Nowadays, everyone is running behind buying stocks thinking it's free money. Little do they know about the menace that comes with it. Today we will study the basics of stocks and how investors use them to value companies.
What are stocks?
Stock is a financial security that gives its owner a claim to an allocated portion of the company’s earnings. Stock often referred to as equity, is an ownership stake in a company. The owners of stock are called stockholders or shareholders.
The number of shares of stock owned indicates how much of the company the shareholder owns. For example, if a company has sliced itself into 1 million pieces, or shares. Those are the number of shares the company has outstanding.
How do investors earn through stocks?
Stocks typically deliver returns to investors in three major forms -
Dividends: Companies, if they choose, may make periodic (usually quarterly) cash payments to the shareholders of record. These payments, typically made from cash generated by the business, can be an important part of the total return investors receive by holding a stock. Companies may also choose to make large one-time dividend payments.
Stock price appreciation: After companies first sell shares to the public, the investors who buy those shares are free to buy and sell them in the secondary market. Investors are constantly buying and selling the shares resulting in earning a significant return on investment.
Special business transactions: Some companies may look to special transactions to unlock value. One of the most common events is spinoffs. Spinoffs occur when companies break out a part of their business and set it up as a separate company, where shares of the new company are distributed tax-free to shareholders of the parent company.
Risks of having stocks?
There are some downsides to having stocks, which can prove to be a nightmare for the stockholders. These include -
Dividends can be suspended or canceled at any time: Unlike interest payments on bonds, which must be paid by companies, dividends can be halted or cut at any time.
Stocks can go down: They can fall or even plummet during times of economic uncertainty or crisis, resulting in a huge loss for the stockholders.
Stocks investors’ claims to assets are inferior: If things go really wrong at a company, stockholders are last in line at the asset buffet.
Types of stock
Common stock: If you buy 100 shares of Reliance, you’re most likely buying the common stock. The shares of common stock are the typical shares being sold by the company. Common stock, at most companies, accounts for a vast majority of the shares outstanding.
Preferred stock: Preferred stock is a unique type of stock that attempts to give shareholders a more bond-like experience. Here, dividends are paid out to stockholders before common stock dividends are issued. Also, it typically pays a higher dividend yield than what’s being paid on the common shares.
However, preferred stock shareholders typically do not hold any voting rights, but common shareholders usually do. Preferred stock can also be callable, meaning the company can at any time buy the shares from investors at a pre–agreed-upon price.
Stock options: Options are financial instruments that give their owners the right, but not the obligation, to buy or sell a stock at a pre-set price sometime in the future. Options can be used by speculators who want to bet that a stock price will rise or fall in the future. Options come in different varieties, including puts, which give owners the right to sell, and calls, which give the right to buy.
An overview of how the companies are being valued
Private companies
The valuation of a private firm is full of assumptions, estimates, and industry averages. With the lack of transparency involved in privately-held companies, it's a difficult task to place a reliable value on such businesses. Ways that investors use to put a price on a company are -
Comparing with public companies: it's sort of a relative valuation method in which you compare the current value of a private business to other similar public businesses by looking at trading multiples like P/E, EV/EBITDA, or other ratios.
If the debt is sold by them: Many large private companies may have debt outstanding. Investors can buy and sell a company’s debt obligations and can look up the prices of the debt to get an idea of how creditworthy the company is considered.
Checking when they raise money: private companies may disclose when they’ve lined up significant amounts of money in a round of financing with investors.
Looking for transactions with public companies: When a company makes a significant buy or sell of interests in another company, that transaction may need to be disclosed and can be used by investors to value them.
Selling shares that are not public yet: introduction of new marketplaces for investors to sell their shares in a company that hasn’t gone public yet are springing up. Investors can use them to know their actual worth.
Examining buyouts: Buyouts can provide information about the worth of different companies, especially smaller, private ones. If a buyout is large enough, the buying company will put out an 8-K regulatory filing alerting its investors of the size and value of the deal.
Analyzing Past Transactions: tracking past transactions can result in creating some patterns which can be helpful for the valuation. You can see how much demand there is for securities in the industry.
Discounted Cash flow analysis: Basically, it looks at the business’s annual cash flow and projects it into the future, and then discounts the value of the future cash flow to today, using a “net present value” calculation. It's a pretty broad topic and will surely be discussed later in some other blog.
Public companies
All the valuation methods discussed for private companies can also be applied here. Additionally, public companies readily have their stock information available on the internet, which makes the valuation process super easy.
The market value of the company, also known as market capitalization can be calculated as -
Market Value = Number of Shares Outstanding × Current Per-Share Stock Price
However, this market value might differ from the actual worth of the company. As the market perception of the company also counts in calculating its value, it might fluctuate drastically and can be deceiving.
Knowing the market price of an asset is very valuable, especially when the market price is different from the value that financial models say. It brings a great opportunity to profit from this difference.
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