What is the stock market?
When a company needs to raise money, it has two options: it could either borrow money, or sell part of its shares in the stock market. Borrowing money is known in economic circles as debt financing while selling shares is known as equity financing. The idea of having a stock exchange began in the United States, and spread to all parts of the world including Africa, Europe, Asia and South America.
The stock market was born during the American Revolution in the mid 18th century; the colonial government sold bonds in its bid to raise money to fund the war. America’s banks started to do the same, but instead of bonds they sold part of their company to whoever could afford to buy a share. That, essentially, is what happens today. Wall Street, New York, became a leading trading center for these stocks. In 1792, the New York Stock Exchange was officially born (ThinkQuest, 2011).
How the stock market operates
Anybody, from an individual investor to a hedge fund trader, can buy or sell stock. To understand how the stock market operates best, it is best to use an example. Assume an individual has $500 and wants to buy the shares of Company X. Most individuals like these call a stockbroker1 and tell they want to buy Company X shares, which cost $50 at that moment. If the broker’s fees are $50, it means the investor can only afford to buy 9 shares of Company X. The transactions are handled by the broker, so all an investor has to do is send the money to the broker, and after a while, he has his/her stock.
From the broker’s point of view, however, it is much more complicated than that. Upon receiving an investor’s request to purchase stock, he calls someone at the stock exchange, who subsequently goes over to where Company X’s shares are traded and purchases them. Once Company X is informed that the stock has been bought, the stock belongs to the investor (ThinkQuest, 2011).
What is bought and sold in the stock market?
In the stock market, there are two main things that are traded: shares and derivatives. When a company is formed, the total capital invested by the company’s founders. This capital is known as stock. The stock is then divided into a number of shares (or equities), and the total number of shares is declared once the business is formed. Each share is given a value, and owning a company’s shares means an individual or company owns part of the business (Hobson, 2007).
Derivatives, on the other hand, refer to securities whose value depends on the underlying assets of a business. There are two main types of assets: standardized derivatives and customized derivatives (Johnson, 1999).
Stock market and financial market regulation
Stock markets are regulated by the respective countries within which they operate. The government of the respective country is responsible for ensuring all stakeholders in the financial market have an equal and fair playing field upon which they can trade. In the Euro zone, for example, the responsibility for the monetary policy has been assigned to the European Central Bank, but the task of supervising banks and financial institutions has been left to the domestic agencies of individual banks (Giorgio, Noia, & Piatti, 2000). In the United States, individual stock exchanges across the country have independent regulatory bodies authorized by the U.S. Commodity Futures Trading Commission. The stock market is regulated to prevent manipulation of the markets, ensure providers of financial services are competent and to reduce violations. Regulatory bodies enforce laws applicable to financial services in order to investigate complaints, protect clients and maintain confidence in the financial system.
Stock market performance: 2008 to 2011
The most significant thing that has happened to the US stock market in the last three years is, without question, the credit crisis of 2008, which occurred when the housing bubble burst. A year before the recession, the Dow Jones Industrial Average hit an all-time high of 14,164 points. Precisely one year and five months later, the Dow closed at 6,547 points, less than half its value. By 2009, everyone was abandoning the credit ship, leaving in droves and investing in Treasury bonds instead. With the benefit of hindsight, most experts believe this would have been the best time to invest, when prices of the stock of most companies were at an all time low (Roth, 2010). By 2010, however, the stock seems to have bounced back. In fact, by October 2010, the Dow Jones was only 17% below the all-time high of October 2007.
Evaluating stock market performance
Knowing how to evaluate the performance of stock market investments is one of the most valuable things to learn about stock market trading. There are five key steps to evaluating stock market investments. The first step is analyzing a stock’s earnings per share. A simple way to do this is to subtract the preferred stock dividends from the net income and to divide the resultant figure by the number of shares outstanding. If the stock’s earning per share is significantly higher than the stock’s price, then it is a brilliant idea to invest in the stock.
The second step is to calculate the dividend payout ratio. The general rule of thumb is that a company with a high dividend ratio invests more in dividend payments rather than in expansion. However, it a company has a low investment ratio, it is more likely to experience stronger growth in earnings.
The third step is to calculate the stock’s price per earning, commonly referred to the P/E ratio. If a company has it stock trading at $50 per share, for example, and its net income is $5 per share, then it means its P/E ratio is 10. If a company’s stock has a higher P/E than the market average, it is usually considered expensive, and vice versa (Kansas, 2005).
