Archive for the ‘Stock Basics’ Category
If you’ve ever watched CNBC or read the Wall Street Journal, you’ve probably heard the term “value investing” thrown around quite a bit. And, like me, you probably assumed that it involves something along the lines of finding good stocks at cheap prices. Well, you’re right, but I think it’s important to lay it out a bit more formally. In a nutshell:
- Stocks prices are affected by many variables which cause them to fluctuate
- Human psychology (i.e., irrational behavior) is a huge driver of these fluctuations
- However, despite this, these stocks do have real underlying values
- Value investing entails buying only those stocks trading significantly below those real values
An Easy to Understand Example
For example, take the current housing situation. If you were to ask the average investor which housing stocks he would buy today, they would probably laugh and respond “I would stay away from anything having to do with housing right now”.
For the most part, they are right. But, what if you found a homebuilding stock that had a strong balance sheet, no debt, and had positioned itself to minimize risk exposure to falling property values? Further, what if that company was trading at a price per share that was lower than the per share value of its assets (if they were to be liquidated)?
A true value investor (i.e., Warren Buffett) would take a conservative approach and wait until the stock traded at a price at least 20% below what he / she thought it was worth before buying it. By doing so, they are taking advantage of irrational investor behavior, as well as the institutional “bias” toward stocks considered en vogue. In addition, they are giving themselves what Benjamin Graham dubbed a “margin of safety” which ensures solid returns.
Cash is, quite simply, king when it comes to stocks. While the income statement captures the earnings of a company for a given period, some of those earnings haven’t been realized yet. That is, the company may have sold 100 mainframes in the first quarter of the year, which will show up as revenue booked on the income statement. However, if the company which purchased those items doesn’t pay for them until the end of the year, that money won’t be reflected as “cash flow” until Q4. Thus, net income is more representative of transactions, while cash flow reflects when money actually changes hands. As you would expect, investors prefer cash since it is “money in hand” vs. an IOU.
There are typically 3 main components of the cash flow statement. In general, these are comprised of a number of detailed line items. We’ll cover the high level concepts below.
The income statement is one of the most important financial statements produced by a company. In a nutshell, the income statement is a summary of operations for a given period (year or quarter) which outlines revenue, cost, and profit produced by the firm. When a company “announces earnings” this is invariably the document which is being referenced. It is also where the Net Income and Earnings Per Share (EPS) metrics are found.
However, keep in mind that earnings numbers can be manipulated using fancy or “creative” accounting techniques which can hide unfavorable performance. Therefore, it is always important to maintain a critical eye when reviewing this document - and to cross reference the Statement of Cash Flows as well. The major components of the Income Statement are outlined below.
Probably the most comprehensive snapshot of a public company, the balance sheet provides a summary of company assets, liabilities, and stockholder’s equity. A good way to understand this is to think of an individual instead of a company. Your assets are what you “have” (e.g., money in the bank, your 401k, etc.) while liabilities are what you “owe” (outstanding loans, credit card debt, etc.). If you subtract the value of your liabilities from the value of your assets you (hopefully) have an amount leftover. This represents your “Net Worth”, and is essentially the same as “Stockholders’ Equity” on the balance sheet. The equation is:
Assets - Liabilities = Stockholders’ Equity
or, equivalently:
Assets = Liabilities + Stockholders’ Equity
As opposed to value stocks, growth stocks are usually what the general public associates with the stock market. These are typically more “exciting”, innovative companies which investors believe will have high earnings growth moving forward. This perception is also usually reflected in the price of the stock. For example, the Russell 1000 growth index has a P/E of approximately 20 and a P/B of about 4. Compare this to the Russell 1000 value index, which has a P/E of about 14 and a P/B of around 2. However, 5 year earnings growth for the growth index is 20% vs. about 17% for the value index.
Growth Investing
Like value stocks, growth investing can also be used to describe an investing “style”. That is, some investors only look for innovative companies which, even though the price is high or above average for the market, still stand to perform well. A classic example of this is Google, which has a P/E of about 47 but is perceived by investors to have good future prospects for growth. However, even growth investors have a problem with paying this much for a stock, or for any stock. You will sometimes hear them described as “GARP” or “Growth At a Reasonable Price” investors. That is, they will pony up for good growth stocks, but won’t pay superflous prices for them. (Even if earnings stand to grow significantly moving forward).
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