The terminology used in the financial markets can be overwhelmingly confusing. If you watch CNBC for even just 30 minutes, you’re likely to hear plenty of terms that make no sense to you. To further complicate things, even though you may know the definition of a term, you may not know really what that term means. Knowing the meaning of a few, basic investing terms will go a long way in helping you become a confident investor.
An investment in knowledge pays the best interest.
- Benjamin Franklin
5 Investing Terms You Need To Know
Stock is one of the most fundamental components of investing, yet I do not believe that many people actually know what a stock is. By definition, a stock is an ownership share of a corporation. But what does that mean? Does that mean if you own a share of Barnes & Noble, you can walk into their store and take a free book? Unfortunately, no it does not.
However, as the owner of a corporation’s stock, you:
- Have claim to a portion of the corporation’s earnings
- Are able to profit when the corporation profits
- Have claim to a portion of the corporation’s assets
- And, depending on the type of stock you own, you may also have voting rights to elect board members at annual meetings
Stocks are issued by a corporation as a means to raise capital. The alternative to issuing stock is borrowing money from lenders or issuing bonds. When stock is issued, investors are allowed to assume part of the risk of ownership in a company. Just as a small business owner is not guaranteed that they will make money, you are not guaranteed that you will make money by being a shareholder.
Typically, when a corporation has profits, there are three things they can do with those profits:
- They can re-invest those profits back into the company (which is typical of growth stocks)
- They can hold those profits in cash reserves
- Or, they can distribute those profits to shareholders in the form of a dividend
Dividends can be paid out in different ways. Typically, they are paid in the form of cash or additional stock. However, it is possible for a company to pay dividend equivalents in company property or goods.
The amount of a dividend is decided by the board of directors, and is paid at regular intervals throughout the year (typically quarterly). Stocks of larger corporations tend to pay out higher dividends, as they are more established.
Dividends are one of two ways a shareholder can make income from a stock. The other way is through capital appreciation, or the increase of a stock’s price over what was initially paid for the shares.
3) Stock Split
A stock split is something that confuses most people, but is really actually pretty simple. When the price of a stock seems high for the “average” investor, sometimes a corporation will choose to split their stock. Essentially, what this means is the number of shares outstanding (stock available) is doubled, and the price of each stock is cut by 50%.
Say a company has 10,000 shares outstanding at $50 per share. The total value of their stock is $500,000. If the company decided to split their stock, they would have 20,000 shares outstanding at $25 per share. At that point, the total value of their stock would still be $500,000, but their price per share would be lower, allowing more investors to purchase shares.
It is also possible for a company to do a reverse stock split, in which the number of outstanding shares is divided by 50% and the price of the stock is doubled.
It is also important to note that stock splits and reverse splits are not always done at a 1:2 ratio. Sometimes stock splits will be at a ratio of 1:3, meaning the number of outstanding stock is tripled, and the price of each share becomes 33% of what the stock was trading at before the split.
Beta is the volatility of a stock compared to the overall market. A beta of 1 is considered to be equally as volatile as the overall market. The Standard & Poor’s 500 (S&P 500) has a beta of 1. A number higher than one means that a stock is likely to be more volatile than the market.
For example: A stock with a beta of 1 is likely to rise and fall at levels closely resembling the overall market. However, a stock with a beta of 1.9 is considered to be 90% more volatile than the overall market, and will have much more movement than a stock with a lower beta.
Being a risk loving investor, this is a number I focus on quite frequently. A stock with a beta higher than 1 is more likely to lose money in the short term, but is also more likely to post large gains as well. If you are an investor who wants to avoid risk and preserve your capital, look for stocks with a beta lower than 1, as they will be less volatile than the overall market.
Over the coming months, I plan on doing a few case study series posts about Beta.
5) Price-Earnings Ratio (P/E Ratio)
The P/E Ratio is the measure of stock price in relation to the Earnings Per Share. P/E is commonly used as a way to quickly (but relatively) value a stock. It is useful to note that when comparing the P/E Ratio of one stock to another, both should be in the same industry. The growth prospects of a municipal utility company are much different than those of technology stocks, so compare apples to apples.
Over the coming weeks and months, we will be delving deeper into each of these terms, and hopefully coming to a greater understanding of what each really means and how they correlate with one another. In addition, we’ll explore other important terms, all with the goal of helping you feel more confident in understanding what you are doing about growing your investments.