9 Fundamentals of Investing You Need to Know
Interested in investing in the stock market? It’s critical to first understand basic fundamentals and terminology (and, hey, it doesn’t hurt to sound like Warren Buffet during conversations).
From inflation to dividends, here are the top nine fundamentals or terms you should know about investing (broken down as simply as possible).
- Inflation refers to the prices of goods and services increasing over time. Investing helps you beat inflation.
- Compound interest helps your investments grow as your initial contributions earn interest and your interest earns interest.
- The market cap tells you how much a company is worth.
- Financial statements help you analyze a company before investing.
- Earnings tell you how much money a company makes over a specific period.
- Value investing means you invest in established companies. Growth investing is investing in companies that have growth potential.
- Book value is how much money a company would have left after selling everything, letting employees go, and paying back its debts.
- Technical analysis is useful if you’re a short-term investor. Fundamental analysis is helpful if you’re a long-term investor.
Over time, things become more expensive. The prices of goods and services increase. This is known as inflation. Investing helps you beat it.
Inflation is a normal part of the economy and typically grows 2% each year. Here’s an example: a movie ticket cost $2.89 in 1980. In 2019, the average movie ticket cost $9.16!
Thanks to inflation, your money loses its value or purchasing power over time. For example, say that you have $1,000. Instead of investing or spending this money, you hide the cash under your mattress. With inflation, this money loses at least 2% of its value each year. In 20 years, it will purchase much less than what it would have originally.
That’s why it’s important to invest (and make the right investments!) so your money can GROW in value and beat inflation.
2. Compound interest
Compound interest is a tool that can significantly grow your money over time and makes your savings work harder for you. Compound interest is a key ingredient to investing.
Here’s how it works: you contribute a certain amount of money into an investment account. Through the magic of compounding, your principal or original deposit earns interest, and this interest earns interest of its own. Your money multiplies without you having to lift a finger. Interest might be compounded daily, weekly, monthly, yearly, etc.
According to Tony Robbins, American author, coach, speaker, and philanthropist, harnessing the power of compound interest is critical. He likens it to a golf game.
Say that you only have $0.10 at Hole 1. Through compound interest, your money doubles every hole. By Hole 18, that $0.10 will have grown to over $13K!
Compound interest’s best friend is time. Here’s another example. Maybe you invest $1,000 into the stock market with an estimated return rate of 7%. You also contribute $100 per month and the interest is compounded monthly. You’ll have over $19K at the end of ten years.
But at the end of thirty years? You’ll have over $130,000 ($93K of that is earnings from interest)! That amount will be much larger if you contribute more to the account every month. If you’re not taking advantage of compound interest yet, you’re missing out on money.
Hint: Use Investor.gov’s free compound interest calculator to calculate how much you could invest and earn with compound interest.
3. Market cap
When investing in stocks or funds, you need to know how much a company is worth first. The market cap tells you the total market value of a company.
To calculate a company’s market cap, multiply the company’s current stock price by the total number of the company’s available shares (aka total shares outstanding).
Let’s say a company has 7,000,000 shares. Its stock price is $29. 7,000,000 x $29 = $200,000,000. $200 million is the market cap. The company’s market cap or value can change day to day, depending on its stock price.
There are different types of market caps:
- Mega-cap: >$200 billion
- Large-cap: $10 billion-$200 billion
- Mid-cap: $2 billion-$10 billion
- Small-cap: $300 million-$2 billion
- Micro-cap: $50 million-$300 million
Companies with large market caps or mega caps (think Amazon) are often considered less risky to invest in than mid-cap companies. Investing in stocks from small-cap and micro-cap companies are high risk investments.
Luckily, you don’t always have to calculate a company’s market cap manually. Go to a site like Yahoo Finance. Type in a company name or stock symbol (e.g. Amazon is AMZN) in the search bar. Scroll down to look at the company’s market cap.
You can also use a website like TradingView’s Stock Screener to apply filters and screen specific companies by their market caps.
4. Financial statements
Financial statements help you analyze a company before investing. Whether you are an active or passive investor, you want to know that your chosen company(s) is profitable or will definitely be profitable in the future.
Public companies are required to release financial statements on a quarterly basis. The most important financial statements include the
- Balance sheet
- Income statement
- Cash flow statement
The balance sheet shows a company’s assets (what they own), liabilities (the company’s debt), and owner’s equity (what the owners have put in). Assets = Liabilities + Equity or Equity = Assets – Liabilities. This information tells you the company’s net worth.
An income statement is also called an earning statement. It reports on the company’s earnings and helps you understand the company’s financial performance. The income statement calculates Total Income – Total Expenses = Net Profit.
The cash flow statement shows a company’s cash flow – money coming in and money going out of a company. This statement is divided into cash from core operations, investing, and financing. A cash flow statement helps financial analysts determine where a company’s cash came from (hopefully core operations).
