Stocks 101: An Ownership Stake

An Ownership Stake

When investing in a bond, there is a certain amount of faith that can be placed in the capital markets system in general and the bond certificate buried deep in our grandparents safe deposit box at the local bank. The large black and white words on the certificate describe all the good things that will come to the bondholder and when they can expect their just rewards. The so-called “Murphy’s Law” comes to mind when thumbing through the underlying prospectus where it describes everything that can go wrong in preventing the bondholder from realizing the expected cash flows.

Investing in stocks is similar in nature to investing in the bonds of a nation, state, city, or corporation. Capital is pledged to help the entity survive and thrive for a period of time with an expectation that there will be a fair return for the risk taken by the stockholder. That is where the comparison takes a fork in the road, however, because a stock certificate represents an ownership stake in the underlying company. There is no large print showing the potential rewards to the investor - just regulatory reports showing all the risks faced by the operating entity.

Who Gets Paid?

Another difference between investing as a bondholder or a stockholder is where they stand in the “pecking order” on the company balance sheet. When things go well and the company thrives, everyone is happy because there is enough “free cash flow” to get paid. The bondholders get paid. The dividends (more on this later) get distributed. The stock price may even go up more than expected.

It is when things do not go as planned that this dynamic can change dramatically. As we can see in the simple balance sheet shown below, there are three main sections to this financial statement: (1) assets, (2) liabilities, and (3) stockholders equity. This particular example uses Apple, Inc. (AAPL) to demonstrate a few basic principles, but they also apply to the Microsofts, Amazons, and Facebooks of the investing world.

Assets can be thought of as things that can positively impact a company in the future. They are ordered in descending order from the most tangible at the top to the least tangible at the bottom. Cash is a very concrete and easily valued line item sitting at the top of our example. As we work down the list, it becomes a little bit harder to determine an exact value of certain assets. Goodwill is an example of value derived from a brand or reputation.

Liabilities are things that can negatively impact a company in the future. Again, they are ordered from the most certain to the least certain items. This is where bonds are listed since they are effectively IOUs. The company (AAPL) must pay back these bondholders before paying the stockholders if their operations are in jeopardy. In addition, there are often several “classes” of bonds with different payback priorities.

Stockholders Equity is what remains after bondholders get paid. This amount is generated from operations - in this case selling Apple Watches, iPhones, iPads, Macs and their related services such as iTunes. There is no guarantee that Stockholders Equity will continue to grow or that it will remain a positive value. In our case of AAPL, Stockholders Equity has grown dramatically over the past few decades.

Assets = Liabilities + Stockholders Equity

One property of a balance sheet is that it represents a snapshot of corporate health at a specific point in time. Stocks traded on public exchanges in the US (like the New York Stock Exchange) are required to update their balance sheets at the end of every fiscal quarter - or face the threat of being “delisted” from the exchange.

Income Or Growth?

Another important piece of the financial puzzle describing a company is their income statement. Small business owners sometimes refer to this report as a profit and loss statement (P&L). If the balance sheet is thought of as a snapshot in time, an income statement describes the flow of funds during a period of time between two dates. Again, publicly traded companies are required to update their income statements after the end of every fiscal quarter and post these reports to a central database named EDGAR that is managed by the Securities and Exchange Commission (SEC).

The table shown below shows the income statement for AAPL during each of the past few quarters. There is a common pattern to most income statements where the “good” things (like sales revenue) are listed up top and the “bad” things (like fixed expenses) are listed below what is often described by analysts as the top line. The bottom line on the income statement is where the rubber meets the road in the form of net income. This is what a small business owner may describe as the profit after accounting for all expenses within the reporting period.

If a company reports a loss (negative net income) during a period, it may not be the end of the world - yet. This loss could come from reduced sales during an economic slump. It could be due to a delayed product launch. Suppliers to the products may have increased  prices and the company could negotiate for volume discounts. The loss is covered by funds from the balance sheet (namely cash) or from stockholders equity. Several quarters - or years - of substantial losses could force the company to cease operations and surrender to the bankruptcy process.

When the operating company generates a profit, there are several things it can do with the money. It can leave the money in the bank as cash. It can pay off overdue bills. They can pay down higher interest debt. They can fund new projects to fuel further firm growth. Or, they can pay some of the profits out to the stockholders in the form of dividends. Dividends can be thought of as an allowance or a stipend for a student. They can be a small portion of the net income for a company or a large portion of the bottom line. Like a personal salary, once a company starts paying out a periodic dividend, it is very hard to curtail the expectation of a continuing stream of dividends.

So, the choice for the company lies between investing their net profits back into fuel further growth in the operations or to pay out some of the profits in the form of dividends. Investors must decide what will give them the best total return in their investment - stocks that generate higher growth or ones that offer higher income over their investment time horizon.

Common Or Preferred?

Similar to the different classes of debt shown on a company balance sheet, there can also be different classes of stock used to help capitalize the growth of a company. Every publicly traded company has what are called common shares of stock. What is less common is another class of stock called preferred. Just as the name implies, a preferred share of stock sits above the common share on the balance sheet. The pecking order idea implies that the holder of the preferred share will be paid their dividend first in the event of a difficult accounting period. Preferred shares may even be paid more than the common shareholders. The downside is that holders of preferred shares do not get to voice their opinion regarding company policy through the proxy voting process.

As a point of reference, there are 5,888 listed stocks currently available to purchase for our clients at TD Ameritrade. 2,205 of these companies pay a dividend, and 311 are listed as preferred shares. Of the stocks paying a dividend, the median dividend yield (annual dividend payment by the current share price) is 2.80% and the maximum yield is 38.35%. That is a lot of income!

Worthless Or Valuable?

This is the $64,000 question - is the stock we are considering for purchase worthless or valuable? There are countless ways to estimate the current value of a stock. One way is to simply look at the balance sheet shown above and assume that the market value of AAPL stock should be equal to the book value of Shareholders Equity. This would be one example of what is referred to as fundamental analysis. Reviewing the income statement to calculate the historical growth rate of sales and profits is another fundamental way to estimate future performance of the company and what that may entail for the stock price. Finally, the cash flow statement (not shown here) is the data that typically is the most accurate portrayal of the inner workings of the operating entity. We will take a deep dive into the cash flow statement in an upcoming post. For now, I will leave you with one of my favorite quotes from the father of value investing.

In the short run, the market is a voting machine but in the long run it is a weighing machine. - Benjamin Graham

Resources

https://www.investopedia.com/stocks-4427785