These 20 graphs form a pictorial essay of a company’s financial statements. This large company survived the Recession of 2007-8!
Copyright © 2017 Douglas R. Knight
Believe it or not, Society is coming to the point where all capable people need to invest in stocks or bonds. So what are stocks and bonds, and why do we need them?
They are valuable certificates purchased from businesses by investors. Businesses need investors’ money to build and sell products to customers for a profit. Investors need the certificate to retrieve their money with a bonus payment. That bonus payment is an enticement to invest in businesses.
Stock and Bonds are different from each other. Stocks represent part ownership in a business. The stock owner hopes to collect portions of business profits called dividends and to eventually sell the stock certificate for a bonus amount. Bonds are written promises to refund investors’ money with an extra amount called interest. Both potentially offer individuals an extra source of money.
Markets for stocks and bonds will grow and endure for future generations. More individuals will become investors out of necessity. The details of investing are interesting and challenging.
Copyright © 2016 Douglas R. Knight
An investment style describes the way an investor earns a total return. The many possible investment styles can be characterized by the holding period (i.e., length of ownership) and method of valuation. Individual investors typically choose between the cyclic, growth, and value styles. Day traders hold stocks less than a day to earn small change from each share. This style is favored by a group of professional speculators and will not be discussed in this article.
A stock investor’s total return is an accumulation of dividends and capital gains. Dividends are the company’s occasional cash distributions to shareholders. Dividends can be withdrawn from the investor’s brokerage account, saved in the brokerage account as cash, or reinvested in stock. Capital gains (‘price appreciation’) are the increase in market value of a stock as calculated by the change in price since purchase multiplied by the number of shares owned. Conversely, capital losses (‘price depreciation’) are the decrease in market value caused by a price change. Capital gains(losses) are realized or unrealized cash flows. The realized gain(loss) produces an actual change the investor’s cash balance resulting from a sale. The unrealized gain(loss) is a theoretical change in cash balance at the moment of accounting.
Investors generally expect capital gains to exceed dividends. Capital gains are only earned by selling shares above the purchase price [this is the principle of ‘buy LOW’, ‘sell HIGH’; remember that a trading fee is charged for each transaction]. The following chart illustrates 3 strategies for earning capital gains:
The “share price” (built into the Y axis) is what traders quote for one share of stock at a particular moment in time. The smooth curves show 3 different trends as the share price moves into the future (along the X axis). In reality, the share price oscillates throughout the trading day as a result of various market forces. However, the curves are drawn as smooth lines for the purpose of forecasting the share price. The future price can’t be predicted with absolute certainty. It’s always true that the further into the future, the less certain an investor can be about predicting the price. Investors can choose to manage the uncertainty in different ways as illustrated by the position and shape of the curves in the graph. The first way (red curve) is to earn a quick profit from a cyclic market. This method requires a gift for timing the market so that the investor can buy at a low price and sell at a high price in a relatively short time period of weeks to months. Second (blue curve), the investor can place a future value on the stock by forecasting the long term growth of company earnings in the belief that stock market participants will pay a higher price for the growth of earnings. If the investor’s analysis is correct, the future selling price will be higher than the present purchasing price. Third (black curve), the unit price may be ‘beaten down’ by a market panic or by other mechanisms causing market participants to lose interest in the stock. The analyst may find that the economic value of the company is worth more than the value of the stock by an amount called the ‘margin of error’. If that margin of error is 50%, then ‘value investors’ are fond of describing their stock purchase as buying a dollar for 50 cents. They will hold the stock as long as it takes for market participants to restore the stock price to the intrinsic value of the company. They are taking a risk that the stock price continues to fall as the company goes out of business.
Analysts make a distinction between the economic value of a company and the market value of that company’s stock. The cyclic investor pays more attention to market value. Growth and Value investors analyze the relationship between company and market value. They believe that over a period of years, the market value of the stock will rise with the economic value of the company. During the holding period they will accumulate any dividend payouts in their cash account or reinvest the dividends in more shares of stock. The accumulation of dividends and capital gains is called compounding the returns.
The future is uncertain. Many unexpected events can affect the share price following the initial purchase. Re-valuation of the company and its stock are essential to managing the risk of a long-term stock investment.