Chapter 12: The Stock Market
As we began to cover in Chapter 3, there are lots of ways you can earn a higher rate of return on your savings. We mentioned that most options fall into the two categories of buying ownership or lending your money. One option is to own part of a company by purchasing shares. The company takes your savings, invests them in its business and pays you back in the future. If you’re dealing with shares of multiple companies, they’re called stocks. The stock market provides a marketplace where you can go to buy and sell stocks.
People typically have one of two reactions when they hear the words “stock market.” Some think it’s a way to make quick money and are keen to dive right in. Others think it’s the fastest way to lose your savings and avoid it at all costs. It requires the combination of these views to best benefit from investing in stocks. After all, the stock market offers an excellent way to potentially grow your money while managing your risk. In Chapter 3, we mentioned you can minimize your risk by diversifying and investing for a long period of time.
How Shares Work
To understand how a share works, we’ll consider a boy looking to set up a snow cone stand in his neighbourhood. He needs money to start his business—to buy a stand, cups and syrup. He’s done his research and knows that it should cost $40 to buy everything he needs. One small issue, however, is that he doesn’t have the money needed to get started. As a result, he approaches his brother and sister to ask for $20 from each of them. In exchange for their money, the boy offers them each 25% ownership in his snow cone business.
Both siblings agree and pay their brother $20 to help him set up shop. The 25% ownership that each sibling now has is considered their share of the company. Their share represents the claim to a portion of any profits the snow cone stand earns in the future. While this is a simplified example, shares in the stock market follow a very similar format. They provide you a claim to a portion of the company’s future profits and assets, which may include cash, buildings, patents and more.
There’s one key difference between our example and the stock market. With the stock market, instead of buying the share directly from the company, you often buy it from an existing investor. For instance, let’s continue our snow cone example above and consider what happens if three days later, the sister needs money. She could ask her father if he would give her $10 for half of her share of the snow cone stand. Now, instead of the father buying his share directly from the snow cone business, he’s purchasing it from an investor. The father agrees, happy to be a part of the new family business, and pays his daughter $10 for half her share of the company. Both the father and the daughter now own 12.5% of the snow cone stand.
Exhibit 31 – Four family members now have a share of the snow cone stand. The founding boy kept half of the business for his efforts in coordinating everything and running the stand.
Share Value
Shares are bought and sold—or traded—at whatever price the buyer and seller agree is fair. The value of a share depends on a great deal of factors that often involve uncertainty. As a result, everyone may have a different opinion of what a share is worth. It’s only when two people agree to a price that a trade takes place. Once again revisiting our snow cone example, $20 for 25% ownership could be an excellent investment if the boy can generate large profits. However, it’s also possible that due to a lack of customers or an increase in the cost of syrup, the stand could lose money. As more information is learned about the snow cone stand’s performance, the value of the shares could go up or down. For example, if two weeks in, the ambitious young boy has made $60, the value of the shares would be worth much more than before. However, if lower temperatures and rainfall prevent sales for a month, the value of the shares would likely fall.
There are two ways to make money in the stock market. You can purchase a share and keep it for many years, collecting your share of the company’s profits as time passes, or you can purchase a share and sell it later for more than you originally paid. For example, if the brother who paid $20 for his 25% share later sells to his mother for $40, he’d earn a $20 profit.
Buying and holding or, buying and selling stocks offer the chance to grow your savings at a faster rate. It’s important to once again mention that buying stocks—and many of the investment options we’ll discuss—presents the potential that you’ll lose money. If the father wants to sell his share after the stand has been struggling for a month, he may only get $5. As a result, the father has lost 50% of his money by purchasing the share for $10 and selling it for $5.
Historical Performance
There is a risk that if you buy stocks, you could lose some of your money. We mentioned briefly in Chapter 3 that the Canadian stock market lost roughly 14% in 2002 and 33% in 2008. However, we also mentioned that over ten-year periods average returns ranged from 3% to 11%. These numbers are based on the performance of a popular Canadian exchange-traded fund (ETF)—which we’ll discuss in chapter 14—that invests in a broad range of Canadian companies.
