Stocks & Shares
In this lesson we will cover:
– The factors that influence stock prices
– Important financial data when analysing stocks
– The difference between physical shares and CFDs
Each segment of the financial markets has its own rules and quirks. Currencies for example, have their value determined mainly by the health of a country’s economy, by Central Bank policy and moves in interest rates.
Commodities, on the other hand, are priced mainly due to supply and demand.
Stocks (and indices, which cover all the stocks in that market) are interesting instruments as their price is not only related to activity within the individual business(es), but can also be priced relative to the economy as a whole.
Additionally, while a 5% change (or greater) in the value of a currency or a commodity is considered to be an unusual or extraordinary event, it is quite commonplace for stocks.
Stocks & Shares
In the United States, “stocks” are a shorthand way of saying “common stock”, whereas in the UK, the term “shares” is used instead of”ordinary shares.” The two expressions are practically identical in meaning; both refer to shares which have no special privileges or rights but which are entitled to whatever capital or income remains after prior claims have been satisfied.
A share is simply a divided unit of the value of a company. For example, if a company is worth £200 million, and there are 10 million shares, then each share is worth £20. Those shares can and do go up and down in value for various reasons.
Companies issue shares to raise money. Investors buy shares in these companies because they believe the company will do well and they want to ‘share’ in their success.
Furthermore, a stock/share is a type of security, and signifies ownership in a company and a right to its assets and earnings.
When you buy a stock/share of a specific company, you become part of its ownership structure. You also obtain a right to receive a dividend.
If you become a majority stakeholder in a company, trading stocks/shares becomes more complicated. You not only decide on what to do with the securities you have bought, but also have a right to decide on the company’s future by participating in the General Meeting (GM) of shareholders.
Common stock owners can be invited to vote on a company’s affairs, for example new appointments to the Board of Directors, and whether mergers, acquisitions and takeovers should occur.
Stock Prices
There are many factors that affect stock prices. Let’s highlight the most important ones:
Earnings
Earnings are crucial in analysing stocks. The more the company earns, the more expensive its shares should become, in theory.
When a company is making money it may pass the profit onto shareholders in the form of a dividend. It could also buy back its shares, or invest, which should lead to a rise in the company’s value.
If the amount of stock remains more or less unchanged, a rise in the company’s value leads to a higher price for each share.
It’s important to remember that sometimes a company with a high price of its stock might not be making much money.
However, the rising price means that investors are hoping that a profit will appear in the future. If not, prices could fall sharply as happened in the case of the dot-com bubble and in 2020, Chesapeake Energy.
Despite dismal earnings, investors bought Chesapeake, inflating it to over $70 a share, before the company filed for Chapter 11 bankruptcy.
This is why earnings are crucial to watch while trading stocks.
Industry & Sector
Companies conduct business within specific sectors of the economy. For example, Apple is a technology company in the manufacturing sector, which means that it isn’t competing with Coca-Cola. Even though Cocal Cola is also a manufacturer, Coca Cola is a fast moving consumer goods (FMCG) company.
Instead, Apple competes with other technology and manufacturing companies, for example Samsung, Huawei and Hewlett-Packard.
If the level of competition within a sector is extremely high, it may begin to impact a company’s profits, thus pushing the value of its stock.
Finances
The financial situation of a company determines its ability to exist in the long-term.
A deterioration in this area could lead to dramatic moves in a company’s stocks, with the share price of banks during the 2008 GFC being the best example.
Another example is Hertz Corporation. In 2020, Hertz filed for Chapter 11 bankruptcy, citing a sharp decline in revenue and future bookings caused by the COVID-19 pandemic.
Economic Conditions
Stock prices depend not only on events within the company and Board Room, but also in the broader economy. For example, a deteriorating economy or recession could result in a fall in earnings or even bankruptcy, which negatively impacts the stock price.
On the other hand, higher economic growth could improve the outlook for a company, leading to a rise in the price of its shares.
Ratios
Valuing a company is definitely not an easy task. Examining financial statements, outlook on earnings, industry (and sector data as a whole) and other information can be almost overwhelming.
However, there is a simple way to compare different stocks which can to help to determine if an investment in a specific company might be profitable.
Financial ratios allow you to make these comparisons to determine if a trading opportunity exists.
The most commonly used ratios in fundamental analysis on stocks and shares now follow.
Earnings Per Share
Earnings Per Share (EPS) is a ratio that calculates the net income earned for every outstanding share. In other words, this amount is the money earned by every share if the entire profits are divided by the total number of shares at the end of the year.
In some ways, it also reflects the profitability of the company from a shareholder’s perspective. The higher it is, the more attractive the stocks.
Price to Earnings
The Price to Earnings (P/E) ratio is the most widely used valuation indicator in stocks, although it is far from perfect.
It is a valuation of a company’s current share price compared to its per-share earnings. A high ratio means investors have to pay more for today’s earnings, while a lower ratio means that the stock may be undervalued.
Stocks with a high P/E could be overpriced, which make investments less attractive.
The general rule is that the lower the P/E ratio, the more attractive the stock.
Finding undervalued stock and investing in it is called “value investing”, an investing method made famous by Warren Buffett.
Dividend Yield (DY)
This is a ratio that indicates how much a company pays out in dividends each year relative to its share price.
Dividend yield is represented as a percentage and can be calculated by dividing the value of dividends paid in a given year per share of stock held by the value of one share of stock. The ratio is a useful tool for so called “dividend investors” that are looking for stocks that have exhibited stable growth and pay a solid dividend.
However, it should be noted that some companies pay no dividend at all. Berkshire-Hathaway is an incredibly successful company, but does not pay a dividend to its shareholders. This is because company founder and CEO Warren Buffett believes that the company’s money can be better spent in other ways.
Buffett feels that investing back into the business provides more long-term value to shareholders than paying them directly, because the company’s financial success rewards shareholders with higher stock values
Stocks & Shares CFDs
CFD trading enables you to go long (buy) if you believe a share price will rise, or go short (sell) if you believe a share price will fall.
CFDs are therefore much more flexible than buying physical stocks and shares, giving you the ability to take advantage and potentially profit in both rising and falling markets.
Be aware that, unlike when trading physical stocks, positions held overnight may incur a daily financing fee called “swaps”. A swap is an overnight (or rollover) interest fee that can be charged (or credited) on the underlying instrument when you decide to keep a position open overnight.
Additionally, remember that buying a stock or share CFD does not make you an owner of the company, and you don’t receive any dividends or other payments from the underlying company.