The School of Hard Stocks
The concept of stocks is simple — companies raise money they never have to pay back by selling stocks to the public, and investors buy stocks in the hopes that the stocks will eventually be worth more than they paid for them. Owning a stock (also called “equity” or “share”) means owning a teeny-weeny slice of that company, so technically you’re a business owner (shareholder) without ever having to go to work! The even better news? Shareholders aren’t personally liable if the company can’t pay its debts. Owning stocks also means you have limited voting rights about management.
Any investment always comes with some risk, and stocks are no different. Stock values fluctuate according to supply and demand, and companies suffer, struggle through quarters and even completely fail. For example, if your company goes belly up, you could lose your entire initial investment due to bankruptcy. The gamble is often worth it, however; the average annual stock return is 10 percent (not including the effect of inflation), according to USA Today.
Stock prices vary (a lot). One share for profitable companies can cost hundreds of dollars, while others for smaller companies can be less than five bucks. Less expensive stocks are also called “penny stocks.” The higher the cost, the bigger the risk — and the bigger the possible reward. Investors also often purchase multiple stocks for the same company since the more shares you own, the bigger portion of the company’s profit you can reap.Swapping Out
Stock exchanges (like the New York Stock Exchange and the London Stock Exchange) are basically markets where investors can sell their stocks to other people.
How it works: When you decide to cash in on your investment, you’ll contact a brokerage firm, who will then contact the exchange on your behalf. A specialist at the exchange can match you with a buyer and determine the price using an auction method. There are also virtual markets, like NASDAQ, that don’t require brokers.
But how can you find stocks that are a good fit for you? Choose a company you’re interested in. Then assess its performance and compare it to its competitors. It’s not always so easy to see how a company is performing. Check out the following before making your decision.
Income: To find out what a company is making, take a gander at the company’s:
• Gross profit margin. This number represents how many cents to the dollar of revenue a company actually makes. If this number is above one, the company making money.
• Price/Earning (P/E) ratio. This shows how much money investors are willing to pay per a stock’s dollar of earnings. For example, a P/E ratio of 20 means investors are willing to pay $20 for every $1 the company generates. Historically, this ratio ranges from around 15–25; a high ratio means the market is optimistic about a company’s future growth.
Debt: To compare a company’s overall debt (aka liabilities) to its assets, look at the balance sheet to determine the company’s:
• Working capital. This measurement indicates a company’s financial strength, meaning how many assets it has compared to liabilities. If its debt outweighs what it owns, the company may be unable to pay off its debt.
• Debt/Equity ratio. This number shows how much debt compared to equity a company uses to finance its assets. For example, a debt/equity ratio of three means a company has $3 of debt per $1 of equity. Generally, the higher the number, the riskier the company.
Cash flow: This number shows where a company’s income is coming from and where it goes. You can find this info on a company’s cash flow statement.
Now it’s your turn. Try researching a few companies you’re interested in and see how much stock shares will cost you. Can’t afford a stock in big name companies like Apple or Google? Try a penny stock instead.