When considering investing in stocks, there is a lot that we must learn. First we must determine whether we have the time/knowledge to choose our own investments or if we should take a more passive route (hiring a broker, passive index investing, choosing age-related mutual funds, etc). Then we must figure out our investing temperament and risk tolerance, decide on an length of time to stay invested, and then develop a strategy for evaluating the performance of our investments.
What Investing in Stocks Represents
However, before we begin to wrap our heads around all of those topics, we must understand the most basic truth of investing in stocks. When you purchase stock, you are buying a share of the ownership of a company. In fact, this is why it is referred to as purchasing “stock” or “a share” of a particular company.
When a company needs to raise money, they have two main options from which to choose. First, they can issue debt – selling bonds and notes on the open market, or borrowing directly through banks and other institutions. They also have the option of selling equity (ownership) to raise money. This is where the stock market comes in to play.
When a company chooses to sell equity, it is referred to as a Public Offering – an Initial Public Offering (IPO) is the name for the first time a company sells shares to the public; while a Secondary Offering refers to a company that has already conducted an IPO, but still needs to raise more money at some point in the future. The primary owners usually maintain majority ownership in the company (holding on to at least 51% of the shares of stock).
Once an IPO takes place, the shares of stock are now sold and traded on the secondary market. This means that you and I can buy and sell tiny pieces of ownership of any publicaly-traded company via the “stock market”!
Investing in Stocks as an Owner
Understanding this truth should change how we evaluate investing opportunities. Instead of looking at the price of a share of stock as a random number, you will now understand that price to be the cost of owning one share of that particular company.
Instead of gambling with your money trying to guess which way a random number will jump over the next few weeks, you will now try to decide what the value of a company will be over time, and if the current stock price reflects that.
This means that you must evaluate the value of the company whose stock you are thinking of buying. You will not only look at their current products, competitors, and industry, but you will also look at their future prospects to determine the company’s value.
Yahoo Finance has a wealth of pertinent information (news, historical price information, analyst opinions, reports, financial metrics and ratios, etc) about most companies, so you don’t have to do all of that research alone.
If after your evaluation you determine that you would be willing to pay $50 for a share of stock (for example), and the stock is currently trading for $45, then buy it (assuming that it met all of your other qualifications listed in the first paragraph)! If it is trading for more than what you determine to be a fair value, then pass it by (or short it)! Pretty simple.
Remember that the current price of any investment vehicle should be the present value of all future earnings. So just be sure that you are investing in stocks because they present value of their future earnings is less than the current price. Yes, I know that I just said that the two should be equal, but we live in an imperfect world with irrational people (which is why being a contrarian is often very profitable); so take advantage of true value when you see it!
If you can understand this fact, then you will automatically be ahead of most investors out there!
photo by Alan Cleaver