– how shares are classified
– important concepts in order to understand the stock market
– how to calculate the value of stocks and shares
In this lesson, we’ll cover concepts such as chips, caps, and sectors.
Chips: can mean a variety of things – company size, business or country – depending on the type of chip you’re talking about.
Sector: refers to the type of industry in which a company operates.
A single company can be classified in several different ways. For example, British Airways is a blue chip company, a large cap company and operates within the travel and tourism sector. So each term represents a classification of different companies grouped together by similar traits.
This metaphor originally referred to the different colored chips in a casino. Blue chips had the highest value so the term blue chip is used to refer to the highest value companies. Since then, other chips have been introduced that have very different meanings.
– Blue Chip: large, highly valued companies able to easily withstand market shocks and fluctuations. Safe for investing with limited risk but also with limited growth potential.
– Green Chip: companies that work in green energy, sustainable products and services, or whose primary operations are otherwise associated with environmentalism.
– Red Chip: any Chinese company listed in an exchange outside China.
– Purple Chip: large, Chinese companies listed outside China (blue + red chip).
A company’s cap refers to its market capitalization, which is the total market value of all issued shares. Companies are categorized by their total value into five primary categories:
· Large cap: total market capitalization of $10 billion or more
· Mid cap: total market capitalization between $2-10 billion
· Small cap: total market capitalization of less than $2 billion
· Micro cap: total market capitalization between $50 million and $300 million
· Nano cap: total market capitalization of less than $50 million
Multiply the number of shares issued by the market price per share. So if a company has 100 million shares in issue and each sells for $20, total market capitalization would be $2 billion. In this example, the company would thus be mid cap.
Investors monitor market capitalization as it provides a reference point for the amount of potential risk and return associated with an organization. The larger a company’s market capitalization, the more likely it is to be viewed as a lower-risk company that will sustain its value and possibly pay dividends. Smaller market cap companies tend to be higher risk but have greater potential for fast growth.
The sector in which a company operates refers to its primary industry. Different sectors respond differently to external economic conditions, seasonal trends and other variables so knowing the sector a company operates in as well as the variables that influence the price and performance of the companies in that sector can be helpful.
Some of the most common sectors are: automotive, consumer goods, energy, financial, healthcare, hospitality, industrial, infrastructure, technology, and telecom.
In corporate finance, bulls and bears are used as metaphors for what the stock market is doing at any given point in time.
– Bullish: the stock market is increasing in value.
– Bearish: the stock market is decreasing in value.
No criteria exist for how much the stock market must change in value but the implication is that the change is significant enough to warrant that investors consider altering their investing strategy as a result.
A share index is an average that is monitored by investors to get an idea of what’s happening in the overall stock market. Each index is typically calculated using some form of weighted average that takes several different companies, weighs them using its preferred method and then takes the market value of the weighted average measured by the prices of the underlying stocks and shares.
Each index uses its own method for calculating averages for different types of companies, different sizes of companies and so on.
Some examples of indices are:
– FTSE 100: a share index of the 100 companies listed on the London Stock Exchange with the highest market capitalization.
– S&P 500: a composite of 500 companies chosen by Standard and Poor’s.
– NASDAQ: it has 12 different indices, each focusing on a different sector or market capitalization.
No index includes all the stocks and shares from a particular nation. Instead, each attempts to provide an average idea of what the overall stock market is doing, as well as what individual categories of stocks and shares are doing.
Many people prefer to look at an individual company to assess its financial and competitive performance. Others look at the performance of entire sectors and then simply choose one or more companies from a sector that appears to be doing well given the current economic conditions. Many investors, particularly traders, watch for fluctuations in the total stock market, hoping to generate earnings by taking advantage of intervals in price over time.
Three primary categories of equity valuation models exist:
1) Absolute Models
Sometimes called intrinsic models, these look for the value of the company itself, seeking to find a measure that can capture the exact value of each company. These models include the following:
– dividend discount model: attempts to use the present discounted value of future dividends to value the price of a share.
– liquidation value: the total of the revenues achievable from selling all the company’s assets after paying back liabilities. This is used as a price floor for total market capitalization.
– free cash flow method: estimates cash flows to the firm and to equity, to estimate both fair price and growth rates.
Sometimes called extrinsic models, these intend to understand how the price and value of a company can be assessed by looking at variables that are influenced by things outside the organization’s control such as share price, other companies in the sector and the performance of a company relative to economic and market performance ratios.
Common values included in these models are earnings per share, the P/E (price to earnings) ratio and market responsiveness.
These models tend to be more complex but only in the sense that they attempt to use methods employed by both absolute and relative models. Often they attempt to find differentials in the intrinsic and extrinsic values.
Corporate analysis is one of the primary methods of determining the value of stocks and shares because the value of the underlying company contributes to the value of the shares. A number of different methods are used to analyze corporate performance.
In the long term, the price of shares tends to float around the assessed value of the company, coming down eventually if it’s too high or getting recognized eventually if it’s a good bargain, driving prices back up again.
Each industry responds differently and at different times to different variables. Understanding how each sector responds to cycles and policies in the economy is important for traders and investors alike.
For example, during a recession, companies that work in consumer goods tend to see a boost in share prices because demand for these goods doesn’t decrease greatly. People give up other, more discretionary goods in order to get the things they need.
After you establish the relationship between a sector and other sectors in the economy, you can start to evaluate the sector itself. Things to consider:
– How many competitors exist in this sector?
– What makes the successful firms more competitive?
– What are the risks of new entrants into the market?
– How is the industry as a whole changing over time?
As you know, macroeconomics is the study of large-scale, collective economic management. It’s usually related to the national economy or other issues involving an aggregate of smaller economic entities.
Let’s quickly recap some of the macroeconomic influences on performance, value and price:
· Business Cycle: two or more progressive quarters of negative GDP growth is the current definition of a recession, which is one of the four parts of the business cycle – the others being recovery, boom and slump. The rate of change in growth that an economy experiences changes stocks and share prices.
· Employment: the ratio of people who have jobs compared to the total workforce. Unemployment is the ratio of people who don’t have jobs compared to the total workforce. High unemployment tends to harm stocks and share prices.
· Inflation: a change in the purchasing power of a currency, meaning that you need more money to purchase an equal amount of goods. High inflation tends to slow stock market value growth.
· Fiscal policy: refers to any issues related to taxation and government spending. The influence of these policies on stock and share prices depends on the specifics of the policy. Increases in spending help those companies who receive the government funds. Even the impact of higher taxation depends greatly on who’s being taxed.