The fourth step is using a stock’s Return on Investment. A good example of how to calculate return on investment is if a person purchases 200 shares of a stock at $600, and sells all these shares at a cumulative price of $800, then the return on investment is approximately 33%. This is derived by subtracting the cost from the gains, and dividing the resulting figure by the cost. Finally, the last step is to use stock charting tools to evaluate a stock’s performance over a short period.
Understanding Stock market indexes
Stock market indexes are used to measure the performance of a section of the stock market. This section is usually a group of companies, selected and grouped based on geographic location, performance, mutual interests, industry and different criteria. There are two types of stock market indexes: price-weighted indexes and value-weighted indexes. Price-weighted indexes simply add up the price of the individual stocks. The Dow Jones Industrial Index, for example, consists of 30 companies whose stock added up and the value of the index calculated. The main disadvantage with price-weighted indexes is that its value is affected not by the value of the company, but by the price per share.
On the other hand, value-weighted indexes assign a value in the index that is proportional to the value of a company (Kendall, 2008). The Standard and Poors 500 (S&P 500) is one such company. The most valuable companies in the index, Exxon, General Electric and Microsoft, weigh approximately 4%, 3% and 2.5% respectively in the index. The other 497 companies have to share the remaining 90% or so of the index.
Below are tables and figures showing the averages of Dow Jones Industrial Average between 2004 and 2010, and S&P 500’s top daily holdings as of October 27, 2011 (iShares, 2011).
Table 1: Dow Jones Index Chart 2004 to 2011 (CME Group Index Services, 2011)
A close look at the graph above and it is easy to see that the Dow Jones Industrial Average is a reflection of the economic trend of the United States within the same period. Between 2004 and 2007, the country was in the middle of an economic boom, created by the housing bubble. 2008, when the credit crisis hit, the DJIA followed suit, plunging to a record average low of just over -30%.
Table 2: S&P 500 Top Daily Holdings as at 10.27.2011
Exxon Mobil, International Business Machines Corporation, Chevron, Microsoft and General Electric Co., are all leading companies that have enjoyed tremendous success. It is no surprise, therefore, that they are among the top daily holdings in the S&P 500 index, and have been in these top five positions consistently for the last decade. The other companies in the list are also highly successful companies, with track records over the last half century that few other companies can boast of.
Recommended companies to invest in
The two recommended stocks to buy are Microsoft stocks (NYSE:MSFT) and McDonald’s stocks (NYSE:MCD).
Background of companies
Microsoft
Microsoft is the brainchild of its co-founders Bill Gates and Paul Allen. The company was started in 1975, and initially was a microchip processor programming company before branching into creating operating systems in 1980. Thirty years later, the company has made billionaires out of its founder and chairman, Bill Gates, co-owner Paul Allen and boasts one of the most consistent share prices in the country.
McDonald’s
Just like Microsoft, McDonald’s started as a small restaurant, founded by brothers Richard and Maurice McDonald. Despite slow beginnings, McDonald’s soon picked up and became a fast-food selling restaurant, a trend that was picking up in the 1940s. Success for the company, however, came when the McDonald brothers’ equity in the firm was purchased by Ray Kroc, an American investor and businessman. With aggressive business tactics and tactical genius, Kroc expanded the business into one of the most recognizable brands in the world today. With 64 million customers served daily in its restaurants, it is the globe’s largest hamburger fast food restaurant.
Motivation for investing in the companies
Industry
Microsoft is in the computer technology industry while McDonald’s is in the fast food industry. Not only are both industries the most consistent industries in the 21st century, they also are the drivers of business life on earth.
Computer technology has become an indispensable part of business and personal life, with PCs, handheld devices and computer technology used in almost all aspects of business and daily life. As a proprietary company that provides support for both large businesses and individuals across the world, Microsoft is at the nucleus of computer technology, and is bound to remain relevant in the technology industry for a long time. There are, of course, serious companies that threaten the growth of Microsoft, like Google and Apple Inc. In fact, Apple has now become the highest earning computer company, surpassing Microsoft, which had been the giant of the market for several years.
McDonald’s is in the fast food business, which happens to be one of the most consistent business fields in history. There is a constant demand, and McDonald’s business practice of serving affordable food in a clean and healthy environment has pushed the company into the high-end of global business.
Share Performance
The graphs below show the share performance of Microsoft’s MSFT and McDonald’s MCD shares, compared to the S&P 500 index and the Dow Jones Industrial Index over a 20 year period.