Throughout history, investing in stocks over long periods has provided positive returns. These positive returns make sense when we once again consider what investing in stocks really is. You’re buying partial ownership of a diverse range of companies. The goal for all these companies is to provide a product or service that’s worth more to a customer than it costs to produce. While it isn’t always the case, most companies succeed in creating value through their operations. The value created results in the stock market increasing in value over time.
Factors That Affect Share Value
Now that we understand how a share works, let’s discuss the factors that drive what it’s worth. Since a share is a portion of a company, its value depends on:
What the company owns, also called assets
This could include cash, buildings, patents, trademarks and more.
What the company owes, also called liabilities
This could include loans, amounts owed to suppliers and more.
What the company earns, also called net income
This includes current and future profits or losses.
Depending on the type of company, these factors will differ in importance. For instance, companies that operate in traditional industries, like manufacturing or real estate, may own a lot of buildings. In this case, the amount they own could be an important consideration. In a different case, a tech company may own little more than an app. Here, the share would be valued on how much the company could earn in the future. In either case, if a company owes a lot to borrowers, this can be the most important factor an investor considers.
You may not be interested in picking individual stocks, and for most of us, that’s the right approach. However, understanding how the stock market works will help increase your comfort using it to help grow your savings. Let’s continue discussing the factors that investors consider when deciding whether to buy or sell stocks.
Book Value
The simplest way to value a company is to look at what it owns and subtract what it owes. If a company owns its head office, factory and delivery trucks, they could have $200 million in assets. They may have borrowed $50 million from a bank and owe their suppliers $5 million for a recent delivery. In this case, if the company sold everything it owned and paid back what it owed, it would have $145 million left. This $145 million value is referred to as the company’s book value. It’s what the company’s worth today if they sold everything and stopped operating.
When you invest in the stock market, you’re buying companies that own assets like buildings and patents. These assets are what you see as you walk down the street or what you feel as you enter your favourite store. Either way, the value of a share is backed up partially by what the company owns.
Earnings
A company’s goal is to use what they own to earn money by selling goods or services for more than they cost. Therefore, rather than simply considering the book value, most investors consider what the company can earn. Some companies are focused on earning a profit today, and others are willing to wait.
Companies can be categorized depending on what stage of growth they’re at. Some may be growing their business for the future, while others are at a mature state with little room left to grow. When considering a growth company, its current earnings are less important than what it could earn in the future. An established company that’s investing to grow additional services is considered both on its current and future earnings. Mature companies that aren’t increasing capacity or entering new markets are valued based on current earnings.
Exhibit 32 – Companies can be categorized into three stages of growth. Depending on the company’s stage, investors are focused on different types of earnings.
Earnings are important because they allow the company to grow or pay you back money. A common approach to valuing a company is to forecast the amount it could earn over its lifetime. If a company could earn $10 billion over the next twenty years, it may be worth $5 billion today. It’s worth less today than it may earn since that money is both uncertain and in the future.
Market Value
Investors consider what the company owns and owes, which is represented by the book value. They also look at the potential earnings of the company in the future. This combination allows them to determine what the company is worth today. The total value of the business based on what investors believe is referred to as its market capitalization. This is also referred to as market cap or market value, and it’s what the market of investors believes the company is worth.
The market value is calculated by multiplying the number of shares in the company by the current price of a share. For instance, a company with 10 million shares and a $100 share price would have a market cap of $1 billion. Typically, companies are grouped by their market cap into small-cap (less than $2 billion), mid-cap (from $2 billion to $10 billion) and large-cap (larger than $10 billion). A company’s market capitalization can influence who owns its shares and how easy its shares are to buy and sell.
Comparing the Price to Earnings
While a company’s earnings are important, looking at them on their own doesn’t help much. For instance, earnings of $50 million could be excellent for a small company with 100 employees or disaster for a global business. To address this, a commonly referenced measurement is a P/E ratio. This stands for price-to-earnings ratio, and it’s a comparison of a company’s earnings to its market cap. In our previous example, if a company had earnings of $50 million and was worth $1 billion, its P/E ratio would be twenty.
