By Wylan Mancogna and Jacob Mondek
MAR 15, 2018
Throughout America’s history, the stock market has frequently fluctuated based on investors buying and selling shares. St. Thomas Aquinas High School’s (STA) AP Economics teacher Mr. Rob Williams explained that, “Companies sell shares to investment banks, who then sell shares to customers.” Stocks are sources of capital for companies, which makes them valuable for business growth. According to Zacks.com, stocks represent ownership interest in companies and are important to individuals and businesses. A stock can be either undervalued or overvalued. An overvalued stock is a stock that is trading for value not justified by its financial performance. An undervalued stock is a stock that is selling substantially below its potential value based on measurable factors such as cash flow. Recently though, the American stock market has experienced record breaking highs followed by swift downswings. According to The Balance.com “… the Dow Jones Industrial Average highest closing record is 26,616.71 set on January 26, 2018.”
Stocks are leading indicators of how well a company is doing, such as whether it is over or undervalued. An example would be Amazon, whose stock is currently 25 times overvalued. Mr. Williams also explained that the traditional Standards & Poor’s (S&P) 500 price to earnings multiple would be from 16 to 18, and anything above 20 could be considered overvalued. Having a price multiple of anything above 20 could lead to a correction in the price of the company’s stock unless the company is growing its earnings and revenue to support a multiple expansion. A correction is when the stock value drops because it has been overvalued.
According to NASDAQ.com, the technical term for determining a company’s financial performance is Earnings Per Share (EPS). EPS is calculated by dividing a company’s net income by its number of common outstanding shares. Net income is the income after taxes. EPS is used as a key performance indicator of companies because it is a way for stockholders to know the financial health of the business. The higher the EPS, the better. For example, if a company has a net income of $35,000 and 14,000 shares of common stock, the EPS would be $2.50.
There are a variety of emotional factors that affect buying and selling shares. Emotional components that may influence a novice or even reputable trader, and/or broker, could be confidence and greed. Confidence is good when the market is profitable but when overconfident one may be susceptible to liquidating their assets too soon or too late causing them to lose money. When buying or selling stocks correctly, one could make immense profits. However, greed and/or a lack of market analysis and understanding can cause unnecessary stress, anger, and other negative results. Investing successfully adds to a person’s financial stability and could lead to financial independence.
Regardless of whether you’re buying or selling stocks, it is crucial to become familiar with terminology and metrics used throughout the investment world. It is also essential to recognize when companies are undervalued or overvalued in order to understand when it is best to buy and sell. Beware of the pitfalls of emotion-based trading, which may result in poor judgement and serious losses. Dollar cost averaging, investing in core positions consistently over time and investing in diversified groups of sectors is the best way to avoid risks, as well as potentially harmful emotions.