Everyone loves a bull market, and an investor seemingly cannot go wrong when the market continues to reach new highs. At Goldman Sachs, a bull market is said to occur when stocks exhibit "expanding multiples", we will give you a simpler definition. Essentially, a bull market occurs when stock prices (as measured by an index like the Dow Jones Industrial or the S&P 500) move up. A bear market occurs when stocks fall. Simple. More specifically, bear markets occur when the market has fallen by greater than 20 percent from its highs, and a "correction" occurs when the market has fallen by more than 10 percent but less than 20 percent.
The Mighty Dow Jones
The most widely publicized, most widely traded, and most widely tracked stock index in the world is the Dow Jones Industrial Average. The Dow was created in 1896 as a yardstick to measure the performance of the U.S. stock market in general. Initially composed of only 12 stocks, the Dow began trading at a mere 41 points. Today it is made up of 30 large companies in a variety of industries.
Dow's Performance
The Dow has historically performed remarkably well, especially since 1990. Speculation runs rampant as to when the current bull market will end, but any and all naysayers in the past 10 years have been proven wrong time and time again. Propelling the Dow upward is a combination of the success of U.S. businesses in capturing productivity/efficiency gains, the continuing economic expansion, rapidly growing market share in world markets, and the U.S.'s global dominance in the expanding technology sectors.
While the Dow dominates news and conversation, investors should take care to know its limitation; as a market barometer. For one, the Dow can be swiftly moved by changes in only one stock. Roughly speaking, for every dollar that a Dow component stock moves, the Dow Index will move be approximately three points. Therefore, a $10 move in IBM in one day (a 7.5 percent change) will cause a change in the Dow of 30 points! Also, the Dow is only composed of immense companies, and will only reflect movements in big-cap stocks.
Although the Dow is widely watched and cited because it's comprised of select, large companies, the Dow cannot gauge fluctuations and movements in smaller companies. Also, many economists and market watchers complain that the Dow includes only two pure technology companies, IBM and Hewlett-Packard, and far too many industrial companies such as International Paper, Caterpillar, and Union Carbide. Because of this imbalance, industry observers suggest, the Dow Jones just does not match the make-up of our economy today. On a worldwide basis, though, the ubiquity, acceptance and influence of the mighty Dow cannot be matches by any other index.
Besides the Dow Jones, investors follow many other important benchmarks. The NYSE Composite Index, which measures the performance of every stock traded on the New York Stock Exchange, represents an excellent broad market measure. The S&P 500 Index, composed of the 500 largest publicly traded companies in the U.S., also presents a nice broad market measure, but, like the Dow is limited to large companies. Technology and smaller stocks comprise the Nasdaq Index, so that benchmark is followed by investors who focus on these market segments. The Russell 2000 compiles 2000 small-cap stocks, and measures stock performance in that segment of companies.
Big-Cap and Small-Cap
At a basic level, market capitalization or "market cap," represents the company's value according to the market," and is calculated by multiplying the total number of shares by share price. (This is the equity value of the company.) Companies and their stocks tend to be categorized into three categories: big-cap, mid-cap and small-cap.
While there are no hard and fast rules, generally speaking, a company with a market cap greater than $5 billion will be classified as a big-cap stock. These companies tend to be established, mature companies, although with the market valuation of Internet companies going haywire, this is not necessarily the case. Sometimes huge companies with $25 billion and greater market caps, for example, GE, Microsoft and Mobil, are called mega-cap stocks. Small-cap stocks tend to be riskier, but are also often the faster growing companies. Roughly speaking, a small-cap stock includes those companies with market caps less than $1 billion. And as one might expect, the stocks in between $1 billion and $5 billion are referred to as mid-cap stocks.
What Moves The Stock Market?
Not surprisingly, the factors that most influence the broader stock market are economic in nature. Among equities, Gross Domestic Product (GDP) and the Consumer Price Index (CPI) are king.
When GDP slows substantially, market investors fear a recession. And if economic conditions worsen and the market enters a recession, many companies will face reduced demand for their products, company earnings will be hurt, and hence equity (stock) prices will decline. Thus, when the GDP suffers, so does the stock market.