You can visit Edgar Company Filings to search for these financial statements for different companies. This information is typically most useful for financial analysts and portfolio managers, but can be helpful for you to review as well.
Earnings tell you how much money a company makes or their net profit over a specific period. To calculate earnings, you use two different ratios:
- Earnings Per Share (EPS)
- Price to Earnings (PE)
Let’s first calculate Earnings Per Share (EPS). Say that you are considering investing in the stock of Company A that’s earned $1,000,000 this year. Their number of shares outstanding (the total number of the company’s available shares) is 200,000. Divide $1,000,000 by 200,000 to get the EPS. In this case, the EPS is five.
This means that every shareholder or investor gets $5 from each share of the company’s earnings. This number might sound great if you compare it to Company B that has an EPS of $2.
However, you also need to look at Price to Earnings (PE). PE divides share price by a company’s Earning Per Share. It helps you understand how much you are paying for each dollar the company earns. Maybe the share price of Company A is $500. Divide the share price ($500) by the Earnings Per Share ($5) to get 100.
Each one of your shares earns $5, but you’re paying 100 times each dollar that the company makes. Now take Company B. Company B’s share price is $40. With an EPS of $2, you’re only paying 20 times each dollar that the company makes. Company B sounds like the better investment since you’re getting more bang for your buck.
6. Value vs. growth stocks
Do you want to invest in established companies or companies that have growth potential? Enter value vs. growth stocks.
One investing option is to choose mature companies that you already know make lots of money like Apple or Walmart. This income likely won’t change much over time. You invest in value stocks. Value stocks normally have a low PE ratio and pay dividends.
Warren Buffet is a value investor. He invests in value stocks with companies like Coca-Cola and American Express. These companies are stable.
On the flip side, you can also choose companies that aren’t making a lot of money YET, but you’re confident that they will have high earnings growth in the future. You invest in growth stocks. Growth stocks typically have a high PE ratio and don’t pay dividends.
An example of a growth stock is Tesla. Tesla projects a future Price-to-Earnings (aka Forward PE) or what they expect to make next year.
Value investing is riskier than growth investing because it’s not 100% guaranteed that a company will make as much money as they think. However, it is possible to invest in both value and growth stocks to create a healthy investment portfolio.
7. Book value
Book value is how much money a company would have left if they
- sold everything – from buildings to equipment,
- let employees go, and
- paid off debts in full.
This value is important because it helps you better understand a company’s true worth. It’s also helpful to compare value companies with growth companies.
To understand what a company’s actual book value is on a per share basis, you have to calculate Book Value per Share (BVPS). Divide a company’s book value by the number of outstanding shares.
But you’d also want to know how much you are paying for each dollar of book value. You’d look at Price-to-Book (P/B). Divide a company’s stock price by its Book Value per Share. You want the PB ratio to be as low as possible.
Value companies have low PB ratios while growth companies have high PB ratios. For example, say that Amazon has a PB of 14. This means that you’d pay 14x for each $1 of book value the company has. Now say that Tesla has a PB of 30. You’d pay 30x for each $1 of book value the company has.
Dividends are portions of a company’s profits that are paid to its shareholders. These dividends are paid in cash or as more stock. Dividends must be approved by a company’s board of directors.
So why are dividends important? Because if you add dividend stocks to your portfolio, you can expect regular income and earn profits without selling stocks.
There are different types of dividends including:
- Cash dividends. These dividends are normally paid quarterly in cash.
- Special dividends. Special dividends are typically a one-time cash payment.
- Stock dividends. Stock dividends mean that more shares or stocks are given to shareholders in place of cash.
Cash dividends are the most common type. Say that you own 100 shares in a company. If that company pays $0.50 per share in cash dividends per quarter, you’ll receive $50 per quarter or $200 per year in dividends.
As a reward for shareholders, value companies like Walmart typically pay dividends for investing in their stocks. Dividends help increase the stock price AND increase investor loyalty.
Now, not all companies pay dividends. Growth companies like Tesla don’t normally pay dividends because they need to re-invest the money to grow their business. It’s healthy to have a mix of dividend and non-dividend stocks within your portfolio.
9. Technical vs. fundamental analysis
A technical analysis is the study of statistical charts (price and volume) to predict price movement in the future.
Fundamental analysis is analyzing everything that might impact a company’s financial health. It analyzes factors like:
- Cash flow
- Competitive environment
- Business developments
Unless you’re investing in index or mutual funds, you’d want to use a fundamental analysis as a long-term investor. You want to look at the fundamentals of a company to understand what its given stock is really worth – not short-term price movements or volume. You want to identify companies with positive futures.
Day traders and speculators look at technical analysis. They analyze charts and patterns, as well as stock price and trading volume data. This information is used to guess when a stock will rise or fall (and hopefully buy and sell at the right time).
Get started with the fundamentals of investing.
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