock market. Generally, if a company does well and profits grow, the stock price rises over time. Conversely, individual stocks can go down if a company’s prospects become less promising and some stocks can even become worthless.

Private stocks vs. public stocks

Not all large companies sell their stock in the stock market. Some companies choose to remain privately held. These companies may still have investors, but their stock isn’t publicly traded. Cargill, for example, a company with nearly $115 billion in annual revenue, is a privately-held company, as are many other well-known brands, like Staples and Fidelity Investments.

Common stock, preferred stock, and stock classes

Not all shares are created equal. In most cases, when you’re trading stocks, you’re trading common stock. For some companies, however, you may also find preferred stock. Common shares provide more liquidity, meaning they can be more easily bought and sold — but are also more volatile, meaning the price is more likely to fluctuate. Part of what makes preferred stock less volatile is that preferred stock often has a fixed dividend structure which provides regular payments to shareholders based on profit. Lowered volatility for preferred stock also means it may also have a lower potential for price appreciation.

You may also encounter different classes of stock, such as Class-A, Class-B, or Class-C shares. For example, Google has all three classes of stock. Retail investors own Class-A shares, while founders own Class-B shares. Class-C shares are issued to employees. The largest distinction is voting rights for the shares. Within Google’s structure, Class-A shares get one vote, Class-B shares get 10 votes, and Class-C shares do not have voting rights.

It’s also common for different classes of stock to trade at different prices and some classes of stock may not trade publicly at all, like Google’s Class-B shares.

What is a stock market exchange?

When we think of the stock market, many of us think of the loud trading pits of the New York Stock Exchange on Wall Street. Technology has quieted the trading pits, with the vast majority of trades taking place electronically or automated by software. The New York Stock Exchange is only one part of the stock market. Several other major exchanges exist and the physical buildings and trading floors are a smaller part of the stock market’s activity than in the past.

A publicly-traded company is traded through an exchange and must meet certain requirements to be listed on the exchange as well as to remain listed on the exchange.

The role of brokers

A broker is a middleman between the investor and the stock market exchange. While the image of a stockbroker in a fancy suit and power tie may still hold true, most brokers are online companies now. Online software has become the new intermediary between investors and trading exchanges. Any of a number of online brokers can be used to buy and sell stocks, with commissions as low as $5 per trade.

Low-cost brokerages have made investing more accessible. However, there are several other key aspects to stock trading you should understand before buying stock in your favorite company.

Price Per Share

One of the easiest-to-understand stock terms is the price per share. If you see on the news that your favorite stock just broke $100 per share, that price reflects the last trade that was executed. Price alone doesn’t tell the whole story, however. Without the context of knowing how much the company is earning, how much debt the company has, the company’s future prospects for growth, and the number of shares the company has outstanding, the stock price doesn’t have much meaning.

Ask Price, Bid Price, and Spread

If you’ve ever bought a car or a house, you’re familiar with ask price and bid price. The ask is what the seller wants for their shares. The bid price is what a buyer wants to pay. If you trade stocks online, you’ll be able to see both of these prices in your trading dashboard. The prices come from live buy and sell orders that are in the system but which haven’t yet been executed. The current stock price reflects the most recent trade executed.

The importance of bid and ask prices becomes more evident when you are using market orders, which we’ll discuss next. Imagine you have 100 shares of a company and the stock is priced at $100. If the bid price is $99 and you sell with a market order, you lost 1% ($1) on every share you sold plus the cost of commission.

The difference between the bid and the ask is called the spread. On high-volume stocks, the spread is often very small or virtually nonexistent. However, on thinly-traded stocks that don’t have many buyers or sellers, the spread can be significant and a hasty buy or sell trade can be costly.

Market orders and limit orders

When you buy or sell stocks, there are different types of orders you can use to make your trade. We’ll discuss the two most common types.

A market order executes the trade as quickly as possible and matches your buy or sell order with bids and asks that are in the system. What you may find is that your trade becomes several trades, each with a commission charge, because the number of shares you’re selling or buying may not match exactly with the orders from other buyers or sellers. Your buying or selling price can also vary considerably from the last price you saw flash across the screen. Market orders carry risk but execute quickly.

A limit order typically costs more in commission but allows you to set a price for your trade. The risk with a limit order is that the order may not execute at all. If your stock was trading at $100 and is having a bad day based on news, your sell limit order at $100 may not ever execute. Prices may continue downward leaving you stuck with the shares until you cancel the sell order and choose a lower sell limit or use a market order. Limit orders can set a maximum price for buying or a minimum price for selling.

