your company is successful, compare its net worth with the net worth from the same point a year earlier. A firm that has a $4 million net worth on December 31, 2020, and a $5 million net worth on December 31, 2021, is doing well; its net worth has gone up 25 percent ($1 million) in one year.
Income minus expenses equals net income. In other words, take what you make (your income), subtract what you spend (your expenses), and the remainder is your net income (or net profit or net earnings — your gain).A company’s profitability is the whole point of investing in its stock. As it profits, the business becomes more valuable, and in turn, its stock price becomes more valuable. To discover a firm’s net income, look at its income statement. Try to determine whether the company uses its gains wisely, either by reinvesting them for continued growth or by paying down debt.
Do a comparative financial analysis. That’s a mouthful, but it’s just a fancy way of saying how a company is doing now compared with something else (like a prior period or a similar company).If you know that the company you’re looking at had a net income of $50,000 for the year, you may ask, “Is that good or bad?” Obviously, making a net profit is good, but you also need to know whether it’s good compared to something else. If the company had a net profit of $40,000 the year before, you know that the company’s profitability is improving. But if a similar company had a net profit of $100,000 the year before and in the current year is making $50,000, then you may want to either avoid the company making the lesser profit or see what (if anything) went wrong with the company making less.
Accounting can be this simple. If you understand these three basic points, you’re ahead of the curve (in stock investing as well as in your personal finances). For more information on how to use a company’s financial statements to pick good stocks, see Chapter 4 in Book 3.
Understanding how economics affects stocks
Economics. Double ugh! No, you aren’t required to understand “the inelasticity of demand aggregates” (thank heavens!) or “marginal utility” (say what?). But a working knowledge of basic economics is crucial to your success and proficiency as a stock investor. The stock market and the economy are joined at the hip. The good (or bad) things that happen to one have a direct effect on the other. The following sections give you the lowdown.
Getting the hang of the basic concepts
Supply and demand: How can anyone possibly think about economics without thinking of the ageless concept of supply and demand? Supply and demand can be simply stated as the relationship between what’s available (the supply) and what people want and are willing to pay for (the demand). This equation is the main engine of economic activity and is extremely important for your stock investing analysis and decision-making process. Do you really want to buy stock in a company that makes elephant-foot umbrella stands if you find out that the company has an oversupply and nobody wants to buy them anyway?
Cause and effect: If you pick up a prominent news report and read, “Companies in the table industry are expecting plummeting sales,” do you rush out and invest in companies that sell chairs or manufacture tablecloths? Considering cause and effect is an exercise in logical thinking, and logic is a major component of sound economic thought.When you read business news, play it out in your mind. What good (or bad) can logically be expected given a certain event or situation? If you’re looking for an effect (“I want a stock price that keeps increasing”), you also want to understand the cause. Here are some typical events that can cause a stock’s price to rise:Positive news reports about a company: The news may report that the company is enjoying success with increased sales or a new product.Positive news reports about a company’s industry: The media may be highlighting that the industry is poised to do well.Positive news reports about a company’s customers: Maybe your company is in industry A, but its customers are in industry B. If you see good news about industry B, that may be good news for your stock.Negative news reports about a company’s competitors: If the competitors are in trouble, their customers may seek alternatives to buy from, including your company.
Economic effects from government actions: Political and governmental actions have economic consequences. As a matter of fact, nothing has a greater effect on investing and economics than government. Government actions usually manifest themselves as taxes, laws, or regulations. They also can take on a more ominous appearance, such as war or the threat of war. Government can willfully (or even accidentally) cause a company to go bankrupt, disrupt an entire industry, or even cause a depression. Government controls the money supply, credit, and all public securities markets.
Gaining insight from past mistakes
Because most investors ignored some basic observations about economics in the late 1990s, they subsequently lost trillions in their stock portfolios during 2000–2002. During 2000–2008, the United States experienced the greatest expansion of total debt in history, coupled with a record expansion of the money supply. The Federal Reserve (or “the Fed”), the U.S. government’s central bank, controls both. This growth of debt and money supply resulted in more consumer (and corporate) borrowing, spending, and investing. The debt and spending that hyperstimulated the stock market during the late 1990s (stocks rose 25 percent per year for five straight years during that time period) came back with a vengeance afterwards.
When the stock market bubble popped during 2000–2002, it was soon replaced with the housing bubble, which popped during 2005–2006. And February 2020 witnessed a major correction (the Dow Jones industrials, for example, fell over 11 percent during the five trading days ending February 28) over fears due to the coronavirus.
Of course, you should always be happy to earn 25 percent per year with your investments, but such a return can’t be sustained and encourages speculation. In the end, spending started to slow down because consumers and businesses became too indebted. This slowdown in turn caused the sales of goods and services to taper off. Companies were left with too much overhead, capacity, and debt because they had expanded too eagerly. At this point, businesses were caught in a financial bind. Too much debt and too many expenses in a slowing economy mean one thing: Profits shrink or disappear. To stay in business, companies had to do the logical thing — cut expenses. What’s usually the biggest expense for companies? People! Many companies started laying off employees. As a result, consumer spending dropped further because more people were either laid off or had second thoughts about their own job security.
As people had little in the way of savings and too much in the way of debt, they had to sell their stock to pay their bills. This trend was a major reason that stocks started to fall in 2000. Earnings started to drop because of shrinking sales from a sputtering economy. As earnings fell, stock prices also fell.
With some hiccups along the way, the stock market has solidly zigzagged upward since the early 2000s, and the Dow Jones breached the 29,000 level in early 2020, but investors should be just as wary when the market is at nosebleed levels as they are when bear markets hit because market highs tend to be followed by the next bear market or downward move. Stock markets in February 2020 did correct painfully (a fall of 10 percent or more is a correction; a bear market is 20 percent or more), and they offered a buying opportunity for value-oriented investors.
