Subject: Stocks - Basics

Last-Revised: 26 Aug 1994
Contributed-By: Art Kamlet (artkamlet at aol.com), Edward Lupin

Perhaps we should start by looking at the basics: What is stock? Why does a company issue stock? Why do investors pay good money for little pieces of paper called stock certificates? What do investors look for? What about Value Line ratings and what about dividends?

To start with, if a company wants to raise capital (money), one of its options is to issue stock. A company has other methods, such as issuing bonds and getting a loan from the bank. But stock raises capital without creating debt; i.e., without creating a legal obligation to repay borrowed funds.

What do the buyers of the stock -- the new owners of the company -- expect for their investment? The popular answer, the answer many people would give is: they expect to make lots of money, they expect other people to pay them more than they paid themselves. Well, that doesn't just happen randomly or by chance (well, maybe sometimes it does, who knows?).

The less popular, less simple answer is: shareholders -- the company's owners -- expect their investment to earn more, for the company, than other forms of investment. If that happens, if the return on investment is high, the price tends to increase. Why?

Who really knows? But it is true that within an industry the Price/Earnings (i.e., P/E) ratio tends to stay within a narrow range over any reasonable period of time -- measured in months or a year or so.

So if the earnings go up, the price goes up. And investors look for companies whose earnings are likely to go up. How much?

There's a number -- the accountants call it Shareholder Equity -- that in some magical sense represents the amount of money the investors have invested in the company. I say magical because while it translates to (Assets - Liabilities) there is often a lot of accounting trickery that goes into determining Assets and Liabilities.

But looking at Shareholder Equity, (and dividing that by the number of shares held to get the book value per share) if a company is able to earn, say, $1.50 on a stock whose book value is $10, that's a 15% return. That's actually a good return these days, much better than you can get in a bank or C/D or Treasury bond, and so people might be more encouraged to buy, while sellers are anxious to hold on. So the price might be bid up to the point where sellers might be persuaded to sell.

A measure that is also sometimes used to assess the price is the Price/Book (i.e., P/B) ratio. This is just the stock price at a particular time divided by the book value.

What about dividends? Dividends are certainly more tangible income than potential earnings increases and stock price increases, so what does it mean when a dividend is non-existent or very low? And what do people mean when they talk about a stock's yield?

To begin with the easy question first, the yield is the annual dividend divided by the stock price. For example, if company XYZ is paying $.25 per quarter ($1.00 per year) and XYZ is trading at $10 per share, the yield is 10%.

A company paying no or low dividends (zero or low yield) is really saying to its investors -- its owners, "We believe we can earn more, and return more value to shareholders by retaining the earnings, by putting that money to work, than by paying it out and not having it to invest in new plant or goods or salaries." And having said that, they are expected to earn a good return on not only their previous equity, but on the increased equity represented by retained earnings.

So a company whose book value last year was $10 and who retains its entire $1.50 earnings, increases its book value to 11.50 less certain expenses. The $1.50 in earnings represents a 15% return. Let's say that the new book value is 11. To keep up the streak (i.e., to earn a 15% return again), the company must generate earnings of at least $1.65 this year just to keep up with the goal of a 15% return on equity. If the company earns $1.80, the owners have indeed made a good investment, and other investors, seeking to get in on a good thing, bid up the price.

That's the theory anyway. In spite of that, many investors still buy or sell based on what some commentator says or on announcement of a new product or on the hiring (or resignation) of a key officer, or on general sexiness of the company's products. And that will always happen.

What is the moral of all this: Look at a company's financials, look at the Value Line and S&P charts and recommendations, and do some homework before buying.

Do Value Line and S&P take the actual dividend into account when issuing their "Timeliness" and "Safety" ratings? Not exactly. They report it, but their ratings are primarily based on earnings potential, performance in their industry, past history, and a few other factors. (I don't think anyone knows all the other factors. That's why people pay for the ratings.)

Can a stock broker be relied on to provide well-analyzed, well thought out information and recommendations? Yes and no.

On the one hand, a stock broker is in business to sell you stock. Would you trust a used-car dealer to carefully analyze the available cars and sell you the best car for the best price? Then why would you trust a broker to do the same?

On the other hand, there are people who get paid to analyze company financial positions and make carefully thought out recommendations, sometimes to buy or to hold or to sell stock. While many of these folks work in the "research" departments of full-service brokers, some work for Value Line, S&P etc, and have less of an axe to grind. Brokers who rely on this information really do have solid grounding behind their recommendations.

Probably the best people to listen to are those who make investment decisions for the largest of Mutual Funds, although the investment decisions are often after the fact, and announced 4 times a year.

An even better source would be those who make investment decisions for the very large pension funds, which have more money invested than most mutual funds. Unfortunately that information is often less available. If you can catch one of these people on CNN for example, that could be interesting.

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