The New York Stock Exchange
The most prestigious exchange in the world is the New York Stock Exchange (NYSE). The "Big Board" was founded over 200 years ago in 1792 with the signing of the Buttonwood Agreement by 24 New York City stockbrokers and merchants. Currently the NYSE, with companies like General Electric, McDonald's, Citigroup, Coca-Cola, Gillette and Wal-Mart, is the market of choice for the largest companies in America.
The Trading Floor of the NYSE
The NYSE is the first type of exchange (as we referred to above), where much of the trading is done face-to-face on a trading floor. This is also referred to as a listed exchange. Orders come in through brokerage firms that are members of the exchange and flow down to floor brokers who go to a specific spot on the floor where the stock trades. At this location, known as the trading post, there is a specific person known as the specialist whose job is to match buyers and sellers. Prices are determined using an auction method: the current price is the highest amount any buyer is willing to pay and the lowest price at which someone is willing to sell. Once a trade has been made, the details are sent back to the brokerage firm, who then notifies the investor who placed the order. Although there is human contact in this process, don't think that the NYSE is still in the Stone Age: computers play a huge role in the process.
The second type of exchange is the virtual sort called an over-the-counter (OTC) market, of which the NASDAQ is the most popular. These markets have no central location or floor brokers whatsoever. Trading is done through a computer and telecommunications network of dealers. It used to be that the largest companies were listed only on the NYSE while all other second tier stocks traded on the other exchanges. The tech boom of the late '90s changed all this; now the Nasdaq is home to several of not just the biggest technology companies but also biggest overall such as Apple, Microsoft, Cisco, Intel, and Facebook. This has resulted in the Nasdaq becoming a serious competitor to the NYSE.
On the Nasdaq brokerages act as market makers for various stocks. A market maker provides continuous bid and ask prices within a prescribed percentage spread for shares for which they are designated to make a market. They may match up buyers and sellers directly but usually they will maintain an inventory of shares to meet demands of investors.
ASX or Australian Stock Exchange
The ASX Group's origins as a national exchange go back to 1987. The Australian Stock Exchange Limited was formed in 1987 after the Australian Parliament drafted legislation that enabled the amalgamation of six independent state-based stock exchanges. Each of those exchanges brought with it a history of share trading dating back to the 19th century.
In 2006 The Australian Stock Exchange merged with the Sydney Futures Exchange and originally operated under the name Australian Securities Exchange.
Later, however, ASX launched a new group structure to better position it in the contemporary financial market environment. From 1 August 2010 the Australian Securities Exchange has been known as the ASX Group. Today ASX is a world top-10 exchange group measured by market capitalisation.
The third largest exchange in the U.S. is the American Stock Exchange (AMEX). The AMEX used to be an alternative to the NYSE, but that role has since been filled by the Nasdaq. In fact, the National Association of Securities Dealers (NASD), which is the parent of Nasdaq, bought the AMEX in 1998. Almost all trading now on the AMEX is in small-cap stocks and derivatives. There are many stock exchanges located in just about every country around the world. American markets are undoubtedly the largest, but they still represent only a fraction of total investment around the globe.
The two other main financial hubs are London, home of the London Stock Exchange, and Hong Kong, home of the Hong Kong Stock Exchange. The last place worth mentioning is the over-the-counter bulletin board (OTCBB). The Nasdaq is an over-the-counter market, but the term commonly refers to small public companies that don't meet the listing requirements of any of the regulated markets, including the Nasdaq. The OTCBB is home to penny stocks because there is little to no regulation. This makes investing in an OTCBB stock very risky.
You've now learned what a stock/share is and a little bit about the principles behind the stock market, but how do you actually go about buying shares? Thankfully, you don't have to go down into the trading pit yelling and screaming your order. There are two main ways to purchase stock:
Using a Brokerage
The most common method to buy stocks is to use a brokerage. Brokerages come in two different forms. Full-service brokerages offer you expert advice and can manage your account but they also charge more. Discount brokerages (Online brokerages) offer little in the way of personal attention but are much cheaper. At one time, only the wealthy could afford a broker since only full-service brokers were available. With the internet came the explosion of online discount brokers. Thanks to them nearly anybody can now afford to invest in the market.
