When it comes to investing in the stock market, you’ll find a lot of advice. There are many strategies used to try getting great returns. And as it goes with everything, you have good strategies and bad ones. The strategy you want to choose for your portfolio is up to you. Let me share some important basics you should be aware of before investing in the stock market.
” The big money is not in the buying and the selling, but in the waiting. ” ~ Charlie Munger
What is the stock market?
A stock market is a place where investors buy and sell pieces of companies, called stocks. A company can issue stocks in order to raise capital for growth and expansion. The initial price at which a company issues shares is called the par value of the stock. A stock can’t be sold below its par value. If a stock goes up in value, the amount that exceeds the par value is called “additional paid-in capital”. This can be found on the shareholders’ equity section of the balance sheet. The balance sheet is part of the financial reports a company is obligated to release.
The market price of a stock depends on the number of stocks outstanding and the amount an investor is willing to pay for it. In other words, if a company is priced at $1.000.000 and has 1000 shares outstanding, the price per share would be $1.000. Notice I said, “a company that’s PRICED at $1.000.000”. The word price and worth are often used interchangeably, but there is a huge difference between the two. I will tell you more about that, later.
” Price is what you pay, value is what you get. ” ~ Warren Buffett
What is a stock?
As I said previously, a stock is a piece of a company. It’s very important to always keep that in mind. When you buy a share of a company, you are not buying something that is magically going to go up in price and make you money.
Thus, if you buy a piece of a company, you become one of the owners of the company. And therefore you are entitled to a piece of the earnings, (or losses).
How do stocks provide money to investors?
There are two ways an investor can make money with stocks. When a company makes a profit, it will either reinvest the money into the company, or it will pay a dividend to the investor. However, most companies do both. Some companies don’t pay a dividend, and that’s ok as long as they invest it well.
When the company uses the profits for investments, they are either buying new assets that will increase the profit the company makes, or they will do share buybacks. Both make investors willing to pay more for the stock. And when the buying side is willing to pay more, the selling side will be able to sell their shares at a premium to the price they paid for it. Note that in order to realize their profit they need to sell the stock in this case.
Management can also decide to pay out a part of the profit to its investors in the form of dividends. This way the investor earns money without having to sell the stock.
What to look for before buying a stock?
(In this writing, I will try to not get too technical and keep this basic.)
Imagine you are looking to buy a store. What would be a good question to ask yourself before determining whether or not you want to buy that store and how much you are willing to pay for it?
Thought about it?
You would want to know:
- How much profit does the company make?
- Who are its main competitors?
- Does it have a competitive advantage? (something that protects the business from competitors taking market share)
- How much is the industry expected to grow?
- What profits can you expect in the future?
- What are the risks involved in the company?
- How does management mitigate risks?
- Does the company have good management?
- Will this company still be around in 30 years?
As you can see, there are many questions to answer before we are going to decide whether or not it would be profitable to buy a business. And the same goes for stocks. We are not looking at a chart or a price that will go up, we are looking at a business managed by people.
The great thing about this al is that the answers to those questions are not that hard to find. You just need to learn where to find the information you need to answer these questions and how to interpret that information.
And by reading this article, you are already on your way to learn how to be a good investor.
Where to find information about a company?
Publicly listed companies are obligated to release financial reports every quarter and annually. In these financial reports, you will find :
- The balance sheet (shows what a company owns and owes)
- The income statement (shows the profit and losses)
- The cash flow statement (shows the cash inflows and outflows)
What price should I pay for a stock?
Thinking about the price of a stock is very important. Believe it or not, but many people overlook this aspect. Before we decide to buy a stock, we would like to know if the price of the stock is higher, equal to or below what it’s worth.
The price we pay for a stock will greatly affect the returns we are going to get.
Imagine you buy a house that is worth $300.000 and you buy it for $400.000, how many years do you think it will take before you could sell that house for $400.000?
Thought about it?
It would probably take quite some time to get your money back from that investment. Now, imagine how much more time it would take in order for you to make a profit on the sale of that house?
On the other hand, if you saw that house priced at $250.000 and you figured out it is actually worth $300.000, you could almost make a profit instantly.
This is what we try to do when we are looking to buy a company. We will try to find a company that is undervalued. We want to buy a company when it is priced way below what it is actually worth. This is both protection against errors in our assessment of the company as it is an additional profit and protection against risk.
How can a company be undervalued?
From time to time a company gets into trouble. They get some bad news that causes some investors to panic. This panic drives investors to sell their shares of the company which makes the share price go down.
A value investor will try to determine whether or not there really is a problem with the company. They will determine if this problem will affect future earnings and if this is not just a short-term struggle?
Take, for example, Facebook. They got into a privacy scandal which drove the share price down to its lowest point in nearly 2 years. Now the stock price has completely recovered. Some value investors have used this short-term panic as an opportunity to buy their way into Facebook stock at discount prices.
” Be fearful when others are greedy and only greedy when others are fearful.” ~ Warren Buffett
How to find out if a company is undervalued?
Finding out if a company is undervalued demands an in-depth analysis of the company. Of course, there are some indicators to look at before deciding to analyze a company. There are some key metrics and ratios that indicate undervaluation. You’ll find more about that here.
- Buying one stock should be seen as buying the whole company
- The price of a stock is very important to ensure a high return
- We will only buy companies that are undervalued
I have learned many things about value investing by reading books. If you are interested in learning more about investing as well, consider reading “The Intelligent Investor ~ Benjamin Graham“. This book is considered the bible of value investing. However, this book can be a bit hard to read for beginning investors.
“I hope you enjoyed reading this article as much as I did writing it. If you are interested to increase your knowledge about investing and finance, consider following this website to read more about those subjects.”
“ An investment in knowledge pays the best interest.” ~ Benjamin Franklin
*DISCLAIMER: The content on this website is written in good faith and I believe its accurate. However, this content should be considered informational and not for taking financial decisions.