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Finance > Stocks
& Investments > Stocks
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STOCKS
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Characteristics: Stockholders have an ownership interest
in a business. Most of the businesses in the U.S. are privately owned, but
investors can buy shares in more than 10,000 corporations that are publicly
traded. This includes most of the titans of industry, such as IBM and
Coca-Cola, as well as many small companies. Today, many millions of people in
the U.S. own stock in publicly traded companies or in equity mutual funds that
invest in stocks.
When buying stock, an investor is typically hoping that the
perceived value of the company will rise, producing a capital gain when the
shares are sold later to someone else at a higher price. Capital gains are one
of two components that typically constitute the total return from stock
investments. Another way in which stock ownership pays a return is through
dividends, the portion of a corporation's earnings that is paid to
stockholders. To compute a stock's dividend yield, divide the amount of the
annual dividend by the current price per share. For example, if a stock is
priced at $10 a share and the annual dividend is $0.50 a share, the dividend
yield is $0.50/$10.00, or 5%.
There is wide variation in the performance of common stocks,
both for the general market and for individual issues. However, as we have
already explained, if you can ride out the interim ups and downs (the price
volitility), the long-term value of stock market investments tends to grow with
the economy. Through 1993, stock prices, as measured by the S&P 500 (an index
based on 500 large companies), rose in 16 of the previous 20 years. The annual
performance ranged from a 32% rise in 1975 to a 30% decline the year before.
Also, holders of common stock received dividends, which averaged more than 4%
annually of their investments' market value. Over this 20-year period, the
stock market's compound annual total return, including both price increases and
dividends, was about 13%. In comparison, consumer prices advanced at about a 6%
compound annual rate during the same period.
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Fundamental vs. Technical Analysis: One
widely used approach to stock market investing is to focus on fundamentals.
Fundamentals include factors such as the earnings, cash flow, and balance sheet
statistics of a given company, plus general economic conditions and the
industry in which the company operates. Such an analysis looks at whether the
current valuation of a company, as seen in its stock price, adequately reflects
the level of business success perceived for it in the future.
A second approach to investing emphasizes technical factors
related to trading activity. A technical analyst, or chartist, attempts to
forecast the direction of stock prices by examining their trends. For example,
if a stock price breaks above a prior resistance level, it may be headed up
further.
Obviously, there is a relationship between the fundamental and
the technical factors. If a stock price has what appears to be upward momentum,
this probably reflects favorable fundamental factors, such as a good earnings
report from the company or the announcement of a new product. Although an
awareness of trading patterns can be helpful in timing investments, technical
analysis can be quite specialized, and we suggest that most investors emphasize
a fundamental approach to investing.
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Assessing a Stock: When looking at a
potential stock investment, you might consider several questions: What is the
primary business of the company? What is the company's competitive position
relative to others in the same industry? Does it have clear advantages or
disadvantages? What level of market share does it have? How much does its
overall business depend on a single customer or on general economic conditions?
What are the prospects for growth?
Although the past is not necessarily indicative of future
results, it is advisable to examine a company's historical performance. Look at
10-year trends in the company's income statement data, as published, for
example, in the Standard & Poor's Stock Reports. Have revenues and profits been
generally growing? If not, why? Also, has revenue growth primarily been coming
from higher volume, new products, acquisitions, or increased prices? What has
the trend in profitability been? Have earnings as a percentage of revenues been
on the rise?
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Some Key Ratios: Certain ratios can be
useful tools in analyzing and comparing companies. Financial ratios provide
ways to quantify a company's operating success and financial well-being.
Valuation ratios gauge how fairly a stock is priced. The ratios for a given
company don't mean much by themselves, but they are very revealing when
compared with the company's historical ratios and with the ratios of comparable
companies in the same industry. Although the list is far from comprehensive, a
look at the following key ratios will help you evaluate a potential investment:
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Return on Assets (ROA) and Return on Equity (ROE):
Net income (minus preferred stock dividends) divided by average total assets
(ROA); and net income divided by average total common equity (ROE). These
financial ratios indicate how profitably a company is investing funds from
stock offerings, borrowings, and retained earnings. When debt leverage is used
effectively (that is, generating a profitable return from borrowed funds), a
company's ROE should be higher than its ROA.
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Long-Term Debt to Total Capital: Obtained
from the balance sheet, this ratio is used to gauge a company's financial
strength. (Total capital equals shareholders' equity plus long-term debt; often
this analysis is done as a debt to equity ratio.) A "clean" balance sheet has
little or no debt. Companies capitalized with 50% debt (a debt to equity ratio
of 1:1) or more might be overleveraged; heavy interest payments could limit
growth of future earnings and restrict available financing for maintenance or
expansion. This concept is similar to looking at the size of a homeowner's
mortgage relative to the value of the house. For firms such as utility
companies, however, a large proportion of debt, or financial leverage, is
typically less of a concern than for other types of companies because utility
companies have a relatively predictable and adequate stream of income and cash
flow to cover interest expense.
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Current Ratio The relationship between
current assets (those that are relatively liquid and/or are likely to be turned
into cash within the next year) and current liabilities (payments due within
one year). This ratio is especially critical for companies having financial
difficulties. For many industrial companies, a ratio in which current assets
are at least 1.5 times current liabilities suggests the ability to meet
near-term obligations. A ratio of significantly less than that amount could
signal a coming cash crunch. However, advisable benchmarks may differ
significantly among various industries.
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