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Stock Market Basics for Young Investors

Last summer’s Martha Stewart/ImClone stock fiasco was just one in a long list of scandals on The Street that can make the world of investing appear dark, complicated, and sinister to market newcomers.

The cases of ImClone, Enron, Arthur Anderson, Adelphia and Tyco, to name a few, have certainly fanned the flames of fear for those who are too terrified of losing their money in a bad investment to ever consider the long-term benefits.

It’s no secret that college students are constantly strapped for cash, putting every dollar at an absolute premium, but even this population segment should not let fear stop them from planning for their future. Managing a few stocks isn’t as complicated as it seems, and the benefits of investing should never be underestimated.

“If you’re not making money off of your money, you’re losing money-due to inflation and other things,” said William Meyers, a stock investor and senior in the University of Virginia’s School of Commerce. “But most of us don’t have the discretionary income… liquidity is the biggest problem for college-age kids.”

Income and assets aside, however, one of the most important things for a prospective investor to do is educate themselves about the market. Even an amount as small as $100, if invested well, can bring in reasonable dividends.

“There are a lot of people out there and a lot of people selling advice who don’t know what they’re talking about,” said Arthur J. Keown, R.B. Pamplin Professor of Finance at Virginia Tech University. “The more you understand the less likely it is that you’ll fall prey to those people.”

So let’s begin at the beginning: what exactly is a stock, anyway? When you buy stock in a company, you are literally purchasing an ownership stake in that company. Even if you own just one share of a company’s stock you have a legitimate claim (albeit a very small one) on every asset and every dollar that company earns. Of course, companies sell stock to raise money, not because they want 100,000 new executive VPs.

Stocks can generally be divided up and classified according to market capitalization (size), style and sector. The market capitalization of a company is how much investors think the entire company is worth, based on the current share price times the total number of shares outstanding. In other words, if a company is trading 50 million shares of stock at $10 per share, that company is considered to be worth $500 million (50,000,000 x $10 = $500 million).

The Stock Market in 5 Easy Pieces*:

  • Micro-Cap: ‹ $500 million
  • Small Cap: $500 million to $2 billion
  • Mid-Cap: $2 billion to $10 billion
  • Large Cap: $10 billion to $100 billion
  • Mega Cap: › $100 billion

Large-cap stocks are companies like Ford and General Electric, very established and stable but with less growth potential than up-and-coming small caps. The increased chance of small-cap growth comes with a tag of increased risk too, however. Deciding which size stocks are right for you depends ultimately on how long you plan to leave your money in the market.

“The two big players in any investment are the interest rate and the number of years that you allow compounding to occur,” Keown said. “It’s important to understand the time value of money. There’s no question the sooner you can get going on it, the better…don’t procrastinate.”

The next thing a potential investor needs to understand is the way his or her stocks are being evaluated on the market-their “valuation.” One way to calculate valuation is by comparing a company’s stock price with its earnings (the P/E ratio). To calculate the P/E ratio of a stock divide the current price per share by earnings per share.

For example, let’s say IBM was trading for $100 per share, and projected to earn about $5.50 per share. So IBM’s P/E would be 18 (100/5.5=18). By comparison Home Depot is trading at $52 per share, and is slated to earn about $1.50 per share, a P/E of 35 (52/1.5=35). Even though IBM is trading at nearly twice the share price of Home Depot, based on the P/E ratio their stock would actually be cheaper (18<35).

A lower P/E ratio means that a stock’s price is more closely tied to its actual earnings. But if Home Depot’s growth rate is projected to be much higher than IBM’s, it could mean that the company is a better buy in terms of overall return. In other words, a higher P/E value becomes more acceptable.

All other things aside, a key factor to consider when investing is your own personal comfort level. Higher risk investments have the potential to pay bigger dividends, but they also come with a higher risk of losing your money.

“I tell folks to invest to eat well but not beyond the point that they no longer sleep well,” said Richard F. DeMong, Virginia Bankers Professor of Bank Management at the University of Virginia. “That eat/well sleep well trade-off is different for each individual.”

* Source: www.money.cnn.com

© 2008, Young Money Media, LLC. All rights reserved.

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One Response to Stock Market Basics for Young Investors

  1. Pingback: How a Stock Market Works

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