The figures above show two main characteristics about the share prices of Microsoft and McDonald’s. First, the share prices of these two companies have been consistently above the Dow Jones Industrial and the S&P 500 indexes for over 15 years. This is a mark of consistency that is vital for investors. It is a reflection of the company’s solid policies, proven business practices and experience in their respective fields. Secondly, these companies perform better than their peers in the stock market consistently, which is always a healthy sign of a company that is geared towards excellence, and second place is considered ‘first among losers’.
Financial health of the companies
The best way to judge the financial health of these companies is by looking at their recent profit margins and their dividends per share over the last 20 years. Microsoft’s net profit over the first quarter of 2011 was $5.41 billion (68 cents per share). This is mostly a result of the success of the Office Suite, where sales rose to $17.37 billion (BCS, 2011). On the other hand, for the three months that ended 30 September 2011, McDonald’s profits rose by 14% to $7.1 billion, up from $6.3 billion a year before (Lemaire, 2011).
The graphs below illustrate the companies’ dividends per share over the last twenty years (eight years for Microsoft)2. Just like with their share prices, their dividends have been consistent, another sign of sound financial management within the company. Microsoft’s dividends over the recession, for example, barely flinched.
Risk
Risk in investment is used to refer to the possibility that one may invest in a venture and end up making less than what the investment made.
Measuring Risk
One way to measure risk is by using standard deviation, which measures the dispersion around a central tendency. Risk is often referred to as deviation from an expected outcome (Lamb, 2011). According to Harper (2010), volatility is also referred to as annualized standard deviation. Therefore, to measure risk, a stock’s volatility has to be measured over a period of past time.
When measuring standard deviation, two parameters are required: a historical period, and an interval. The interval could be daily, weekly, monthly or annually, and the period can be of any length. It is essential to note that as the interval decreases, standard deviation increases, and vice versa. Annualized standard deviation is then measured by multiplying the standard deviation by the square root of the interval (Harper, 2010).
Riskiness of the two companies
Using the standard deviation method, the riskiness of McDonald’s shares and Microsoft’s shares is calculated using their annual data.
Table 3: Standard Deviation
Table 4: Annualized Standard Deviation – Risk
It is evident that based on the trends of the last three years, the McDonald’s stock presents much higher risk than the Microsoft stock. However, both figures do not fall far from the acceptable limit.
Conclusion
With the kind of money won by X, it is tempting to invest in a number of small shares in order to spread risk. However, trying to avoid risk also jeopardizes the chances of making profits and gaining the best out of a stock. Microsoft and McDonald’s have relatively expensive shares, but $100,000 is a decent amount of money. They may not be the most profitable shares in the business, but they present a safe way to invest, with near guaranteed results.
It is foolhardy to suggest that there is no risk involved in investing in a company’s shares. Even the largest companies with large market share and high profits all become victims to the pressures markets if they are not properly run. The key to investing with as little risk as possible is investing in shares with consistent prices.
References
BCS. (2011). Office helps boost Microsoft profits. Web.
CME Group Index Services. (2011). Dow Jones Indexes Analytics. New York: Dow Jones.
Giorgio, G. D., Noia, C. D., & Piatti, L. (2000). Financial Market Regulation: The Case of Italy and a Proposal for the Euro Area. Philadelphia: The Wharton School.
Harper, D. (2010). The Uses And Limits Of Volatility. Web.
Hobson, R. (2007). What are Shares? In R. Hobson, Shares Made Simple: A Beginner’s Guide to the Stock Market (p. 3). Hampshire: Harriman House.
InvestorGuide. (2011). McDonald’s (MCD). Web.
InvestorGuide. (2011). Microsoft (MSFT). Web.
iShares. (2011). S&P 500 Index Fund. Web.
Johnson, P. M. (1999). What are derivatives? In P. M. Johnson, Derivatives: a manager’s guide to the world’s most powerful financial instruments (pp. 1-2). New York: McGraw Hill.
Kansas, D. (2005). The Wall Street Journal complete money & investing guidebook. New York : Three Rivers Press.
Kendall, C. (2008). Understanding Stock Market Indexes (and Index Trading). Web.
Lamb, K. (2011). Measuring And Managing Investment Risk. Web.
Lemaire, B. (2011). McDonald’s Q3 profit beats Street. Web.
Roth, A. (2010). 3 Years After the Stock Market Peak: Here are the Lessons. Web.
ThinkQuest. (2011). The Stock Market. Web.
Yahoo! Finance. (2011). Historical Prices. Web.
Footnotes
- 1 – A stockbroker is basically an individual that purchases stock on behalf of individuals and companies.
- 2 – Information obtained from Yahoo! Finance (2011)