You can view the P/E ratio as how many years’ profit the company needs to pay back your investment in full. If the company makes $50 million for twenty years, they’d have earned their current value of $1 billion. These numbers also give a sense of the return you’re earning on your investment. If the company earns $50 million and is worth $1 billion, they’re earning 5% a year.
P/E ratios vary over time, depending on economic conditions. However, the average is often between ten and twenty. High P/E ratios are very common for high-growth companies that expect larger earnings in the future. As the company’s earnings increase and growth slows, the P/E ratio typically decreases. Low P/E ratios are common for stocks that are having difficulties and may earn less in the future. A P/E ratio is a quick way to compare two companies of similar size and stage of growth.
Exhibit 33 – Earnings are very important to a share’s value. However, it needs to be compared to the size of the company. The following chart outlines a range of P/E ratios with examples.
Dividends
Earnings allow companies to grow or give money back to their investors. One way they can give money back is by paying you a dividend. This is often done by more established companies that no longer need all their profit to grow. Dividends are the simplest way to see the return on your investment in a stock. For example, if you buy a share for $20 and each year you get $1 in dividends, your return from dividends is 5%. This 5% value is called the dividend yield. Dividend yields typically range from 1% to 10%, with an average around 2.5%. An important note is that companies can lower their dividend at any time. Therefore, just because a company is paying a high dividend today, doesn’t mean they’ll continue to. Companies try to avoid lowering their dividend, but in challenging times, it happens.
Emotions
We mentioned above that there are three main factors that determine what a share is worth.
What the company owns
What the company owes
What the company earns
However, there’s a fourth factor that should be added to the list.
How investors feel
This could include hope, excitement, euphoria, anxiety, fear, panic and more.
As investors view the same share while in a different emotional state, the value can change dramatically. If you’re excited for the future of an industry, like electric cars, you’ll probably view these manufacturers more favourably. You may believe the company’s future earnings will be enormous and will be prepared to pay more for a share. However, several months later, you may fear the economy is slowing down and that future earnings will be low. In this case, you may pay very little for the same share.
These emotions can swing from day to day, as well as in longer-term cycles. While very little may have changed for the company, the price of its shares can move up or down significantly. Regardless of the type of emotion, it’s important to remember how much of a role they play in the stock market. This, once again, emphasizes the importance of ignoring the noise. Remember that underlying all your stock investments are assets and potential future earnings.
Exhibit 34 – Combining what the company owns, owes and earns determines what it’s worth.
Exhibit 35 – Investors view this share over time while in different emotional states. In good times, they apply a premium and pay more, and in bad times, they apply a discount and pay less.
Exhibit 36 – The combination of all these factors creates the share price over time.
Managing Risk
A company’s value is highly dependent on an uncertain future. If a change in regulation limits a factory’s production, then its value falls. If a company loses a major client, it’s future earnings could drop significantly. These events are unpredictable, which is why the stock market presents a higher level of risk. Layered on top of the risks to the business, there is also a risk that investor emotions will shift. All this risk is especially high if you buy only a few companies. If you invest 100% of your money in a single company and it loses a major lawsuit, you could lose everything. However, if you invest 1% of your money in 100 companies and any go bankrupt, you’d lose up to 1%. To lower the impact an event can have on your savings, it’s wise to diversify.
Final Thoughts
As we mentioned in Chapter 4, it’s common to invest in higher-risk investments to help earn a higher return. To do this, it’s important that you don’t need your money in the near-term. The stock market has historically been a way to put your money to work to grow your savings for the future. You can invest in stocks with savings in any of the accounts we discuss in this blog. Regardless of the account, it’s important to remember the material covered in part I. This includes your risk exposure, diversification, long-term investing, research and obtaining a professional opinion as required. With the stock market now covered, it’s time to discuss lower-risk investment options. These options can provide greater diversity and predictability to your savings.
Key Takeaways
Stocks are a common way to grow savings at a faster rate while taking on more risk.
Minimize your risk by investing in many different companies over a long period.
Stock prices are determined by what a company owns, owes and earns, as well as investors’ emotions.
This blog is a duplicate of the recently self-published book The Snowman’s Guide to Personal Finance available for purchase here.