How the Stock Market Works (1952) - Animated Video by the New York Stock Exchange


How do you evaluate stocks?

A lot of people enter the stockmarket with a simple gusto to buy low and sell high. While that line of thinking is not inherently bad, it represents an unhealthy obsession with the price movements of a stock rather than its fundamental value. You wouldn't buy a part of a convenience store when it's priced at a billion dollars, but that's a real risk when investors are blind to company fundamentals. That leads nicely into the main point here: the fundamental value of a stock is about how much money you can earn without selling it. Thus, for the average investor, the fundamental value of a stock has everything to do with the future expected dividends of the company. I'd go as far to say, dividends are the most important pillar of intelligent stock investing.

What about the book value of the company?

Book value is interesting because it is practical and misleading at the same time. If a company has no debt, equipment worth a million dollars, and a 500K market cap, then you could theoretically acquire and liquidate the company and make a profit as long as you sold the equipment for at least 50% of book value. Yet the average investor has no such power. An average shareholder also has no guarantee that a company with excellent net assets today will decide to liquidate before they tumble downwards too much. It is common to see companies struggle for a while before they declare bankruptcy, pay their employees, pay their secured and unsecured creditors, then leave nothing for common stockholders. Furthermore, to consider book value alone harbors a pessimistic outlook on the company where liquidation stands out as the primary way to make money. The correct way to consider book value is as a supplement to dividend forecasting; a backup store of value in case things go unexpectedly, and as a measure of capital, equipment and otherwise, that can be used both for business operations and as collateral for long-term debt.

How would you evaluate companies that do not currently issue dividends?

Such companies are usually in their growth phase or experiencing turbulent years due to market saturation or a cyclic downturn in the industry. These stocks have value because they are expected to grow or recover, then eventually issue dividends. Your analysis should focus on forecasting the earnings per share (EPS) trajectory of the company, supplemented by an estimate of the anticipated dividend payout ratio (DPR). The result will be your forecast of the company's dividend payout curve over time. Now you can determine what share price would produce a reasonable average dividend yield into the future. Importantly, note the period of time that you have to wait before the company starts issuing dividends. These zero-dividend years cut into the average dividend yield, which combine with the risk associated with early-stage companies to be the compelling reason why growth companies are appropriately priced attractively during their formative years.

Index Funds

What do you think about index funds?

They've certainly been popularized over the past decade. I don't think enough people understand their risks and composition. New investors don't want to miss out on a bull market so they get whisked into index funds rather blindly and without considering the all-important price factor. It's because the average investor is understandably doubtful of most active funds from their subpar performance, and also doesn't want to deal with the hassle of trying to time the market. Yet investors must realize that while index funds have performed well historically, their bandwagoning today has produced grossly overvalued stocks and momentum toward a heavy correction. People can't keep buying businesses regardless of price and expect the hidden gems to always offset the overvalued and failing ones. Indeed, the more people buy index funds, the more their average rate of return diminishes.

How should the average investor consider index funds?

First they should really understand what an index is, and how index funds assign weights to each stock depending on key metrics such as market cap, revenue, earnings, assets, and dividend yield. Index funds offer plenty of diversification, so you're pretty well protected from the risk of losing everything. Also, if the index contains dividend stocks, you can be fairly sure you'll get some rate of return off them. Other than those, index funds offer no more guarantees as long as investors are blind to price. The paradox of index funds is that you want to buy when the price is right, yet determining that is impractical to do across all stocks in the index. So you always have a more incomplete and wider picture of the fundamentals for index funds than, say, a group of 10 stocks. Index funds really depend on the market of each stock to hold an appropriate price for their risk and return expectations.

Do you recommend index funds?

I'm not sure. Index funds seem fine in general as long as enough of their constituent stock prices are reasonable. Broad index funds are good during a bull market driven by real economic growth. Narrow index funds are excellent when a particular industry or sector experiences non-zero-sum earnings growth. Overall, investors should know that the fundamental return of an index fund comes from dividends and positive weighted-average earnings growth, minus capital loss from companies heading towards bankruptcy. Personally, as an active investor I would never buy an index fund because of the incomplete fundamental picture. For the average investor, it's tough because their options are limited. Overvalued index funds, underperforming active funds, or unskilled self-selection? Frankly, the blind passivity of index funds risks mediocre returns, while the ambition of self-selection often yields volatile results, some tragic. I'd recommend most people to just find a smart active fund led by truly smart people, or go for a hybrid portfolio between passive and active fund allotments.


What do you think about options?

Well, options can be a cost-effective way to profit from stock price fluctuations. But options alone have a fundamental problem. You see, in order to make money off options the price of the stock needs to move in a certain direction, up or down or sideways. Meanwhile stock prices can often get quite detached from rational earnings expectations. So even if the business performs excellently, your call options are simply not guaranteed to yield a return.

Wouldn't you agree that stock prices eventually correct themselves over time?

Yes, prices do eventually correct and normalize into a reasonable range of risk and return. However, because options are contrained by a time bound, even options with long exercise periods may fail. Consider a put option for a company destined to lose significant market share, for which the stock price remains stubbornly high for years due to irrational investor confidence.

Is there a way to account for this extra layer of risk?

You'd have to consider signals, sentiment, and alternative investments. Signals are like quarterly earnings reports and partnership declarations. They are objective drivers of demand for the stock. Sentiment involves popular opinions and prevailing conclusions such as peak oil and rare earth mineral shortages. Even a company destined for success may have a few bad quarters, get marked by poor sentiment requiring contrarian confidence, or float low during times of incredible returns in other sectors.

Are any option strategies worthwhile for the average investor?

Absolutely. The way I recommend you use options is to protect an existing stock position. By holding put options during turbulent times for the company, you have a simple way to cut your losses in case something really bad happens. This can be particularly useful when awaiting important company results with an announcement in the near future. The tradeoff is that you make an up-front payment for the put option, cutting into any future gains from company success. Another strategy is to normalize the gains of an existing stock position by selling call options. Though, the compelling disadvantage of selling call options is that you may be forced to sacrifice a well-priced long position on the company.

Recommended Stock Investing Principles

Preserve at least 30% of your portfolio in defensive investments such as dividend stocks and bonds.

For the average investor, the correct way to evaluate the fundamental value of a stock is to consider its rate of return without selling it.

It is better to execute a great trade successfully than to miss the opportunity trying to optimize the price.

There is no reason to sell stock at a loss in response to falling price, unless the fundamentals have actually changed- in fact, it is the great time to buy more.

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