02. General Investment (Gyan)

What Is Equity? How Is It Different From A "Stock", "Share" Or "Scrip"?

Stock, Share, Scrip, Common Stock, Common Equity, Equity all practically refer to the same thing, namely an ownership interest in a company.

In addition to shares of common stock, a company could also issue several different types of shares, for example "Preferred". These are valued and traded separately, and have market prices different from that of the Common Stock.

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What Is The Face Value (FV) Of A Stock?

Face Value (FV) is the base price on which dividend amounts are calculated when dividends are announced as percentages. If a company announces a 25% dividend and its stock's FV happens to be 10.00, then the per-share dividend amount works out to 2.50 (= 10.00 * 25%).

These days many companies worldwide issue shares of common stock with no Face Value. They simply announce the dividend amount per share.

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What's A Stock Quote?

A Stock Quote consists of bid price and the total number of shares bid at that price, and ask (aka offer) price and the number of shares on offer at that price.

As several market makers and dealers typically have concurrent bids and offers on any stock, the exchange selects the highest bid and the lowest ask as the best prices available to sellers or buyers, respectively.

When buying or selling activity depletes the quantity available at best offer or bid price, the next-best is designated the best.

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What Is Market Capitalization (Market Cap)?

Market cap = price per share * number of shares issued & outstanding (I&O).

Example: if Company X has 100,000,000 shares authorized and has issued 85,000,000 out of these, and the market price is 100.00, then its market cap = 85,000,000 * 100.00 = 8.5 billion.

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What Is Small Cap, Mid Cap, Large Cap?

MilkorWater groups stocks into 5 groups according to their market capitalization – Mega Caps, Large Caps, MidCaps, Small Caps and Micro Caps. There is no universal agreement on the exact grouping, but one can obtain pretty strong hints from looking at some popular cap-based indexes.

The exact cutoff levels of these grouping can change over time but we endeavor to maintain the same approximate distribution.

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My Newspaper Reports "Company ABCD Declares 25% Dividend"... Does That Mean I Got 25% Return On My Money Invested?

Not exactly. What matters to an investor is the dividend yield of the stock – the return on investment (ROI) they get from the dividend. (see FAQ:How Is ROI (Return On Investment) Calculated?)

Example: A company stock has a Face Value (FV) of 10.00, current market price (CMP) of 250.00 and the company board announces a 25% annual dividend. The per-share dividend amount will be = 10.00 (FV) x 25% = 2.50 and the dividend yield a much smaller 100 * 2.50 / 250.00 =1.00 %. Now, that feels quite different from that headline, doesn't it?

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What Is Short Selling?

The typical retail investment cycle is first buy, then sell. In Short Selling, this is reversed – first sell then buy. P&L however is calculated the same way: sell price – buy price.

When does an investor opt for Short Selling – when they expect the price to fall. So they "go short" (buying would make them "go long"). However, if the stock price rises instead, so rises their loss.

How is Short Selling made possible? Your brokerage firm behind the scenes borrows the shares you don't own on your behalf, and returns the same when you square off the position. One can also short-sell a stock using Futures but that's not an exact same thing.

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How Is ROI (Return On Investment) Calculated?

ROI = (investment gain or loss) / (purchase price).

ROI calculated as above is also called Holding Period Return (HPR). If you have two investment ideas each with a different time duration and you want to compare the two, you can simply annualize their ROIs to get an apples-to-apples comparison. It's easy to do using standard "compounding interest" formulas.

Example: You invested 10,000 in a stock and have a gain of 2,000. The ROI (or, HPR) = 2,000 / 10,000 = 0.20 or 20%. If the investment was only for 6 months then the Annualized ROI = 44%.

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What Are These Ratios (Price To Earnings, Price To Sales, Dividends Yield, Return-On-Equity) etc.?

There are only some of the ways to understand a company's financial (i.e., management) or market (i.e., investor) performance. Multiple criteria is used to get a complete view of the contemplated investment.