When the CPI heats up, investors fear inflation. Inflation fears trigger a different chain of events than fears of recession. First, inflation will cause interest rates to rise. Companies with debt will be forced to pay higher interest rates on existing debt, thereby reducing earnings (and earnings per share). And compounding the problem, because ‘Inflation Fears’ cause interest rates to rise, higher rates will make investments other than stocks more attractive from the investor's perspective. Why would an investor purchase a stock that may only earn 8 percent (and carries substantial risk), when lower risk CD's and government bonds offer similar yields with less risk? These inflation fears are known as "capital allocations" in the market. Investors typically reallocate funds from stocks to low-risk bonds when the economy experiences a slowdown and vice versa, when the opposite occurs.
What Factors Most Impact Individual Stocks?
When it comes to individual stocks, it's all about earnings, earnings, earnings. No other measure even compares to earnings per share (EPS) when it comes to an individual stock's price. Every quarter, companies must report EPS figures, and stockholders wait with bated breath, ready to compare the actual EPS figure with the EPS estimates. For instance, if a company reports $1.00 EPS for a quarter, but the market had anticipated EPS of $1.20, and then the stock will be dramatically "hit" in the market that day. Conversely, a company that beats its estimates will rally in the markets.
Perhaps surprisingly, the market does not care about last year's earnings. Investors maintain a tough, "what have you done for me lately" attitude, and forgive slowly a company that "misses its numbers".
Stock valuation measures and ratios
As far as stocks go, it is important to realize that absolute stock prices mean nothing. To clarify how this works, consider the following ratios and what they mean. Keep in mind that these are only a few of the major ratios, and that literally hundreds of financial and accounting ratios have been invented to compare dissimilar companies. For an explanation of basic accounting concepts, see the Appendix at the back of this book.
You can't go far into a discussion about the stock market without hearing about the all-important price to earnings ratio, or P/E ratio. By definition, a P/E ratio equals the stock price divided by the earnings per share. In usage, investors use the P/E ratio to indicate how "cheap" or "expensive" a stock is.
Consider the following example. Two similar firms each have $50 in EPS. Company A's stock price is $15.00 per share, and Company B's stock price is $30.00 per share.
Clearly, Company A is "cheaper" than Company B with regard to the P/E ratio because both firms exhibit the same level of earnings, but A's stock trades at a higher price. That is, Company A's P/E ratio of 10 (15/1.5) is lower than Company B's P/E ratio of 20 (30/1.5). Hence, Company A's stock is cheaper. The terminology one hears in the market is, "Company A is trading at 10 times earnings, while Company B is trading at 20 times earnings." Twenty times is a higher multiple.
However, the true measure of cheapness vs. richness cannot be summed up by the P/E ratio. Some firms simply deserve higher P/E ratios than others, and some deserve lower P/Es. Importantly, the distinguishing factor is the anticipated growth in earnings per share.
PEG Ratio
Because companies grow at different rates, another comparison investors often make is between the P/E ratio and the stock's expected growth rate in EPS. Returning to our previous example, let's say Company A has an expected EPS growth rate of 10 percent, while Company B's expected growth rate is 20 percent.
We might propose that the market values Company A at 10 times earnings because it anticipates 10 percent annual growth in EPS over the next five years. Company B is growing faster - at a 20 percent rate - and therefore justifies the 20 times earnings stock price. To determine true cheapness, market analysts have developed a ratio that compares the P/E to the growth rate - the PEG ratio. In this example, one could argue that both companies are valued similarly (both have PEG ratios of 1).
Sophisticated market investors therefore utilize this PEG ratio. Roughly speaking, the average company has a PEG ratio of 1:1 or 1 (i.e. the P/E ratio matches the anticipated growth rate). By convention, expensive firms have a PEG ratio greater than one, and cheap stocks have a PEG ratio less than one.
