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 Investing in the stock market is both a rewarding and a risky proposition. Many investors are quite comfortable knowing their mutual funds are professionally managed, and the diversification of those portfolios has kept risk to a minimum. But for other investors, selecting individual stocks provides both a sense of control and satisfaction.
In this article, we're going to cover some of the keys to successful stock market investing. That discussion will include how to go about researching companies, as well as a primer on stock trading terms and financial ratios. We're also going to explain how risk and reward are determined by market forces, and the affect price volatility can have on some investors. Finally, we'll help you to understand when it is the right time to sell stocks.
Buying Stocks
Your approach to buying stock in a company should be the same approach you'd use for any other purchase of this magnitude. Most of us wouldn't think of spending $5,000 without thoroughly researching the product or service we're thinking about buying. The same thought process should apply to common stocks.
Researching Companies
While we've written extensively on the topic of researching stocks elsewhere, in this publication we're just going to cover the basics. When you are buying common stock in a company, you're actually becoming a part owner of that company. For that reason, you need to think like a business owner when evaluating each company.
Thinking like a business owner entails finding companies that are considered leaders in their industry and / or demonstrate superior brand loyalty or some other kind of competitive edge. Strong brand names such as Coca Cola or Starbucks can usually demand a premium price for their products - and that translates into higher profit margins.
Understanding Financial Ratios
One of the fundamental ways you can understand the financial well-being of a company is by examining that company's financial ratios. Here there is almost an endless list of possible ratios from which to choose and, once again, we provide more guidance on this topic in our article Understanding Financial Ratios.
In this publication, our discussion is going to be limited to four principal areas - price, profitability, financial condition, and investment return.
- The Price Ratio we chose was Price / Earnings Ratio or P/E
- The Profitability Ratio we chose was Net Profit Margin
- The Ratios of Financial Condition we chose was the Debt / Equity Ratio
- Finally, the Investment Ratio we chose was Return on Equity
Explanations for each of these financial ratios appear below:
- Price / Earnings Ratio - The price to earnings ratio or P/E ratio is the stock's price divided by the latest 12 months of earnings per share. The P/E ratio is an indicator of the premium you'll be paying for a stock, and is also an indicator of future growth.
- Net Profit Margin (%) - The net profit margin is the ratio of net profits to sales. This is the best indicator of the company's efficiency in that net profit takes into consideration all expenses of the company. You want the net profit margin of the stock you are going to pick to be as high as possible.
- Debt / Equity Ratio - The debt / equity ratio is a measure of the long-term debt divided by the common stock equity. This financial ratio is a measure of leverage. The lower the debt to equity ratio, the less likely a company will be affected by a downturn in the economy.
- Interest Coverage - The interest coverage is the company's latest 12 months' earnings before interest and taxes (EBIT) divided by the latest 12 months' interest expense. Interest coverage tells us how easily a company can handle its debt service. The higher the interest coverage value, the easier it is for the company to pay back its debt.
- Return on Equity - A company's return on equity ratio, or ROE, is calculated by taking the latest 12 months' net income and divided it by common stock equity. The return on equity ratio is perhaps the most widely used, and most valuable, measure of how well a company is performing for its shareholders. The higher a company's return on equity, the better the company is performing.
Common Stock Trading Terms
If you're thinking about trading stocks for the first time, you need to make sure you understand the fundamentals of stock trading. Listed below are the most common trading terms used today:
Market Order
A market order is used to buy or sell a stock as quickly as possible at the prevailing price when the buy order reaches the marketplace. A market order guarantees you a transaction will occur, but does not guarantee the price paid, or received, for the securities.
Limit Order
A limit order is used to buy or sell a stock only at a price specified (also known as the limit) or at a better price. With a limit order there is no guarantee that a transaction will occur. But if it does, then the price will be better than the one set by the trader.
Stop Order or Stop Loss Order
A stop loss order is used to sell a stock once the market price has reached a stop price - which is set below the current market price. Stop orders are used to protect a gain, or prevent further loss on an investment.
Stop Limit Orders
A stop limit order is used to sell a security at a specified price, or better, after a stop price has been reached. A stop limit order identifies the minimum price you're willing to accept for the stock you own. There are two parts to a stop limit order - the stop price and the limit price.
Once a stock's price moves through the stop price, the trade then becomes a limit order. For this reason, there is no guarantee that a stop limit order will be filled since the stock can trade through the limit price before the order is executed.
Market Risks and Rewards
Risk and reward often go hand-in-hand. You could eliminate all possible risk of losing money (preserve capital) by putting your money in a safe. But even under these circumstances, you run the risk that over time inflation will erode the buying power of that money. And while buying stocks entails greater risk, the potential rewards are greater too.
As smart investors, we want to maximize the returns we're achieving at any given level of risk. Thankfully, there are several ways to minimize the risks associated with buying stocks. Earlier we talked about researching companies before buying their stock and that's a great way to help minimize risk
Diversifying your portfolio is a second way to minimize risk. By holding a portfolio of stocks, we can eliminate the risk associated with any single company underperforming versus market expectations. While we're still at the mercy of macroeconomic factors that can affect the entire stock market, diversification allows us eliminate the added risk associated with holding stock in just one company.
Price Volatility
If you're new to buying stocks, then you need to be aware that some stocks are more volatile than others. By this we mean that some stocks experience price swings - both up and down - that are extreme when compared to the stock market itself. The most common measure of relative price volatility is a stock beta.
To get a better gauge on your individual risk tolerance, you might want to look at our risk tolerance calculator.
Knowing When to Sell Stocks
Whenever you buy a stock, you should also be thinking about the best time to sell the stock - this is sometimes referred to as an exit strategy. For some investors, knowing when to sell a stock is a twofold decision that involves target prices:
- Price Increases - setting a target price at which point you're willing to lock-in your profits and sell the stock.
- Price Decreases - if the stock you buy starts to falter, you should have a price point in mind where you're going to limit your losses and sell the stock.
Another approach is to ignore the target price theory altogether and simply hold onto a stock as long as it's performing as expected. When a stock's price appreciation is no longer meeting your expectations, then it's time to sell that stock and lock in your gain.
Selling Stocks and Income Taxes
Finally, you should understand the income tax consequences of investing in the stock market in terms of capital gains. If you hold onto a security for more than 12 months, then any long-term capital gain is taxed at just 15% for individuals in the top four tax brackets. Short-term gains, on the other hand, are taxed at ordinary federal income tax rates, which are often higher than 15% for most investors.
About the Author - Successful Stock Investing
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