Price-to-Earnings Ratio (PE) = Stock Price / Annual Earnings Per Share. It is arguably the most commonly quoted of market ratios. PE is often higher for companies experiencing strong earnings growth (the growth stocks) and lower for companies where earnings growth has somewhat matured (the matured companies). For cyclical companies, one tends to take average earnings over the business cycle. Note that PEs tend to vary a lot and can even be negative.

Dividend Yield % = 100 * Annual Dividend Amount / Current Stock Price.

Price-to-Sales (PS) = Stock Price / Annual Revenues Per Share = Market Capitalization of the Stock / Annual Revenues.

Like PS ratio, Return-on-Equity (ROE) is another measure of management efficiency and is computed as = Earnings / Owner's Capital.

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What Is This Thing Called "Risk Free Rate"?

Think of guaranteed bank/post-office savings rates, or the interest rate on a government bond, where there is no chance of losing your money. The basic idea here is that if one takes any kind of risk in investment, one better be beating at least this rate of return. See FAQ: What Is Sharpe Ratio.

Note that there is no such thing as true risk-free rate. Think Greece, Spain, Libya, ...

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What Is Sharpe Ratio? How Does It Help Answer Risk-Vs-Return Question?

Sharpe Ratio provides a measure of the return on an investment taking into account the risk associated with that investment. The basic idea is that higher the risk, higher should be the return. See FAQ: What Is This Thing Called "Risk Free Rate".

For those who are mathematically inclined,

      Sharpe Ratio = (Return on Investment - Risk-free rate of return) / (volatility of returns).

Risk-free rate of return is typically the rate of return in fixed deposits, government securities, post office deposit etc. These deposits/investments are relatively risk-free. Volatility is calculated as the standard deviation of the stock prices over a period of time. Generally, higher the volatility higher the risk.

Let us explain this with an example. If an analyst stock recommmendation is expected to return 25% over next one year, and the underlining stocks' volatility is 15%, and the risk free rate that I can get from a bank fixed deposit is 9%.

      Sharpe Ratio = (25% - 9%) / 15% = 1.067

What does 1.067 imply? Sharpe Ratio helps you compare different investment ideas based on risk versus reward. So if you compared an analyst stock recommendation with a Sharpe Ratio of 1.067 with another analyst recommendation that has a 20% volatility and a 30% projected return. Which investment would you choose?

      Sharpe Ratio of second investment = (30% - 9%) / 20% = 1.05

As you can see, the second investment has a lower Sharpe Ratio. The second investment option, which is more riskier than the first (because of higher volatility of 20% versus 15%), provides a poorer risk-to-reward ratio (1.05 versus 1.067) than the first invesment option. So the preferred investment option should be to invest in the first analysts' recommendation.

Here are some simple rules of thumb for Sharpe Ratio:

  • The higher the Sharpe Ratio, the better is that investment option.
  • A negative ratio means investor is not even matching the bank rate, and we know how that feels.
  • Another is what is reasonably good - and many long-term investors consider a ratio of 0.35 as "not terrible" and above 0.50 as "definitely good".

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How Is A Stock's Worth Determined? Who Does It?

Whole libraries have been devoted to this topic, so obviously it is complex but also apparently very important. We will summarize it as 4 broad steps.

  • A company is worth all the money it could possibly generate for its owners this year, next year, and so on. Plus what it is already worth today. What investors must pay attention to not so much the formulas but the assumptions behind the numbers. Moreover, the more distant the future, the less reliable the estimates.
  • Estimating how much money company could generate takes a lot of skill and effort. And the results still highly arguable. Watch a little CNBC or NDTV to get an idea.
  • The management team can add (or subtract) significant value. After Satyam and Enron we all ought to know. On the glorious side, there are the likes of Jobs and Buffet. Management brings in value through credibility, competence, foresight and execution.
  • Broad economic and political factors often exert immense influence on a company's present and future prospects.

In summary, add up the company's earnings prospects over its life, consider stability and predictability of earnings and assess this keeping in mind the broad economic scenario picture.