Cash Flow Multiples
For companies with no earnings and therefore no EPS, one cannot calculate the P/E ratio - it is a meaningless number. The quick fix then is to compute the firm's cash flow and compare that to the market value of the firm. The following example illustrates how a typical cash flow multiple like Enterprise Value/EBITDA ratio is calculated.
EBITDA: A proxy for cash flow, EBITDA stands for Earnings before interest, taxes, depreciation and amortization. To calculate EBITDA, work your way up the Income Statement, adding back the appropriate items to net income. Adding together depreciation and amortization to operating earnings, a common subtotal on the income statement, can serve as a shortcut to calculating EBITDA.
Enterprise Value (EV) = Market Value of Equity + Net Debt. To compute market value of equity, simply multiply the current stock price times the number of shares outstanding. Net debt is simply the firm's total debt (as found on the Balance Sheet) minus cash. Therefore, EV, often called Total Market Capitalization, essentially is the market estimate of what the entire firm is worth.
Enterprise Value to Revenue Multiple (EV/Revenue)
If you follow Internet stocks and their valuations, you have probably heard the "multiple of revenue"' lingo. Sometimes it is called the price-sales ratio (though this technically is not correct). Why use this ratio?
For one, many firms not only have negative earnings, but also negative cash flow. That means any cash flow or P/E multiple must be thrown out the window, leaving revenue as the last positive Income Statement number left to compare to the firm's Enterprise Value. Specifically one calculates this ratio by dividing EV by the last 12 months revenue figure. The historical convention was that most firms traded between one and five times revenue, but with the introduction of Internet stocks and astoundingly high valuations of other high-tech firms, the sky's the limit. For example, as of the writing of this book, Amazon traded at a lofty 17 times revenue!
Return on Equity (ROE)
Net income divided by Total Shareholders Equity. An important measure that measures ‘The Income Return’ that a firm earned in any given year. Return on equity is expressed as a percent. Many firms' financial goal is to achieve a certain level of ROE per year, say 20 percent or more.
Value Stocks, Growth Stocks and Momentum Investors
It is important to know that investors typically classify stocks into one of two categories - growth and value stocks. Momentum investors buy a subset of the stocks in the growth category.
Value stocks are those that have been battered by investors. Typically, a stock that trades at low P/E ratios after having once traded at high P/E’s or a stock with declining sales or earnings fits into the value category. Investors choose value stocks with to the hope that their businesses will turn around and profits will return. Or, investors perhaps realize that a stock is trading close to "break-up value," and hence have little downside.
Growth stocks are just the opposite. High P/E's, high growth rates, and often "hot stocks" fit the growth category. Internet stocks, with astoundingly high P/E's, may be classified as growth stocks based on their high growth rates. Keep in mind that a P/E ratio often serves as a proxy for a firm's average expected growth rate.
Momentum investors buy growth stocks that have exhibited strong upward price appreciation. Usually trading at 52-week highs, momentum investors cause these stocks to trade up and down with extreme volatility. Momentum investors, who typically don't care about the firm's business or valuation ratios, will dump their stocks the moment they show price weakness. Thus, a stock run-up by momentum investors can crash dramatically as they bail out at the first sign of trouble.
Common Stock - Also called common equity, common stock represents an ownership interest in a company. The vast majority of stock traded in the markets today is common. Common stock enables investors to vote on company matters. An individual with 51 percent or more of a company's shares owned controls a company's decisions and can appoint anyone he/she wishes to the board of directors or to the management team.
Convertible Preferred Stock - This is a relatively uncommon type of equity issued by a company, often when it cannot successfully sell either straight common stock or straight debt. Preferred stock pays a dividend, in a manner similar to the way a bond pays coupon payments. However, preferred stock ultimately converts to common stock after a period of time. Preferred stock can be viewed as a mix of debt and equity, and is most often used as a way for a risky company to obtain capital when neither debt nor equity works.
Non-Convertible Preferred Stock - Sometimes companies issue non-convertible preferred stock, which remains outstanding in perpetuity and trades similar to stocks. Utilities represent the best example of non-convertible preferred stock issuers.