DRIPs & DIPs
Dividend reinvestment plans (DRIPs) and direct investment plans (DIPs) are plans by which individual companies, for a minimal cost, allow shareholders to purchase stock directly from the company. Drips are a great way to invest small amounts of money at regular intervals.
If you are an Australian resident for Tax purposes then you are able to take advantage of a tax arrangement designed to avoid the 'double taxation' of company profits where companies pay tax on their profits and Shareholders who receive the dividends must still pay income tax upon their receipts. To encourage domestic share ownership, the federal government introduced dividend imputation in 1987. Known as franking, this countered the issue of double taxation. Put simply, an Australian-based investor who holds Australian shares (or share funds) is entitled to a franking credit equal to the amount of the company tax paid. Franked dividends are those paid by a company that has paid company tax.
If a company pays out all of its earnings each year through dividends and achieved earnings before tax of $10.00 per share, it would pay tax of $3.00 per share and then distribute to shareholders the $7.00 as a dividend. With the introduction of franking credits, the company now also gives the share investors $3.00 in franking (or imputation) credits. Subsequently, when the shareholder submits their tax return, they add up the $7.00 dividend and $3.00 franking credit and declare $10.00 per share in pre-tax income. Then they apply whatever tax (from their personal tax bracket) is paid on this $10.00. So, investors on a 15% personal tax rate who would normally have to pay $1.50 of tax, however as $3.00 company tax has been paid by the company to the Australian Tax Office, the shareholder is 'owed' the difference of $1.50 by the ATO. Those on a rate of 48.5% rate would normally pay $4.85. However, as thirty percent tax has already been pre-paid by the company, they only pay the difference between the 48.5 % and 30% tax already paid.
In this case they only have to pay tax of $1.85.To be eligible, the company has to be registered for franking and that the holder of the relevant shares upon which the dividend has been paid has held the shares for 45 days (or 90 days in the case of preference shares). If not, the tax benefit of the franking credits will be denied. Additionally, this rule will not apply to individual shareholders who receive less than $2,000 in franking credits per annum on all shareholdings. Importantly, a company is not required to pass on all credits to shareholders. The degree of passing-on is the percentage of franking, eg a 75%-franked dividend is one upon which only 75% of the maximum possible attachable credits have in fact been attached to that dividend.
Dividend Payout Ratio
This is a means of measuring the sustainability of dividend payments. By calculating the proportion of company profits that are paid out as dividends (dividends per share divided by earnings per share). Therefore if a company is earning $5 per share, and pays a dividend of $4 per share, the payout ratio is 80 per cent.
It must be emphasized that there are no guarantees when it comes to companies listed on the market. Some companies pay out dividends, but many others do not. And there is no obligation to pay out dividends even for those publicly listed companies that have traditionally given them. Without dividends, an investor can make money on a share only through its appreciation in the open market. On the downside, any company may go bankrupt, in which case your investment is worth nothing. Although risk might sound all negative, there is also a bright side. Taking on greater risk demands a greater return on your investment. This is the reason why stocks have historically outperformed other investments such as bonds or savings accounts.
Debt vs. Equity
Why does a company issue stock? Why would the founders share the profits with thousands of people when they could keep profits to themselves? The reason is that at some point every company needs to raise capital. To do this, companies can either borrow it from a financial institution or raise it by selling part of the company, which is known as issuing shares. A company can borrow by taking a loan from a bank or by issuing bonds. Both methods fit under the umbrella of debt financing. On the other hand, issuing shares is called equity financing.