Volume

Trading volume refers to the number of shares traded and can be another consideration when trading stocks. A stock that doesn’t trade often may be difficult to sell at an optimal price. Volume can also indicate market direction. Market swings up or down with low volume don’t indicate conviction by market participants and may be temporary. Moves up or down on high volume can suggest that the stock or the entire market is moving based on news that affects the future for the stock, or perhaps the sector or the economy as a whole.

52-Week Range

The 52-week range tracks the high and low price for a stock within the past year. To most investors, the 52-week range is interesting, but not always relevant. It can, however, be useful for understanding the price performance for a stock, particularly if the stock is hitting new 52-week highs or new 52-week lows.

Earnings Per Share

The earnings per share is a measure of a company’s profit performance. If a company has $1 million in earnings and one million shares outstanding, the earnings per share are $1. Beware of a company with negative earnings and research situations that lead to declining earnings. In both cases, it’s possible that the company should be avoided — but it’s also possible that investments that will help future growth have had a temporary impact on earnings.

Moving Averages

If you took an average of the closing price for a stock over the past 50 days, this gives you the 50-day average for that stock — but the number will change the next day, which is what gives it the name moving average. Think of moving averages as smoother price history charts, plotted with rounder lines that look like hills. In trading, the 50-day and 200-day moving averages are often used as buying or selling indicators as the closing price for a stock crosses these moving average lines or as the lines cross each other.

Market Capitalization

Often just called a market cap, the market capitalization is calculated by multiplying the price per share by the number of outstanding shares. A company with a million shares outstanding each valued at $100 has a market cap of $100 million.

PEG Ratio

In the past, a simpler measurement called a PE ratio was used more frequently. A PE ratio is a Price to Earnings ratio and compares the stock price to earnings per share by dividing the price by the earnings. In value investing, a company with a PE ratio of under 20 was often considered a good value, assuming the rest of the fundamentals were in line.

What the traditional PE measurement left out was earnings growth, which is addressed by the PEG ratio that is now common to the trading dashboards for many online brokerages. To calculate the PEG, you would divide the PE ratio by the earnings growth rate.

Profit Margin (TTM)

A trailing twelve month (TTM) profit margin is useful for comparing stocks within the same industry. The profit margin can help provide a window into the company’s short-term and medium-term future.

Price/Book Ratio

This measurement compares a company’s stock valuation to its book valuation, meaning how much the company is worth on a balance sheet, considering all assets and all liabilities. Traditionally, any ratio below 1.0 meant the stock was priced low and was undervalued. There may be other considerations to evaluate, however, like obstacles to growth or possibly a product that is becoming obsolete.

Dividend Yield

Many companies provide a dividend to investors, which is a quarterly share of the profit. Dividends aren’t guaranteed, but they are common for many types of stocks. Many historical stock market statistics include dividends and assume that dividends are reinvested to boost investment growth. Be aware that for non-retirement accounts, many dividends are taxable, even if reinvested.

Enterprise Value/EBITDA

The EBITDA stands for earnings before interest, taxes, depreciation, and amortization. The EV/EBITDA ratio compares the enterprise value, which the value often used if a company is to be acquired, to the EBITDA. While the SEC encourages investors to use net income as opposed to EBITDA when evaluating stocks due to accounting differences in the two numbers, the EBITDA is often still found on stock trading dashboards.

Stock Splits

It’s common for companies to split their stock when the stock reaches a certain value. To the investor, there is no meaningful difference — except that stocks often rally into and after a split. Otherwise, if a stock splits 2:1, metrics like earnings per share are simply halved, but with twice as many shares outstanding.

Stock Buybacks

Sometimes companies buy back stock as well, taking shares out of circulation. Stock buybacks can increase the earnings per share as well as dividends — but buybacks also cost money during the buyback phase, reducing short-term profits.

Growth stocks vs. value stocks

Much of Warren Buffet’s success was based on buying value stocks in his early investments. Many other stock market millionaires made their money with growth stocks, companies that didn’t have a decades-long history of earnings but which had a new technology or a new approach to business. If you choose well, there are opportunities with both types of investing. However, many experts still recommend simply buying an index fund and letting the market take the guesswork out of investing.

Margin accounts & technical analysis

More commonly than in the past, some investors favor day trading or short-term trading over buy-and-hold investing. This type of trading often involves margin accounts, which are leveraged credit accounts, and technical analysis that can include dozens of indicators which may point to when to buy or sell a stock. There’s a often-quoted yet difficult-to-prove statistic regarding traders which indicates that 95% of traders lose money. We don’t doubt it, though, particularly since margin accounts make it possible for you to lose your entire investment and still owe money to the brokerage. Investing for the long term is a much safer way to play the markets.