Brian Feroldi stops by to discuss the basics of buying stocks and how the stock market works.
What Does It Mean When You Buy A Stock?
A stock represents partial ownership in a business. When you buy a company’s stock you have a permanent claim on that company’s assets and their current and future profit streams, forever. The reason stocks have value is because the businesses that are attached to those stocks can generate profits. They go up in value because the companies grow their profits over time.
The fundamental driver of stock price is the profits of the business.
Related: The Role Of Bonds In A Portfolio
Who Gets The Money When You Buy A Stock?
When a company “goes public” they sell shares of the company to the public. This is called an initial public offering, or IPO.
For example, when Microsoft went public in 1986 they sold a part of the company to the public. On that day they got a huge cash infusion that they invested back into the company.
Companies can do this again at a later time by offering another piece of the company to the public. This is called a secondary stock offering.
But once the shares are sold the company doesn’t benefit directly from shares changing hands. Shares are bought and sold on the New York Stock Exchange and other exchanges. But they are sold person to person. The company itself is not involved.
What Does It Mean When Someone Says A Stock Is “Over Valued”?
If you go to a store and see a sweater for $50, that’s an expensive sweater. If you see another sweater for $4, that’s an inexpensive sweater. However, stocks don’t work that way.
For example, Microsoft is currently trading at $174 per share. In a vacuum that seems expensive, considering there are stocks out there that are trading for under $1.
But price alone is not enough information to know if a stock is a good value. There are metrics that are used to determine the value of a stock, such as the price to earnings ratio (the P/E ratio). This is the price of one share of stock divided by the earnings per share.
For example, Microsoft has generated $44 Billion in profit over the last year. The company is valued at $1.3 Trillion. So divide 1.3 Trillion by 44 Billion and you get just over 30. This means that Microsoft is trading at slightly over 30 times earnings. It has a P/E ratio of 30.
Again, in a vacuum, this number doesn’t mean much. The average P/E ratio of companies in the S&P 500 is about 20. So compared to the average value Microsoft is more expensive. But if there is a good reason for it to be more expensive then it isn’t overvalued.
Microsoft continues to grow and investors see the value in this company and have bid up the price of the company to match it’s perceived value.
What Other Things Do You Look At When Valuing Stocks?
It depends on the company and industry. For example, for companies in the insurance industry, a popular metric is called the price to book ratio. “Book” is the value of all the company’s assets.
Like the P/E ratio, another metric that can work in multiple industries is the price to sales ratio. Which the valuation of the company divided by the company’s sales over the past year. This ratio can apply to growth companies that do not have a lot of profits yet.
Why Are Individual Companies Continuing To See Price Increases Even In Today’s Environment?
There are an endless number of factors that can affect a company’s stock price in the short term. And while we couldn’t have predicted how the stock market was going to respond in this environment we can all but guarantee that it will do well over the long term, 10+ years.
That’s why buy and hold long term investing is the best way to go. In the short term, anything can happen but over time company profits increase and therefore stock prices of the market as a whole will increase.
One book that Brad recommends is The Future Is Faster Than You Think by Peter Diamandis.
Right now, people are looking at today’s struggles as temporary. The news itself doesn’t affect stock prices. In relation to the news, what affects prices is how the news compares to people’s expectations.
For example, if people are expecting unemployment to be at 20% and the news comes out and says unemployment is 19.5% you would expect stock prices to rise. But trying to predict this is almost impossible.
Related: Making Portfolio Adjustments With Big ERN
The Lemonade Stand Example
Let’s say that Brian owns a lemonade stand that earns $1,000 per year and wants to sell it. How much is it worth?
If Jonathan is willing to pay $1,000 then the P/E ratio is 1. Price divided by earnings would be $1,000/$1,000=1. Jonathan is now making 100% profit on his money forever. A great deal for Jonathan but a horrible deal for Brian.
Brad is willing to pay $10,000. This makes the P/E ratio is 10. $10,000/ $1,000= 10. Brad’s return would be 10% on his money. It would take him 10 years to earn back the money he spent on the lemonade stand and then he would still own the asset. This is a good deal for Brad and a good deal for Brian, so they agree to the sale.
But the day before they are going to sign the papers Jeff Bezos announces that all Amazon Prime members get free lemonade for life. How does this affect the price of the lemonade stand? Brad takes back his offer since he has no idea what the new profits of the lemonade stand will be–and they will likely be much lower than the historical $1,000. He changes his offer to $1,000.
The lemonade stand just lost 90% of it’s value. But what actually changed? The business is exactly the same as it was yesterday. The only actual change was Brad’s perception of the stability of future profits.