Hey everyone! I thought it would be interesting and fun to start a series on stock market/investing basics for people that are just starting out. I know firsthand how scary everything can seem and it’s very easy to get overwhelmed with so much information. So, I just wanted to break down the basics into an easy to understand series. Click here to get part 1 of the Stock Market Basics series.
This post will be split into two parts. First, we’ll talk about indices and then we’ll discuss important stock metrics.
What are Stock Indices?
If you have read the financial news lately, you’ve undoubtedly heard that the stock market is currently at all time highs. To measure the performance of the broad economy, we typically track the performance of a collection of stocks (i.e. an index).
You can utilize an index to monitor basically any industry. There are indices that monitor oil and gas companies, technology companies, and even the retail industry.
The Dow And S&P 500
The two most popular indices in the US are the Dow and the S&P 500.
The Dow Jones Industrial Average (or just “the Dow”) is a price-weighted index of 30 stocks that trade on the NYSE and the NASDAQ stock exchanges.
While there is some debate about this, the Dow index is supposed to reflect the underlying growth of the U.S. economy. This is because the index stock components represent some of the largest domestic companies.
You can check out the companies included in the Dow here. Most people purchase products or use the services of many of these companies on a daily basis.
Like the Dow, the Standard & Poor’s 500 (or “S&P 500”) is an important market index. It is a market capitalization (i.e. market value) weighted index of 500 large companies on the NYSE/NASDAQ. The stocks included in the S&P 500 are seen as leading indicators of the US economy.
So, why are these indices widely followed? Well, it’s because they attempt to capture the health of the US economy. When the US economy is healthy and growing, these indices increase in value. Conversely, in times of recession, they decline in value.
Key Financial Terms
You might hear a lot of “fancy” terminology when you read the financial news or hear about it on the radio/TV. At least that was the way I thought about it when I began learning about finance/investing in college.
It can be a little intimidating at first, but it is easy to get the hang of. Let’s go over a few important financial terms.
52 Week High And Low
The 52 week high represents the highest point a stock traded at over the past year. Conversely, the 52 week low represents the lowest point it traded for over the past 52 weeks.
The 52 week high/low tells investors the range the stock has traded at. You’ll often hear commentators in the financial media discuss these terms.
Market Capitalization (“Market Cap”)
A company’s market capitalization (also known as “market cap”) is just a fancy way to describe the value a public company in the open market. Market cap is the price-per-share of the stock multiplied against the number of shares outstanding.
Say a Company has 100 shares outstanding and each share trades at $1. Then this Company has a market cap of $100.
The U.S. public market is home to many different companies of all sizes. There are large companies like Apple and Microsoft and smaller companies with market caps less than $100 million.
The market is typically segregated into several different classifications based on market cap. Everyone has a slightly different definition of these buckets, but here is a good rule of thumb:
Mega cap: These are the largest companies in the world. Mega cap companies are the leaders of their industry and generate billions of sales and profits every year. These companies have a market cap of $100 billion or more.
Large cap: These are companies that have a market cap of $10 billion to $100 billion. Many large, well established companies/brands that fit into this bucket are known as “blue chip stocks.” They have a long history of operations and generating profit.
Mid cap: Mid cap companies have a market cap ranging from $1 billion to $10 billion. These companies are considered to be more volatile (i.e. their stock prices fluctuate more widely) than their larger counterparts.
Small cap: Small cap companies are much smaller and relatively young companies that have a market cap of $300 million to $1 billion. These companies typically do not have the same long-term track record as mid cap, large cap, or mega cap companies. As a result, they should be invested in with much more scrutiny.
Micro cap/nano cap: These companies are very small and typically trade over the counter (OTC) instead of major stock exchanges like the NYSE/NASDAQ. These companies have a market cap less than $300 million. Many of these companies are “penny stocks” and are ripe with scams and other unscrupulous business activity.
An important rule to consider is that all else equal, large cap and mega cap companies are typically more stable stocks. What I mean by “stable” is that their stock prices don’t fluctuate as violently.
Some investors like to get exposure to mid cap and small cap companies because they can provide higher returns if you’re prepared to stomach the volatility.
Share Count And Earnings
Share count is just what it sounds like…the number of shares a company has outstanding. This also includes any stock options or other equity compensation awarded to the management team.
Companies report their earnings/profit/net income on a per-share basis. This just means they are dividing the profit by the number of shares outstanding.
For instance, say a Company generated $100 of profit and has 100 shares outstanding. This means, it has an earnings-per-share (EPS) of $1.
EPS is an important metric because earnings/profit is the primary driver of stock prices for both individual companies and stock indices.
Price-to-Earnings Ratio (P/E Ratio)
The price-to-earnings (or P/E ratio) is used in pretty much every financial media article. It’s basically a quick and dirty way to measure how cheap or expensive a stock or index is.
It represents the stock price divided by earnings-per-share.
What the P/E ratio tells us is how much a stock/index is trading for relative to its earnings. So a P/E ratio of 15 means that investors are willing to pay 15 dollars for every dollar of profit the company generates.
A lot of financial media commentators use P/E as a barometer to see how expensive the market is.
A dividend is a distribution of a company’s profit back to its owners (i.e. the shareholders). Dividends are often paid in cash, but can also be paid with stock. Most companies will pay a dividend on a monthly, quarterly, or annual basis.
A dividend is great because it is another way to earn a return on your investment in addition to stock price appreciation.
As individuals, it’s easy to be intimidated by investing. After all, most of this stuff isn’t taught in school or even in the workplace, so we’re really forced to fend for ourselves. However, if you want to build long-term wealth and beat inflation, investing is 100% necessary.
This wraps up part 2 of this series! There are a lot of topics to discuss because finance/investing is such a big industry. Stay tuned for Part 3 of this Stock Market Basics series 🙂