Financial Pathways: Investing in individual stocks (column)
In my recent columns I have discussed investing in mutual funds, index funds and ETFs. Today I will talk about stocks and how to invest in them.
For those of you who have not yet had an opportunity to be exposed to investments, you might ask what exactly is a stock? Corporations issue common stock to raise money to operate their companies and pay their bills. When you buy a share of common stock, you become a shareholder or partial owner of the company and are entitled to participate in the profits of the corporation. This would include dividend income and a prorated share of the company’s earnings.
In theory this sounds good, but common stockholders receive their share of profits only after all other obligations of the company have been met. There are several reasons why investors like stock over mutual funds. Quite often investors purchase stock with the hope that it will take off and make them a lot of money like Amazon or Apple has done for astute investors. Older investors buy it for the dividend income during retirement. Then there are those who buy stock or want stock because they think it is “sexier” than mutual funds. Individual stocks do usually exhibit more volatility than mutual funds and that can be good or bad.
Stocks are traded throughout the day on the open market on an exchange such as the New York Stock Exchange, Dow and Nasdaq. Settlement of the trade occurs three business days after the trade was placed. In order to purchase stock, you will need to set up a brokerage account at a discount firm such as Charles Schwab. You will have the ability to do transactions online or by calling the trading department at the brokerage firm. There are many companies from which to choose over different sectors and company size, as well as type such as blue chip, growth, value or speculative. Sophisticated institutional investors recommend at least 40 stocks but 60 is the preferred number. A 60 stock equity portfolio or even a 40 stock portfolio would be quite expensive. In addition the research necessary to create a sound portfolio would be monumental. Even Goldman Sachs recently acknowledged that they cannot do the research for every single stock.
Hiring a money manager is essential if you prefer stock. Do your due diligence and have them explain how they screen for stocks, how they place trades and how often they rebalance. Of course you will want to ask them for performance numbers as well.
Let’s talk about stock valuation now. Using the example of Apple, ticker symbol AAPL, Apple closed at $173.97 on Nov. 13. Its earnings per share, or EPS, are $9.20. (Net profit after taxes — preferred dividends paid, divided by number of common shares outstanding = EPS). The price to earnings ratio (P/E ratio) is a measure of investor confidence in a given security and is calculated by dividing the market price per share by the EPS ($173.97 /$9.20 = 18.91). The P/E ratio is an indicator of how aggressively a stock is being priced in the market.
P/Es reflect market conditions but if a P/E is especially high and completely out of line with the market, the stock is overpriced and will probably make a correction to a lower price. In the case of Apple, a P/E of 18.91 is reasonable considering the growth of the market and the returns of the company stock. That means that the stock is selling at almost 19 times its earnings. To put P/E ratios into perspective, the longterm average P/E ratio for stock in the S&P 500 Index, which theoretically represents the 500 largest U.S. companies, is approximately 15.
In addition to checking the P/E, look at multi-year performance and what sectors and types of companies are doing well. Read news on the company outlook once you narrow down your list of stocks. If you decide to invest in stocks on your own, you must take the necessary time to do research. MarketWatch.com is a great place to start.
Nancy Gardner is a certified financial planner. Send your questions to email@example.com.
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