When you own shares of stock you become part owner of a company. If the company does well, the value of your stock should go up over time.
If the company does not do well, the value of your investment will decrease.
Companies issue two types of stock, common and preferred.
Common stock is the basic form of ownership in a company. People who hold common stock have a claim on the assets of a firm after those of preferred stockholders and bondholders.
Preferred stock is ownership in a company, which has a claim on the assets and earnings of a firm before those of common stockholders but after bondholders. The safety of the principal of preferred stock is greater than that of common 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?
To start with, if a company wants to raise capital (money) one of its options is to issue stock. It has other methods, such as issuing bonds or getting a loan from the bank.
But stock raises capital without creating debt, without creating a legal obligation to repay those 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.
Who really knows? But it is true that within an industry the Price/Earnings (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.
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 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!
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 a company is paying 1 per year and 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.
That increased book value – let’s say it is now 11 — means the company must earn at least 1.65 this year just to keep up with its 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 an 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 and …
Do some homework before buying!