How do stocks work?

When investing in the stock market, if you decide to buy stocks from a company, there are multiple key statistics and concepts you should know beforehand. You should always understand them before throwing any money to the company, otherwise I wouldn’t call that investing, but speculating or gambling.

I’ve prepared a list of some really important ones you should always look into. Knowing them should give you a rough idea if the company is worth digging more before investing or if you should run away from it.

Lets start by the first obvious thing you should know, then we’ll go deeper on how to read those numbers.

What is a stock?

The stock of a company represents the ownership of its entity. The ownership can be divided into shares to allow multiple entities to own a part of the company.

When a company decides to go public to raise capital through the stock market, anyone can buy shares of the company up to a certain limit available on the stock market. Each share sold are the result of a transaction. Someone offered to buy X amount of shares and another person agreed to sell the X shares he owned, resulting in a successful transaction.

Buying a stock isn’t really hard. The difficulty is to valuate that stock.

What price should I pay for a share?

The price of a share moves up and down constantly. So many things can affect the value of a stock. This is why it important to understand the fundamentals of a stock to be able to know if a stock is overvalued or undervalued.

Here are the key statistics I lookup to know if a company is on track or if it is going downhill:

Stock price

This one is pretty obvious, but you can check for growth trend of the stock price over the past years. That is probably the first thing I look for when searching. It can give me a rough idea of where the company has been and where it is heading at a quick glance.

Volatility

Has stock price been doing a lot of roller coaster? If the price moves by a lot, you should try to find out why. This could indicate that there is an issue with this company.

 

There is a measure called beta used to calculate volatility of a stock compared to the market.

A beta of 1 means the stock has the same movement as the market. A beta of 1.5 means it would move 50% more, and with a beta of 0.5, the stock would move 50% less than the market. The greater the beta, the greater risk/rewards.

Market cap

This number shows the public value of the company, how it is worth.

Dividend yield

A dividend is the redistribution of profits made from the company to the shareholders. It’s up to the company to decide if they want to pay dividend, how much and how frequent. Most stocks pay a quarterly dividends, meaning every 3 months. Some other pays monthly dividends.

The dividend yield is the percentage yearly dividend redistributed for the stock price at the time of purchase.

For instance, if you buy a 100$ stock that pays 5$ of dividends per year, the dividend yield is 5%. If the next year, the company decides to boost the yearly dividends to 5.50$, the dividend yield has grown to 5.5% for the share you bought previously. Companies can decide to increase, but they can also cut down dividends.

Dividend stability and history

If you want to focus on dividend investment from a company. You should look at the dividend stability and history.

Here are some questions I ask myself:

  • How many years, has the company been paying dividends?
  • How frequent do they pay dividends?
  • Did the company ever cut down dividends?
  • What is the average dividend growth?

Here is a pro-tip I have for you:

For dividend focused companies, there are lists of companies grouped by their dividend track record. You can lookup for companies part of these categories. Companies in these lists have increased their dividends every year consecutively without ever skipping one:

 

Dividend Challengers

5 to 9 years consecutively

Dividend Contenders

10 to 24 years consecutively

Dividend Champions

> 24 years consecutively

Dividend Aristocrats

> 25 years consecutively

 

This does not guarantee that they will keep increasing, but if they skip 1 year, the need to start over to be part of the list.

To give you an example, Coca-Cola (KO) has increased their dividends for more than 50 years now. I have a good feeling that they would want to change that streak now.

A good website I found to lookup the dividend history is this one: https://dividata.com/

Ex-Dividend Date

This is the date where the company records the share counts of each shareholders to prepare themselves for the dividend payment. You could technically own the shares to get recorded for the dividends and sell your shares the next day. You would still receive your dividends pay-out later. We often see a stock price hike around those dates because many investors lookup for stocks by ex-dividend dates so they can do a quick dividend grab and go.

DRIP Eligible

DRIP stands for “dividend re-investment plan”. Some companies offers this. If you agree to this and the company allows it, when you receive dividends from the company, they would be reinvested in the company, with a preferred price most of the time. This is really cool because some investing platforms charges you fees every time you buy or sell stocks. The DRIP eliminates this fee because it is done automatically.

Pay-out Ratio

This number is the percentage of profits redistributed in dividends to the shareholders. It can help us get an idea if the company is paying too much in dividends, eating up all of their profits. When I see this number close to 100% (even more than 100% sometimes), it tells me that the dividends they pay is not sustainable. Unless they find a way to make more profits, there is a high probability that the company will cut their dividends in the future.

Revenue

The income of a company from any income source. (sales, investments, interests, royalties…)

Net Income

This is the revenue – the expenses and taxes. This helps us know if the company handles well the income/expenses to operate.

EPS

EPS stands for “Earnings per share”. This number represents how much money does a company make per share of common stock.

This is how we calculate the EPS:

EPS = (profit – preferred dividends) / weighted average common shares

P/E ratio

This stands for “Price-Earning ratio”. It is an algorithm to help us determine if the share price is over or under valued.

Here is how we calculate it:

Market price of a share / earning per share = P/E ratio

In other words, this is the price you pay for a share compared to the annual profit earnings of the company. The lower the better.

Example:

If you buy a share 10$ and it earns 1$ to the company, you are paying 10 times the annual earnings for that share.

If the P/E ratio of company A is 15 and company B is 20, then the first one is cheaper in terms of what you’re paying relative to what it earns.

Here are the stats for S&P 500. The average 5 years from 2013-2017 is 20.194

Year

P/E Ratio

2017

23.59

2016

22.18

2015

20.02

2014

18.15

2013

17.03

Return on equity (ROE)

This is to determine how efficient the company is with our money. What profit did the company do only using the money from investors.

Profit / Equity = ROE

Here are the stats for S&P 500. The average 5 years from 2013-2017 is 14.06%

Year

Year ROE

Q3

Q2

Q1

2017

24.89%

11.23%

11.67%

11.10%

2016

10.97%

9.42%

4.63%

5.29%

2015

6.46%

9.68%

10.43%

11.08%

2014

13.24%

14.51%

14.45%

14.48%

2013

14.72%

14.10%

13.70%

13.46%

Conclusion

There are a lot more than this, but if you take time to understand these one, you should get a rough idea of how the company is doing. If the numbers shows great values, it does not mean you should automatically invest in the company. You have to understand what the company has to offer as well and use judgement to find out if this investment make sense for the long term.

Those statistics help me filter companies that shows a lot of red flags. Also keep in mind, those values change all the time, if a company is worth investing now, it doesn’t mean it will offer the same deal in the future.

 

Another pro-tip I will give you:

I often compare those values to the S&P 500 index and ask myself, would these numbers beat the market? If not, you should simply invest in the whole market and get the average results instead of taking a risk by putting more money in the same basket.