Investing Terms for Beginners

Investing Terms for Beginners

Varun Singh, Staff Writer

Investing can be intimidating enough for beginners. Add in the roller-coaster year of 2020 with its unprecedented effects on businesses and employment, and it can seem impossible to navigate the stock market. However, the investors that are successful aren’t lucky, and instead earn their profits by mastering basic principles which most people can learn. Although you’re not going to become an expert in investing overnight, or maybe even for a long time, you too can learn the fundamentals of investing and not only earn money but enjoy the process of doing so. 

In investing it’s important to be familiar with certain terms. By doing this, you can better decide what stocks to buy or sell and ultimately improve your experience. Below they’re a few terms that you can familiarize yourself with. This list is by no means all the terminology used in investing, but it can provide you with the basic background information to help get started.

1. The Price/Earnings Ratio (P/E): This compares the price that was originally paid for a stock in proportion to its current earnings. If you had stock with a P/E ratio of 100, that means for every $100 you put into the stock you’d be earning $1. Stocks with a lower P/E ratio are more favorable because this means you can put in less money to earn. 

2. Equity: With any business, you need net funds/assets to get started. These initial funds for a business come from its owners. With a corporation, its owners are a group of shareholders. Rather, with a single proprietary business, the owner is one individual. The owners of a business have a claim into the assets they put in, and this results in them having equity. Equity can be calculated by Equity = Assets – Liabilities (This equation is what comprises a company’s balance sheet). For example, let’s say you start a business with $1000 of your own money, but then you take a $500 loan from a bank. Your assets now amount to $1500, but your equity is still $1000 because that loan from the bank is a liability. 

3. Return on Equity (ROE): The ROE can be used to measure how efficient a company is at generating a profit for its shareholders. ROE = Net Profit/Equity. For example, if your business makes a profit of $200 and has an equity of $1000, then your ROE is 0.20 or 20%. This means your company is making 20% more profit from money previously invested by shareholders. The higher the ROE, the more efficient a company is at making a profit from its invested resources. While investing, it’s important to understand that ROEs will vary greatly between different industries.

4. Dividend Yield: Dividend Yield is the amount of money that is taken from accumulated profits and given to each shareholder. If a company has a Dividend Yield of 1.50%, each shareholder will receive 1.50% back on each stock they own. Investing in companies with the primary goal of receiving high dividends is known as incoming investing. It’s important to note though that not all companies, such as Tesla, give out a dividend yield.

5. Value Investing: This is the method of buying stocks with the hope that their value will increase in the future, and then selling those stocks at a higher price for profit if they do well. For example, let’s say you buy a stock from another investor for twice the money the original investor paid for that specific stock. You would do this because you believe that the value of that stock is going to increase once you buy it, and thus you can sell it later on for an even greater profit. However, this can backfire: let’s say you buy a stock that’s doing really well when the market is up. The stock is expensive, but you want to take part in this rising market and you’re confident the stock will continue to do well. All of the sudden, the market falls along with your expensive stock. Now you’re stuck with a stock that’s currently worth less than what you originally paid for. In a panic, you back out and sell the stock in hopes of recovering a fraction of your money. This is why one of the most common pieces of advice in value investing, as per Warren Buffet, is to “Buy low and sell high.” Using this model, you can take advantage of investors that back out from falling stock prices similar to the previous example. You buy the cheap stocks that people are looking to sell, then hold on to them while they rise in the market. Finally, you can sell them once there’s a substantial rise in their value for you to make a profit.  

Warren Buffet via Getty Images

6. Intrinsic Value: This is the calculation of a stock’s value by financial analysts, using mathematical models and qualitative factors, as opposed to the stocks actual market value. This can be used to determine if a stock is overvalued or undervalued by the market. For example, you can buy a stock that you think is undervalued by the stock market and then sell it for a higher price if it does well.

7. Profit Margins: This is the amount of revenue from a company that becomes profit. If you look at a company like Tesla, which had a revenue of 8.77 billion last quarter, you can see that the company’s activities generate huge amounts of money. However, Tesla’s net profit from last quarter was 331 million. Though this is also a large sum of money, it is a fraction (3.77%) of 8.77 billion. Whereas when you look at a company like AirBnB, which had a revenue of 1.34B and profits of 219.33M last quarter, you can see that its profit margins (16.34%) are a lot higher. Companies that are more profitable can have a higher stock value, although this is not always the case.

Tesla’s revenue vs. profit, via Google

8. Value Stocks: Value stocks are seen as undervalued by the market and thus capable of good returns as they grow. These stocks are more stable and often belong to more mature companies. Value stocks are known to have a slow, but steady pattern of increasing or decreasing value. They are bought cheap, often while experiencing a decline, where the investor is looking for the stock to slowly re-grow in value. However, these investments can take a long time to make profits and sometimes lead to the “Value Trap”: buying cheap stocks that only get cheaper. Examples of Good Value Stocks: Berkshire Hathaway, Goldman Sachs, Exxon Mobil, Johnson and Johnson

9. Growth Stocks: Grow stocks are from companies that are perceived to have the potential to outperform the overall market. Some examples include tech companies and startups. These companies are younger, and have a higher stock price, which means more risk. But if that company does end up making the next big thing, like an iPhone or streaming service, then there’s a chance for very high returns. Most of the time, once these companies reach this point they’re no longer considered growth stocks because they’ve reached their potential and it’s harder to continually grow at a high rate once you’re a large company. However, large companies like Amazon and Netflix are still considered growth stocks, because they’re able to maintain a higher growth rate than the rest of the market. Examples of Good Growth Stocks: Amazon, Apple, Facebook, Netflix, Tesla

10. Cyclicals and Non-Cyclicals: Cyclicals are industries that people don’t necessarily need. Examples include designer clothes, cars, furniture, or other luxury items. Cyclical stocks can grow rapidly in a rising, or “bull”, market because a good economy leads to more money being spent. This results in people buying goods they don’t need, but want to consume. In a falling or “bear” market though, cyclicals won’t perform as well because there’s less money being spent on non-essential items. On the contrary, Non-cyclicals are industries that people can’t live without such as groceries, electricity, and healthcare. Even in a falling market, people will still need to buy non-cyclical goods because they’re essential. Thus, non-cyclicals are a safer investment because there’s always going to be a stable need for things like bread or medication. 

Sources:

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Fernando, Jason. “How Return on Equity Works.” Investopedia, Investopedia, 18 Nov. 2020, www.investopedia.com/terms/r/returnonequity.asp. 

“Growth Stocks – Overview, Characteristics, Examples.” Corporate Finance Institute, CPI, https://corporatefinanceinstitute.com/resources/knowledge/trading-investing/growth-stocks/

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Cover photo credit: New York Stock Exchange via Matej Kastelic/ShutterStock Photography