Stock Basics FAQ

December 11, 2009

Whether in the throes of an economic downturn or not, when you turn on the news you will inevitably encounter reports on how the stock market did today.

If you’re invested in individual stocks, then you should be quite mindful of the day-to-day fluctuations of the market. However, if your portfolio is invested across a diverse group of mutual funds, then what happens on a daily basis shouldn’t matter quite as much.

Your company may also present you with the opportunity to buy its stock at a discount through something called an employee stock purchase plan (ESPP) – or, it may reward you with a few stock options. And who knows, you may become such a staunch believer in a particular company that you want to buy and hold a couple of its shares (to complement your already diversified portfolio, of course).

Whether you’ve got equity invested in your company, you’re investing in mutual funds or individual stocks, or if you’re an aspiring investor or day trader, it’s good to know a thing or two about how the underlying stocks work.

What exactly is a stock?

A share of stock represents a unit of ownership in a public company. (A company “goes public” after they hold an initial public offering, or IPO. This provides companies with a way to raise money: the company sells shares to the public, and those investors receive a slice of the company, or stock, in exchange.)

There are more than 8,400 stocks - also known as equities - that trade in the U.S.

Individual investors typically hold a company’s “common stock.” They’re entitled to dividends (if the company pays them) and get to vote on issues such as electing directors to the board, as well as other matters.

If a company goes kaput, common shareholders line up behind creditors and two other types of investors (bond holders, preferred stock holders) before they can get their money back.

All stocks have “ticker” symbols, or stock symbols – these are the letters (or letter) that identify a company. You can use them to look up a stock quote online. Google’s ticker symbol, for instance, is GOOG. If you’re watching CNBC or another news channel, these symbols will often crawl across the bottom of your screen with the latest stock quotes.

Where do stocks trade?

They trade on a stock exchange -- a central market place of buyers and sellers -- where stock orders are routed and filled. There are a number of exchanges, though the New York Stock Exchange and the Nasdaq Stock Market are two major stock exchanges. The NYSE - also known as the Big Board - still has a trading floor where traders shout and yell and do their thing, though it’s moving towards a more electronic model. The Nasdaq is completely electronic.

What are the major stock market indexes?

There are several indexes that measure the performance of the stock market, or all stocks collectively, as well as particular pieces of it. We’ve listed some of the most referenced:

Dow Jones Industrial Average - When people talk about how “the market” is doing, they’re usually referring to the DJIA, which tracks the performance of 30 large stocks with well-established track records, from American Express to Walt Disney.

Standard & Poor’s 500 Index – The S&P 500 tracks the largest American companies in a variety of sectors, from finance, health care and energy to utilities and telecommunication services.

Nasdaq Composite Index – this represents the 3,000-plus companies – which includes both U.S. and non-U.S. companies - listed on the Nasdaq Stock Market. It contains a lot of technology-related stocks, so it’s a good indicator for how that sector is faring.

Russell 2000 – this tracks the performance of 2,000 small-capitalization stocks.

What’s the difference between large-cap, mid-cap and small-cap stocks?

First, let’s explain what “cap” stands for. “Cap” is shorthand for market-capitalization: this is a way to measure the size or value of a company. It’s computed by multiplying a company’s stock price by the number of its total shares outstanding. Capitalization is also a barometer of risk -- typically, smaller companies tend to be riskier and more volatile than larger companies.

Here’s how the various segments are broken down (keep in mind that these ranges may vary a bit, depending on who you ask):

Large-capitalization stocks: These are the big guys, or companies whose total market-cap is worth $10 billion or more.

Mid-caps stocks: these stocks have a market-cap approximately between $2 billion and $10 billion.

Small-cap stocks: their market-cap is valued somewhere between about $300 million and $2 billion.

Micro-caps: these are the small-frys, with market-caps less than $300 million.

What’s the difference between a growth stock and a value stock?

Stocks that are trading for less than their worth (or less than their profit levels and other fundamental measures typically command) are deemed “value” stocks. They’re considered good bargains, whose worth should eventually be recognized by the market. At that point, value investors would be rewarded with a higher stock price.

Investors in growth stocks aren’t looking for bargain basement prices – instead, they’re focused on a company’s growth prospects. They may pay a little more for growth stocks because they believe its revenue and profit outlook are well worth it – and will eventually propel the stock even higher.

What’s a dividend?

This is payment made by the company to stockholders – it’s a portion of a company’s earnings that’s paid out on a per-share basis. Dividends are usually paid quarterly and are expressed as a percentage of the stock’s current market price.

The payment of dividends also sends a signal to investors about the company’s financial health: if they increase the dividend, investors take it as a positive sign. The company is doing well and has surplus cash to dole out to investors. If they stop paying or cut their dividend, investors are likely to get nervous.

Not all companies pay dividends – for instance, younger companies focused on growth are often better off reinvesting that cash into the company. Financial services, utilities and auto companies tend to be regular dividend-payers, though financial and utilities are known for increasing their payments over time.

How do you know whether a stock is any good?

Evaluating stocks involves a lot of hard work, which is why we recommend investing in funds (that requires its own kind of homework, but at least you’re not placing a bet on one company).

Picking stocks is much like evaluating any business or company you might consider buying. After all, when you buy a stock, you’re essentially purchasing a stake in a business.

So when assessing a stock, you want to think about the company’s profitability. How are you going to get paid? Does the stock pay a dividend? Does the company invest its earnings back into the business in order to expand it, increase its value, which will hopefully lift its stock price? Who’s the competition?

One popular measure you’re likely to hear about is a stock’s price-to-earnings ratio, or P/E ratio. This figure takes a company’s stock price and divides it by its annual earnings per share (total net income divided by total shares outstanding). A stock that trades at $30 a share and has annual net income of $3 a share would have a P/E of 10. (You can typically find a company’s earnings information on their website in their “investor relations” section.)

Market pros will often compare a stock’s P/E to the overall market’s P/E. For instance, if the S&P 500’s P/E is currently trading at 18, shares of our company would appear to be undervalued. If it was trading above 18, it might be considered expensive. That doesn’t mean you should shun a stock just because it’s expensive or buy it just because it appears cheap. For instance, a stock with a high P/E might have little in the way of earnings today, but its prospects could be really positive.

What happens when a stock splits?

A stock split increases the number of shares a company has outstanding. So, for instance, if an investor owns a share of stock trading at $50 and it undergoes a 2-for-1 stock split, the investor will be left with two shares worth $25 a share (dividends will also drop in proportion).

Investors typically view stock splits as a good thing – and often bid up the shares - even though, fundamentally, nothing has changed. Stock split enthusiasts, however, say a lower share price makes the stock appealing to a wider range of investors.

A reverse split is just the opposite: it reduces the number of shares and the stock prices increase.