In this quick article, I'm going to tell you why you should be invested in equities, explain the 3 categories of stock, and teach you how to pick the best stocks!
Disclaimer: This article is educational and not advice. Please seek the council of a licensed professional before making any changes to your finances, to ensure they make sense for your unique situation. I am happy to help, or you can visit www.brokercheck.org to find an unbiased list of professionals.
Why You Should Be Invested In Equities
Being a business owner is one of the best ways to make money because you're leveraging the abilities of other people through the deployment of capital. If you've got a good business model and an eager market, you can scale your business as large as you want, and your income increases with your revenues.
The problem is, starting a business is really hard, reaching stability and profitability is really hard, and scaling becomes increasingly more difficult the bigger you get!
So while being a business owner is great... it's too much work and risk for most people.
Fortunately, I've got good news for you! Even though you might not want to, or be able to start your own business, you can still be a business owner by purchasing stock of a company that's already established!
Fundamentally, owning stock means you are part-owner of that company. As an owner, you are entitled to a portion of it's profits, and the value of your stake can increase if the company becomes more valuable.
All of this is completely passive because after making the purchase, you don't have to do anything to make money! Your assets make money for you!
Now I'd guess that your greatest financial desire is to achieve "financial independence". To not be reliant upon anyone else to pay your bills and enjoy your lifestyle. To not need to work to make ends meet... Right?
Well, owning companies is one of, if not the, easiest ways to achieve that.
3 Categories of Stock
Large, established, profitable companies who are not really trying to grow. They've already reached the top and are working to maintain their market share and profit margins for the benefit of shareholders (people who own stock).
The primary benefit of owning stock in this type of company is the dividend (distribution of profits to shareholders). Typically, each quarter, the company will hold a shareholder's meeting and explain how they performed over the past quarter, set goals for the next quarter, and announce whether they will distribute a dividend. It'll be a fixed dollar amount per share, but is displayed on websites as "dividend yield" (like how much a farm "yields" in produce), which is calculated as a parentage of the stock price at the time of the dividend.
The value of the stock should increase over time as well, but only moderately (6-8% historically). What's great is you get both. Not only can you benefit from the value of your ownership stake going up in value, but you can also get dividends on top of that! So if the stock price increases 6% and they distribute a 2% dividend, your total return is 8%.
To put that in dollars, if you own 1,000 shares worth $100 each for a total investment of $100,000 and the price increases 6%, then they distribute a $.50/share quarterly dividend, you've made $2,000 of annual dividend income AND $6,000 of potential (you must sell it to realize it, of course) capital gain income!
Also large, established companies, but these are still actively trying new things and ways of making money to scale up. They're probably trying to expand into new markets (industries, demographics, countries, etc.) and are spending a lot of money on marketing and R&D. They are trying to increase revenues (sales) to increase their stock price for shareholders.
The primary benefit of owning stock in this type of company is the appreciation of it's stock price, which must grow significantly faster than "value" alternatives to attract investor's money since growth companies typically do not distribute much, if any, of their profits in dividends. That's because, of course, they're reinvesting any and all profits they make back into the company to fuel growth.
Therefore, the stock price of growth companies is expected to increase by 8-12%+ per year. The higher the better of course.
This can go very well, with some companies averaging much more than 12% annually, creating significantly more wealth than if you'd been invested in value companies, for example.
However, the risk/reward trade-off is that growth companies tend to be more fragile than value companies. So you have more "industry risk" if there is disruption in their industry, of if tax laws change, or the economy goes through hard times, etc.
Generally small or "distressed" companies that are "risky" because there is a high degree of uncertainty about their future prospects, which is reflected in their stock price.
In the case of a small company (currently defined as a company with a market cap of $300m to $2b), they may be trying to bring a new product or service into the mainstream and simply haven't had time to prove that they have a viable long-term business. Or they may simply have plateaued and are struggling to break through resistance.
As for distressed companies, they may have done very well in the past, but are currently going through tough times due to mismanagement, market conditions, supply chain issues, etc. Or, they may simply be dealing with bad press that's scaring everyone away.
Whatever the case may be, a company is "speculative" when there is not a reasonable degree of certainty that the value of your investment is safe, or that it will grow at a reasonable rate, or that it will be profitable. But you believe the majority is wrong and they will pull through it.
If you're right, you will be rewarded very handsomely for taking the risk... BUT if you're wrong, you could lose everything due to the company going bankrupt, or the situation getting worse. It often takes years for your prediction to come true, and the price may go down significantly before turning around, so it takes an iron stomach and a lot of conviction to hang in there long enough to find out.
How to Pick The Best Stocks
What makes a "good" stock very much depends on what you're trying to achieve... So I'll tell you what to look for and where to find it, but you'll need to decide what your investment objective is for this to be relevant.
Quick note before we get into that though... Many people refer to flipping stocks or "trading" as investing, but it simply isn't. Traders watch charts for trends, thinking they can predict the future, then place bets based on what they think will happen. We're not doing that... We're investing in businesses!
There are two main reports that you can use to analyze any business: The profit and loss (P&L) statement, and the balance sheet (BS). The cashflow report can be useful too, if the P&L or BS doesn't make sense, but that's rare.
These reports are open to the public for every publicly listed company. You can access the entire report through the company's investor website, or you can view key information on database websites like Google Finance, Morningstar, etc.
Now, all the numbers on these websites are meaningful, but here are a few of my favorites;
5 yr average return: Short-term movement can vary tremendously, but 5 yr performance is a really good indicator of how well a company's stock has done (and likely will do).
P/E Ratio: This stat shows the ratio of the stock's price to the company's earnings per share. In other words, how much in profits does the company have to potentially distribute to shareholders as a dividend?
Dividend Yield: What profits the company has distributed to shareholders, expressed as an annualized percentage of the share price at the time of the dividend.
Year/Year Net Income: I like to see a company with increasing revenues and correspondingly increasing net income. This indicates good management, marketing, and leadership.
Year/Year Operating Expenses: For a company to have profits to distribute, they must maintain their margins. If operating expenses are increasing faster than revenues, that's not good and will put pressure on future profits.
Assets, Liabilities, & Cash: Company finances work a lot like household finances. If a company is bad at managing it's money and is overleveraged, it's only a matter of time before that catches up with them. Likewise, if they don't keep enough cash on hand, they could be put in a bind if the economy slows down.
Price to Book: The multiple of a company's stock price to how much it's worth on paper. This is subjective but gives you an idea of whether the price is irrational.
As you have seen, investing in equities, or companies, is a great way to build wealth and create passive income to achieve financial independence. Hopefully this article has given you some valuable insights that'll help you make better investment decisions!
If it has, and you think this article would be interesting or helpful to someone else, be sure to share it with them!
My name's Ross Kline, thank you for reading, and may you live a rich and wealthy life!
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