10 Basic Things You NEED To Know About The Stock Market For Beginner

Over 15 percent of retail investors joined the stock market in 2020. And that number has grown a lot more since then. The fact that more people have access to the stock market s a great thing. This also means that there are many new investors who might not yet understand the stock market and are essentially just gambling with their money.

So let’s go over 10 things the new investors must know about the stock market.

In order to do this let’s use our friend tom, he’s a new investor and he’s looking to build wealth for himself and his family but he doesn’t know a whole lot about the stock market yet.

Tom starts with a simple question

What is a stock or share? 

Tom learns that stocks are simple pieces of ownership in a company. If someone owns stock in a company that means that they are part owner of this company and they are entitled to their profits and their losses. But tom also learns that there are different types of stock.

So in order to choose correctly, he wants to learn the distinctions between the different stocks. He learns that there is common stock preferred stock and restricted stock and they all behave differently from each other.

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What is common stock or equity or share?

Common stock is well the most common this is the stock that anyone can buy on any exchange. A common stock gives the owner voting rights to elect the board of directors and corporate policies. Usually, shareholders get one vote per share they own so the more common stock someone has the more decision power they have within the company.

What is preferred stock or preferential share/equity?

Preferred stock is very different from common stock there are upsides and drawbacks to owning this type of asset. 

The advantage of owning preferred stock is that it tends to be less risky and volatile than common stock. In the case, the company goes bankrupt preferred shareholders can claim company assets and get paid off before common stockholders do.

The benefit of preferred stocks is that their value isn’t influenced by the stock market. So if the value of the common stock goes down preferred stock keeps its value. An attractive feature of preferred stocks is that they offer greater income security. Since preferred stocks tend to have fixed dividend payouts at regular intervals. These dividends are paid before they issue dividends to common stockholders.

Now there are many disadvantages to owning preferred stocks-

For example, preferred stocks have no voting rights like common stocks do so shareholders of preferred stocks have absolutely no say in the company’s future. Now the fact that preferred stock is not influenced by the movements of the stock market makes it a bit of a double-edged sword. Since this stock doesn’t follow the stock market it also has very limited growth potential. As common stock grows in value preferred stock tends to keep its value. Missing out on potential growth that one can get from common stock. 

Preferred stock is ideal for those investors looking for income security and stability, not for those looking for growth. Many use this type of asset once they are in their retirement age and they are looking to use their investments income. The value of this type of asset is sensitive to interest rates, if interest rates go down the value of the preferred stock goes up and vice versa.

What is Restricted stock/share or equity?

And finally, we have

Restricted stock–  this type of stock is typically given to insiders and executives as part of their compensation for working at the company. But this stock cannot be bought or sold without special permission from the securities and exchange commission. For example, let’s say that tom starts a new job as the CEO of company x, and he is given 100 000 shares of restricted stock of the company.

Since his shares are restricted these shares don’t hold any tangible value until they vest. Vesting simply means that the owner of these shares gets full rights to these assets. In simple words, these shares are locked until they vest or unlock to become common stock. Now the vesting terms depend on the requirements the company set in place.

For example, stocks can begin investing three years into tom’s job as the company’s CEO and will release 70 000 shares over the period of seven years after that. This means that after three years of working at the company tom will receive the full rights of 10 000 shares per year for him to do as he pleases. This also means that if tom decides to leave his job he will lose the remaining shares that haven’t vested.

Many companies use restricted shares to reward performance. For example, tom will be rewarded 70 000 shares if he stays as the CEO of the company for 10 years and the other 30 000 shares will be rewarded if he meets certain performance goals like increasing revenue cutting costs or increasing share price. So now tom understands the different types of stock and what fits best for his financial goals.

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While walking his dog tom gets a notification from his investing app saying that company x has an IPO next week. Tom isn’t sure what this means so he goes home to do some research he learns that

What is an IPO(Initial Public Offer)?

IPO simply means initial public offering. And this is when a private company first becomes public and anyone can buy shares of it.

This got him curious about why companies become/go public.

After some research, he found out the different reasons why entrepreneurs take their companies public in the first place. The first reason is to raise capital to expand the company. When a company first goes public they issue new stock to be sold to the public the money that comes from the sale of this new stock goes to the company to be used as they see fit.

The reason why entrepreneurs take their companies public?

A funny thing happens when a company issues new stock, when a company goes public and issues new stock the ownership of the founders and early investors gets deluded. In other words, their share of ownership shrinks a little.

For example, let’s say that tom and three other founders each have 25 ownership in a company. There are a total of 100 shares, and each holds 25 of them, so they take the company public and issue 25 shares of new stock by selling on their IPO. This means that the company now has 125 outstanding shares instead of 100. This also means that tom’s 25 shares are no longer worth 25 of the company. His ownership is now 20%.