Typically, in an Investment Bank or Brokerage or Research organization, an Equity Research Analyst is tasked with assessing a company's future performance, and Economists with assessing the broad economic and political framework. They then collaborate to make a fair value assessment for a company. Of course everyone is entitled to make an estimate of their own.

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What Does An Equity Research Analyst Do?

First things first, this is not meant to be a job description...

An equity research analyst assess a company's short, medium and long term prospects as an investment. To this end, they often talk to company management, competitors, distributors, customers, economists and other sources to gather their data. Thus they arrive at a prediction of company's financial performance such as revenues, costs, cash flows, net profits, earning-per-share (EPS, growth rate, etc. over different lengths of time such a quarterly for a year or two, and annual for a few more years beyond that. They summarize their findings in a "research report" which is a very useful thing to read.

Many analysts stop at predicting the financial performance of a company. This might be sufficient inputs to a professional investor who can input these into their own mathematical models and make their Buy-Hold-Sell decisions. Such investors can also monitor progress on a continuous basis.

Some equity research analysts take a step further and also make a target or projected prices and implied returns. How Is A Stock's Worth Determined? Who Does It?How Is A Stock's Worth Determined? Who Does It? who are often wanting in resources and capabilities to build sophisticated mathematical models and make such projections themselves.

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What's A Liquid Stock And What Is Impact Cost?

A "liquid" stock is where there is plenty of buying and selling going on so that a handful of orders do not make the prices jump a lot.

Impact Cost is one such measure. This is interpreted as the average % change in price – observed from recent trading history – when a stipulated quantity or amount of stock is bought or sold. It's a useful input in assessing riskiness of an investment.

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What's The Difference Between A Market Order And A Limit Order?

A Market buy order tells the exchange to execute the order at the best available offer price. Likewise with a sell order and bid price. (see FAQ: What's A Stock Quote).

A Limit buy order tells the exchange to execute the order only at prices equal or below the limit price.

There are many more order types and it pays (literally!) to get familiar with them so that one can use the most suitable kind for the situation on hand. For example Stop Loss orders are designed to protect one's gains or limit the losses. A Stop Loss sell order tells the exchange to consider the order only after the stock has traded below your stop price.

Different order types can be often combined, each portion used and ejected, like a spaceship ejecting empty fuel containers. Please check your broker's rulebook to understand the exact interpretation of the order types they support. Also read your exchange's website for market rules. It can mean real money in your bank!

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How And What Can I Infer From A Long Term Stock Performance Chart?

A chart usually tells two stories – a long term trend and short term patterns. One might want to use the long term trend during investigating an idea, and the short term patterns to make the buy/sell entry. This obviously requires both skill and luck.

Over long term, one may try to overlay the stock chart with overall market index performance and economic cycles, and even major world events, to better understand a company's performance and driving forces behind its stock price.

On MilkorWater Stock Summary page, one can also visualize the long-term trend lines drawn by different analyst recommendations, and also how these pan out over time.

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What Are The Factors To Keep In Mind When Investing On A Long Term Basis?

Among other things, a long-term investor should keep in mind the (a) present and future prospects of the business sector or industry of the company, (b) the company's financial performance, (c) key news/events relevant to the company or its industry, (d) its exposure to broad factors such a currency rates, government licensing, geopolitical factors, etc.

As an information source, the management's quarterly and annual discussion of company results ranks almost at the top, along with research analyst reports. The analyst recommendations serve as a consolidated sentiment (see MilkorWater Stocks We Cover and individual stock pages) and can be complemented with Investor sentiments. One must watch out in particular for changes in these sentiments and look for probable causes.

Flexibility in adjusting and accepting new information, ... the list of factors can possibly go on for ever. BUT... the most important factor to consider is the level of risk associated with the stock and if it fits within your own risk tolerance. A glance at virtually any stock chart should be able to convince you that stocks can fall and rise majorly in without prior hints. Can you live with, say, a 20% drop in your portfolio value within a few short days?

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