Issuing shares is advantageous for the company because it does not require the company to pay back the money or make interest payments along the way. All that the shareholders get in return for their money is the hope that the shares will someday be worth more than what they paid for them. The first sale of a shares, which is issued by the private company itself, is called the initial public offering (IPO). It is important that you understand the distinction between a company financing through debt and financing through equity.
When you buy a debt investment such as a bond, you are guaranteed the return of your money (the principal) along with promised interest payments. This isn't the case with an equity investment. By becoming an owner, you assume the risk of the company not being successful - just as a small business owner isn't guaranteed a return, neither is a shareholder. As an owner, your claim on assets is less than that of creditors. This means that if a company goes bankrupt and liquidates, you, as a shareholder, don't get any money until the banks and bondholders have been paid out; we call this absolute priority. Shareholders earn a lot if a company is successful, but they also stand to lose their entire investment if the company isn't successful.
Equities - The Science of Valuation
As an investor (or a trader) you will have a specific interest in valuing a stock to help ascertain the growth potential. For example, is XYZ bank better 'value' than its peers? Investors are traditionally willing to pay a premium price for companies consistently posting above-average growth and the ability to identify stocks that are undervalued would allow you to buy at a time that would maximise your gains. There are a number of standard valuation tools that can be used to assist you in reaching a decision. Assuming that all calculations are standardised for all peer group comparisons, these valuation tools can provide credible indications of investment or trading opportunities. They are all based around comparing the current share price to other numbers that can normally be found in the corporate accounts; Earnings, dividend, assets and sales.
The Price/Earnings (P/E) Ratio
Also referred to as the earnings multiple of the company. This is probably the best-known, and most quoted measure of valuation. Calculated as the price per share divided by the amount of earnings per share (net profit after tax) over the preceding 12 months, it is the number of years it will take to recover the purchase price from earnings at the current rate. The accepted theory is that if you can buy a company for 5 times its earnings, it has a better chance of increasing in value than where you pay 15 times its earnings. As always there are exceptions such as a company that has good growth prospects. It can therefore justify a higher ratio due to the earnings growing quickly (this can be verified by using the other valuation tools below). However, the 'tech wreck' period showed us that the PE ratio for a growth company can also be too high with expected growth already factored into the price with little leeway for error.
The Price/Assets Ratio
This tool is typically used when investors are seeking value stocks. Value stocks are those that typically sell with relatively low price/assets ratios which imply that their market value is close to their asset value and that their intangible assets (Structure, staff, management, goodwill etc) are valued at a low level. One would expect that the intangible assets could provide an increase in value; e.g. the appointment of a CEO with a successful track record.
The Price/Sales Ratio
A tool that can assist in measuring a company’s potential, particularly useful when trying to value companies that currently do not have earnings or are experiencing operating difficulties and are reporting depressed earnings.
Bulls and Bears
On the stock market, the Bulls and Bears are in a constant struggle. If you haven't heard of these terms already, you undoubtedly will as you begin to invest.
A Bull Market is when everything in the economy is great, people are finding jobs, gross domestic market (GDP) is growing, and stocks are rising. Things are just plain rosy! Picking stocks during a bull market is easier because everything is going up. Bull markets cannot last forever though, and sometimes they can lead to dangerous situations if stocks become overvalued. If a person is optimistic and believes that stocks will go up, he or she is called a "bull" and is said to have a "bullish outlook".
A Bear Market is when the economy is bad, recession is looming and stock prices are falling. Bear markets make it tough for investors to pick profitable stocks. One solution to this is to make money when stocks are falling using a technique called short selling (we will get to this in the next section). Another strategy is to wait on the sidelines until you feel that the bear market is nearing its end, only starting to buy in anticipation of a bull market. If a person is pessimistic, believing that stocks are going to drop, he or she is called a "bear" and said to have a "bearish outlook". While it's true that you should never invest in something over which you lose sleep, you are also guaranteed never to see any return if you avoid the market completely and never take any risk.
What Type of Investor Will You Be?
