Stocks represent an ownership stake – a share – in a company, and buying some entitles you to a chunk of that firm’s future earnings. Investors like them for a few reasons: stocks can diversify an investment portfolio, may offer regular passive income via dividends, and are typically easy to buy and sell at any point. They could help protect your money from the cash-shrinking effect of rising inflation too, since the stock market’s returns have historically outpaced the rate of inflation.
Those rewards don’t come without a bit of risk, mind you. Buying stock essentially means you’re investing in a company’s future cash flows, which naturally comes with some uncertainty. Take an extreme example: it’s bondholders – not stockholders – who get paid first if a company goes bankrupt, leaving shareholders to scrap over whatever’s left. But there’s a good chance you’ll be compensated for that risk: the stock market usually offers higher returns than either bonds or cash.
There’s no guarantee that today’s top companies will rule the roost tomorrow. That’s why the world’s indexes are always updating to keep track of which ones are going strong, and which are stuck in a rut. Makes sense, then, that you’d want to update your portfolio to make sure you only invest in the best.
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One common way to value a company is by taking its projected earnings and discounting them back to the present day. After all, a company that’s expected to make billions in the future isn’t necessarily worth a 10-figure valuation today. Investors use a “discount rate” to adjust those earnings, which factors in the risks involved and reflects how much they’d want to earn on their investment. And that’s where interest rates come in: lower interest rates bring the discount rate down, increasing a company’s valuation.
That helps explain why some high-growth stocks – like tech ones – have seen their valuations skyrocket over the last few years. See, high-growth stocks often have low profits since they’re reinvesting heavily to fuel their future growth. Thing is, investors expect high profits in the future, and use low discount rates – due to low interest rates – to discount those earnings back to today, resulting in high valuations. The inverse is true too, so rising interest rates push up discount rates and send valuations falling. And that’s exactly what’s been happening in 2022: interest rates have risen, and several major tech stocks have already seen their valuations plummet.
Since investors value a company based on its future earnings, any change in current or projected earnings will be reflected in its stock price. So let’s take a look at the factors that influence a company’s earnings, which can be broadly split into macro and micro happenings.
Macro drivers include things that widely affect how easily companies can generate profits, like economic growth, inflation, and interest rates. Micro ones, meanwhile, are specific to the company and include things like the flexibility of its cost structure, level of debt, and its ability to raise product prices or encourage higher demand. Also pay attention to how much ongoing investment a company needs for things like machinery, since that partly determines how much free cash it can make each year.
Remember, everything’s connected: rising sales might be thanks to a smart strategy, or simply a side effect of a strong economy. And higher sales won’t necessarily lead to rising profits: companies could choose to reinvest in things like staff or marketing, or simply see their profits eaten up by higher costs. That’s why it’s important to look at where cash is going within a company and assess whether you think it’s being smartly allocated.
Companies either reinvest any profit into their operations or dish it out to shareholders through dividends – often opting for a combination of the two. Luckily, there’s a handy way to tell if a company’s likely to cut you a check: a firm’s “dividend yield” will show you how much it pays out relative to its current stock price. To calculate this, you divide its dividend per share by its share price: for example, a company with a dividend per share of $10 and a share price of $110 will have a dividend yield of 9% (10 / 110). And as a shareholder, you’ll receive $10 each year for each share you own.
You can inflation-proof your portfolio by finding stocks with a high enough dividend yield. If inflation’s 7% annually, stocks with a 7% dividend yield or higher would at least preserve the value of your capital during those tough times – assuming a constant share price. Cash that’s left uninvested, meanwhile, would be worth less a year later. And high dividend-paying companies have one more advantage over ones that don’t pay any at all: they’re often less volatile, partly because companies that can afford to pay high dividends are often more mature and stable by nature.
Start by setting out your investment goals, as they’ll help you decide which type of investments to make. The longer your time horizon, the more risk you’ll be able to take on: stocks can be volatile in the short term but tend to rise steadily in the long term, so more time gives you a much better chance to recover any early losses.
You’ll also want to consider diversification: you can hedge your risk by investing across plenty of regions, sectors, and company types. That way, losses in one area can be offset by gains elsewhere, meaning your portfolio’s value won’t swing around wildly. You might also find it helpful to invest little and often. By investing a small amount each month – a.k.a. “dollar-cost averaging” – instead of a single lump sum, you’ll likely be less reactive to short-term shocks and more focused on the long term instead.
This guide was produced by Finimize in partnership with TradeStation.
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Disclaimer: These articles are provided for information purposes only. Occasionally, an opinion about whether to buy or sell a specific investment may be provided. The content is not intended to be a personal recommendation to buy or sell any financial instrument or product, or to adopt any investment strategy as it is not provided based on an assessment of your investing knowledge and experience, your financial situation or your investment objectives. The value of your investments, and the income derived from them, may go down as well as up. You may not get back all the money that you invest. The investments referred to in this article may not be suitable for all investors, and if in doubt, an investor should seek advice from a qualified investment advisor.