Since there are more shares each share holds less value. So by issuing new stock every shareholder’s ownership was deluded. Now there are a few reasons why founders and early investors purposely dilute their own ownership in the company although it might sound counter-intuitive. 

As we said before in many cases the money is used to expand and grow the company. Which can eventually grow the value of the overall company making even their diluted shares worth a lot more.

Another reason why entrepreneurs take their companies public is to create liquidity for themselves and their early investors. In other words, they want to create the ability to trade their ownership in the company into cash by easily selling their stock to investors in the stock market.

What is Lock in period?

But after the IPO insiders have what is called a lock-up period. Which are specific time frames where insiders are not allowed to sell their shares. Now, this is typically between 3 and 24 months after the IPO. After this lock-up period expires many insiders sell their share or part of their share of the company to realize their profits. This is one of the reasons why in many cases we see a dip in the stock soon after the IPO. This is because the lock-up period expires and insiders are able to sell their shares. 

In many cases, companies have what is called a secondary public offering.

What is a secondary public offering?

 This is when a company issues additional shares to sell on the stock market in order to raise capital to pay off debts or further expand. This process also dilutes the value of existing shares since new shares were issued but when new stocks are issued it also dilutes the EPS or earnings per share of the stock.

What is EPS/ Earning per share?

Earnings per share mean how much profit after dividends a company produces. This is calculated by having the total company’s profits subtract their dividends and dividing the results by the number of outstanding shares. This can give us a good indication of what companies might be good investments.

For example, our friend tom is trying to decide which company to invest in sally’s cookies or Brandon’s ice cream company.

Sally’s cookies made one million dollars this year they will pay $200 000 in dividends and they have $100 000 outstanding shares. This means sally’s cookies have an EPS or earnings per share of eight dollars.

Now brand inside swim company made two million dollars in profits this year and is also paying two hundred thousand dollars in dividends. But they have three hundred thousand outstanding shares. This means that their earnings per share are six dollars.

Even though Brandon’s ice cream company made more profit sally’s cookies have a higher EPS. Once we have our EPS we can take a look at the price of this stock. Let’s say that both companies’ shares cost the same both shares are worth 25 each. 

What is PE/ Price to earning ratio? 

With this information, our friend tom can now calculate what is called the PE ratio or price per earnings to see which of these companies is a better investment.

To calculate the PE ratio we take the price of each share of stock and divided it by the EPS. In the case of sally’s cookies, we divide the price of the share of 25 by the 8 EPS this gives us a 3.12 PE ratio.

This means that sally’s cookie’s stock is trading at roughly three times its earnings. Similarly, with Brandon’s ice cream company we divide the price of the share of 25 dollars by 6 EPS which gives us a 4.16 PE ratio. In other words, Brandon’s ice cream company is trading at roughly four times their Earnings. The PE ratio simply compares the price of the stock versus its earnings.

 A high PE ratio means that the price of the stock is much higher than the company’s profits. The stock might be overvalued and has a higher chance of crashing.

A low PE ratio means that the price of the stock is relatively lower compared to its profits.

A company with a low PE ratio might mean that the company is undervalued and has good potential to grow in the future. 

After these calculations, tom realizes that Brandon’s ice cream company is slightly more overvalued than sally’s cookies and therefore sally’s cookies might be a better investment now. The price-to-earnings ratio is only part of tom’s decision to make an educated Investment.

What is Dividend and how to calculate it?

Dividends are an essential part of making this decision. To calculate how much in dividends he would receive he divides the total amount given as dividends by how many outstanding shares there are. So in the case of sally’s cookies, they gave two hundred thousand dollars in dividends to one hundred thousand shares of stock. This means that if tom invested in this company he would receive two dollars per share per year from this company.

In the case of Brandon’s ice cream company they also gave 200 000 in total dividends, but they gave it to 300 000 shares of this stock. This means that if tommy invested in this company he would receive 67 cents per year per share of the company.

What is dividend Yield?

Now each company sells its stock at 25 dollars a share. Tom notices that he would receive two dollars in dividends per every 25 invested with sally’s cookies.

In other words, tom would receive an 8 dividend yield.

if Tommy invested in Brandon’s ice cream company he would receive 67 cents per every 25 dollars invested. So Brandon’s ice cream company would give him a 2.68 dividend yield which is much lower than sally’s cookies. So in terms of dividends, sally’s cookies is a better investment.

Now our friend tom has a much better understanding of the stock market what things mean, and how to analyze stocks to make better investment choices.

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