There are plenty of different investment styles and strategies out there. Even though the bulls and bears are constantly at odds, they can both make money with the changing cycles in the market.
What is all the fuss about?
Reporting season is always a busy time for everybody concerned with the stock market. It is the time when companies open up their books and we see the good, the bad and the ugly of the past six months of work. Companies can bask in the glory of their profits and present their thoughts on the future, or explain away the disappointment of missing past promised targets and promise to do better next time.
Under Corporate Governance regulations companies have to report their earnings for the periods ending June 30 and December 31. Traditionally companies report over a period of a few weeks in August and February (The Banks, apart from CBA, are the exception), but in reality the market, and in particular the analysts, have been under pressure to predict the figures ahead of time. There is plenty of money to be made from going long on a company that will exceed expectations or shorting a stock that disappoints the market. Reporting season is often characterised by high volatility.
The derivatives market (e.g. Options and CFDs) for any one share is affected as investors and speculators jockeying for position, covering existing stock positions and reacting to the buying or selling opportunities presented as markets over-react to short-term news. The market normally reacts by comparing the results with analysts' forecasts and expectations. Therefore it is not uncommon for a company that registers a 40% increase in profits to experience a sharp fall in share price if the market was expecting 50% increase in profits. Conversely a share price rise may be seen for a company that has lost less money than predicted
Reporting Season and Short Term Trading
Please see the CFD and Options lessons sections for more information on what they are, how they work and how they apply to Short Term Trading.
Technical analysts who study the charts over many reporting seasons see something quite startling: the chances of an individual stock selection moving in line with the short-term technical indicators is at best, uncertain. The fact is that the risk-reward scenario of holding a CFD or option overnight when the company is about to report is unfavourable.
From experience, more short-term CFD and option traders get hurt during earnings season than at any other time of the year. Why? There are several mechanics at work during an earnings release.
Firstly, there are the raw numbers themselves. Did they actually beat the estimates? Sometimes it appears as they though they have, but how did they do it? If they did it on falling revenues, then they accomplished the feat by cost cutting or playing the currency spreads. None of them are indicative of great growth.
Then we have the issue of just how much did they beat the estimates by? Quite often beating the estimates can be more a matter of creative accounting than a real estimate of business growth.
Moreover, the short-term technical analysis generally supports the jawboning of the analysts and their estimates. The CFD or Option trader sees the stock price moving with the expectations of the analysts, encouraging the trader to enter the trade. The next morning the company announces their earnings and the share price gaps down of falls quickly, despite the fact that they beat the numbers.
Secondly, there is the all-important guidance. The earnings released is already old news as they represent the half-year that has already past. Fund managers and analysts are very interested in what the company is doing now and what they think they will do in the future. If the guidance is less than encouraging, the stock may well take a knock. As we roll through the earnings season, the best solution for the CFD and Option trader is trade in the direction of the prevailing tend and exit the trade prior to the day before the company reports. The trader may miss some of the ones that explode higher, however on the flip side, they will have avoided the trades that implode. Holding the CFD or option trade on hope would have proved regrettable.
- Shares means ownership, as an owner, you have a claim on the assets and earnings of a company as well as voting rights with your shares
- Shares is equity, bonds are debt. Bondholders are guaranteed a return on their investment and have a higher claim than shareholders. This is generally why shares are considered riskier investments and require a higher rate of return
- You can lose all of your investment with shares. The flip-side of this is you can make a lot of money if you invest in the right company
- The two main types of stocks/shares are common (ordinary) and preferred. It is also possible for a company to create different classes of stock/shares
- Stock markets are places where buyers and sellers of stock meet to trade. The NYSE and the Nasdaq are the most important exchanges in the United States and the ASX the most important exchange in Australia
- Stock prices change according to supply and demand. There are many factors influencing prices, the most important of which is earnings
- There is no consensus as to why stock prices move the way they do
- To buy stocks/shares you can either use a brokerage or a dividend reinvestment plan (DRIP)