Stock Learning Center | Stock Indexes | Rate of Return
Sources of Information | Stock Research | Glossary | Home
Before you buy any shares of stock of a company, you should do your homework because you are actually buying a share of a business. For example, buying shares of IBM will get you into the computer business; shares of Coke will get you into the soft drink business. Doing research in the stock market is like finding information for a school research paper. The steps in analyzing stock are
"How's the market doing?" If you’re a typical stock investor, you’d answer, "It’s up ten points today." Most stock investors know that you are referring to the Dow-Jones Industrial Average (DJIA Index) being up ten points, say from 5000 to 5010.
At one hundred years old, the Dow is the most well-known stock index (yardstick) in the world. What is the Dow? The Dow is an average of thirty bellwether stocks listed in the New York Stock Exchange (NYSE). What does the Dow do? The Dow is a yardstick by which the public can measure the overall performance of the stock market in the United States. The value of the Dow Index started at 86 in 1885 and surpassed 5,000 in November 1995.
Each of the thirty Dow stocks is made of large (blue-chip) companies such as IBM, GE, AT&T, Coke, Disney, and McDonalds, which represent different segments of the economy such as food, computers, and entertainment. Together, these thirty companies represent the US stock market as a whole.
The Dow also has two sisters: the Dow Jones Transportation Index and the Dow Jones Utilities Index. These indexes are the bellwether indicators for the transportation and utility sectors of the US economy.
Standard & Poor’s Corporation has developed an S & P 500 index, which is a benchmark widely used by professional stock investors. Of the 500 stocks in the index, 425 are industrials, 25 are railroads, and 50 are utility companies. It is interesting to note that the software giant, Microsoft, was an S & P newcomer in 1994.
The New York Stock Exchange Index measures the price movement of all common stocks on the NYSE. It also tracks the performance of four subgroups: utility, finance, transportation, and industrial.
The NASDAQ Index measures price movement of all domestic common stocks listed on the NASDAQ, the computer network stock exchange. The index also contains six industry indexes: industrial, bank, insurance, other finance, utility, and transportation.
The AMEX index measures the price movement of all common stocks on the American Stock Exchange.
The Russell 2000 measures the price movement of 2,000 small companies.
Wilshire Associates in Santa Monica, California, has compiled the largest comprehensive index of nearly 7,000 stocks. The S & P 500 Index comprises about seventy percent of the value of the stocks in the Wilshire 5000.
Note : Although these popular stock indexes are convenient yardsticks for measuring movement of the market, they do not account for the reinvestment of dividends. A stock investor should include the reinvested dividends to judge the total return of his stock investments in the long-run.
Let's say you invest $100 in stock, which is called your capital. One year later, your investment yields $110. What is the rate of return of your investment? We calculate it by using the following formula:
((Return - Capital) / Capital) × 100% = Rate of Return
Therefore,
(($110 - $100) / $100) × 100% = 10%
Your rate of return is 10%.
There are two ways to measure the rate of return on an investment.
You initially invest $100. One year later, your investment grows to $200 in value. The year after that, the investment drops back to $100. The rate of return after the first year is
((Return - Capital) / Capital) × 100% = Rate of Return
(($200 - $100) / $100) × 100% = 100%
The rate of return after the second year is
(($100 - $200) / $200) × 100% = -50%
By using the formulas for calculating the average annual rate of return, we get a percentage that measures gains accurately over only a short period. Whereas, the geometric or compound rate of return is a better yardstick to measure your investment over the long run. The arithmetic mean or average return should be used to calculate return on investment only in the short-term.
Note : Mutual fund managers report the average annual rate of return (arithmetic) on the investments they manage. As shown in the above example, the arithmetic return of the investment is 25%, even though the value of the investment is the same as it was two years ago. Thus, mutual fund reports are somewhat deceptive.
Sources of information for market analysis will help you understand the overall economic factors affecting corporate earnings and growth, which in turn move stock prices in the long run. These include the following, which we'll detail:
The most useful daily publications include
The most useful weekly publications are
The most widely used services are
The major publications of the US Department of Commerce include
Two major publications of the Bureau of Labor statistics are
The Federal Reserve publications are
The information for company analysis can be obtained from the company’s quarterly reports, annual reports, and news releases. In addition, companies have to file quarterly reports called 10-Q's and annual reports called 10-K's to the Securities Exchange Commission (SEC); these are available to the general public.
Any initial public offering (IPO) signifies a time when companies first issue stock to the public. As required by the SEC, the company must publish a detailed prospectus that includes information about the company, its products, its officers, its financial status, and any risk factors that may negatively affect its business. You can write or call the brokerage firm that represents these companies for a free copy of their prospectuses. The prospectus of an IPO offers the most comprehensive information about a new company.
Brokerage Firms' Research Reports
Major full-service brokerage firms such as Merrill Lynch employ stock analysts, who specialize in certain industries or companies. They offer buy or sell recommendations for various stocks. They also publish in-depth reports on industries or companies. You can get copies of these reports for a fee from a brokerage firm or you can get a copy if you have an account at that brokerage firm. Some of these reports are also available on the Internet.
You can find most of these resources in the public libraries. Ask the librarian for help since each library has resources in different places. Some of these resources are available on the Internet, which we will discuss later in Stocks in Cyberspace.
There are three basic tools you can use to narrow your research on the companies in which you will ultimately invest:
To become a stock investor, you should start reading the business section of the daily newspaper. The financial section generally covers business news, featuring articles on industries, companies, and economic trends such as inflation, unemployment, and interest rates. In addition, the business section publishes stock tables summarizing the previous day’s trading activities. A typical stock table appears like this:
| 1 | 2 | 3 | 4 | 5 | 6 | 7 | 8 | 9 | |||
| 52 Weeks | Yld | Vol | Net | ||||||||
| Hi | Lo | Stock | Sym | Div | (%) | P/E | 100s | Hi | Lo | Close | Chg |
| 47.88 | 30.63 | Coca-Cola | KO | 0.5 | 1.1 | 37 | 22907 | 46.50 | 45.75 | 45.75 | -0.63 |
Using Coke as an example, we can read the table as follows:
Although you don’t have to be an accounting major before you invest in stock, you should learn how to read a company annual report, a report written annually about the company's operations. Most companies put their best face on in their annual report, distributing the report to shareholders and the general public on request. You can call, write, or e-mail the company for a copy of the annual report, even though you are not a shareholder. A typical annual report starts with a letter to the shareholders from the chief executive officer (CEO) of the company. In this letter, the CEO highlights the accomplishments, explains difficulties, and lays out future plans for the business. The rest of the report, interspersed with color photos, gives a more detailed discussion of the company’s operations.
No matter what the CEO says, the numbers and the financial charts in the report tell a more realistic story.
Value Line gives a one-page comprehensive analysis on each of its 1,700 companies. Along with statistics going back fifteen years and projections going forward two years, Value Line offers what it calls a "timeliness" rating, how well it thinks the stock will do in the next year, from one to five for each company. Only one hundred stocks receive a "1" rating at any time, the "1" stocks being those that have returned an average of 18.4% from 1980 to 1995. Value Line's "1" companies have outperformed the market represented by the S & P 500 Index (average return of 11%) by a wide margin.
You can find the Value Line Investment Survey in most local libraries. The write up of each of the 1,700 companies along with their industry group is updated every three months. To learn how to use Value Line as a tool in picking stocks, click here.