Archive for the ‘Stock Basics’ Category
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).
“Value” stocks are typically characterized by low price to earnings or “P/E” ratios (i.e., they are a bargain or inexpensive when compared to the P/E of the overall stock market). For example, American International Group (AIG) is considered a value stock with a P/E of about 13. Compare this to Google’s current P/E of around 47! What does that mean? Essentially, when we talk about the stock market, think of everything from the perspective of what will happen in the future. A P/E of 13 means that, historically, investors are willing to pay 13 dollars for 1 dollar of earnings in the future. The bottom line: the P/E ratio is a gauge of how expensive the stock is when compared to the market or other stocks. Similarly, value stocks are also characterized by a low price to book value ratio (or P/B ratio). Think of book value as simply all of the assets of a corporation minus everything the corporation “owes” (i.e., the company’s liabilities). Whatever is leftover is considered the “book” value of the company. The concept here is the same: value stocks tend to be inexpensive based on the P/B of the market or other stocks.
Value stocks are generally assumed to be more stable stocks with less “exciting” earnings growth prospects. That is, while the company may be well run and have solid, conservative financials, most investors don’t believe the company will show blockbuster earnings growth moving forward. In addition, they are also usually considered to be less risky investments. However, it is important to maintain a critical eye as this is not always a valid assumption - sometimes a risky company with grim prospects can have a low P/E (i.e., the P/E is low because the market knows the company is going nowhere). Finally, one of the benefits of owning value stocks is that they usually issue a quarterly dividend as a return on investment for shareholders. This is an additional bonus which can help boost long term gains for investors.
The Value Approach
The term value is also used to describe a type of investing style or approach. Individuals who specifically look for “bargain” stocks which trade for a price they believe is below what the stock is actually worth are considered value investors. The most successful investors in history tend to be very good at picking stocks this way. Warren Buffett (you’ve probably heard that name before) is one of the best value investors of all time. The secret to his success (which we all stand to benefit from) is to think of stock investing as investing for the long term in businesses - not as the practice of short term buying and selling, ups and downs, etc. In my opinion, this is truly the only way to be consistently successful in the markets.
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