The value of a stock is in its ability to create a return, to create income or a gain in value for the investor. With common stock, the income is in the form of a dividend, which the company is not obligated to pay. The potential gain is determined by estimations of the future value of the stock.
If you knew that the future value would likely be more than the current market price—over your transaction costs, tax consequences, and opportunity cost—then you would buy the stock.
If you thought the future value would be less, you would short the stock (borrow it to sell with the intent of buying it back when its price falls), or you would just look for another investment.
Every investor wants to know what a stock will be worth, which is why so many stock analysts spend so much time estimating future value. Equity analysis is the process of gathering as much information as possible and making the most educated guesses.
Corporations exist to make profit for the owners. The better a corporation is at doing that, the more valuable it is, and the more valuable are its shares. A company also needs to increase earnings, or grow, because the global economy is competitive. A corporation’s future value depends on its ability to create and grow earnings.
That ability depends on many factors. Some factors are company-specific, some are specific to the industry or sector, and some are macroeconomic forces. Chapter 12 "Investing" discussed these factors in terms of the risk that a stock creates for the investor. The risk is that the company will not be able to earn the expected profit.
A company’s size is an indicator of its earnings and growth potential. Size may correlate with age. A large company typically is more mature than a smaller one, for example. A larger company may have achieved economies of scale or may have gotten large by eliminating competitors or dominating its market. Size in itself is not an indicator of success, but similarly sized companies tend to have similar earnings growth.E. F. Fama and K. R. French, “The Cross-section of Expected Stock Returns,” Journal of Finance 47 (1992): 427–86.
Companies are usually referred to by the size of their market capitalization or market cap, that is, the current market value of the debt and equity they use to finance their assets. Common market cap categories are the sizes micro, small, mid (medium), and large, or
The market capitalization of a company—along with industry and economic indicators—is a valuable indicator of earnings potential.
The economist John Maynard Keynes (1883–1946) famously compared the securities markets with a newspaper beauty contest. You “won” not because you could pick the prettiest contestant, but because you could pick the contestant that everyone else would pick as the prettiest contestant. In other words, the stock market is a popularity contest, but the “best” stock was not necessarily the most popular.
Keynes described investing in the stock market as follows:
“The smart player recognizes that personal criteria of beauty are irrelevant in determining the contest winner. A better strategy is to select those faces the other players are likely to fancy. This logic tends to snowball. After all, the other participants are likely to play the game with at least as keen a perception. Thus, the optimal strategy is not to pick those faces the player thinks are prettiest, or those the other players are likely to fancy, but rather to predict what the average opinion is likely to be about what the average opinion will be.”Burton G. Malkiel, A Random Walk Down Wall Street (New York: W. W. Norton & Company, Inc., 2007).
In the stock market, the forces of supply and demand determine stock prices. The more demand or popularity there is for a company’s stock, the higher its price will go (unless the company issues more shares). A stock is popular, and thus in greater demand, if it is thought to be more valuable—that is, if it has more earnings and growth potential.
Sometimes a company is under- or overpriced relative to the going price for similar companies. If the market recognizes the “error,” the stock price should rise or fall as it “corrects” itself.
A growth stockA stock that is expected to offer excessive rates of growth. is a stock that promises a higher rate of return because the market has underestimated its growth potential. A value stockA stock whose return is based on its current underpricing by the market. is a stock that has been underpriced for some other reason. For example, investors may be wary of the outlook for its industry. Because it is underpriced, a value stock is expected to provide a higher-than-average return.
Stocks may be characterized by the role that they play in a diversified portfolio—and some by their colorful names—as shown in Table 15.1 "Definitions of Stocks and their Roles in a Portfolio".
Table 15.1 Definitions of Stocks and their Roles in a Portfolio
| Definition | Role | |
|---|---|---|
| Growth stock | Underestimated potential for growth. | Expect a higher rate of return. |
| Value stock | Undervalued by the market; underpriced. | Expect a higher-than-average return. |
| Defensive stockA stock with very little volatility that is relatively insensitive to market moves. | Less volatility than the overall market and less sensitive to market changes. | Expect the value to fall less than the market’s during a market decline. |
| Cyclical stockA stock that will move with the market but with more volatility. | More volatility than the overall market and more sensitive to market changes. | When the market rises, expect the price to rise at a higher rate. When the market falls, expect the price to fall at a higher rate. |
| Speculative stockA stock promising excessive value that may already be overvalued. | Overvalued by the market; overpriced. | Expect the price to continue rising for a time before it falls. |
| Blue chip stockStock of a corporation with a history of providing steady returns. | Stock of a stable, well-established, large cap company. | Expect stable returns. |
| Widow-and-orphan stockA blue chip stock that offers a reliable dividend. | A blue chip defensive stock. | Expect a steady dividend. |
| Wallflower stockA stock whose value is overlooked by the market. | Overlooked and therefore underpriced. | Expect the value to rise when the stock is “discovered.” |
| Penny stockThe stock of a corporation with low market capitalization; the stock has a low price (usually less than one dollar) and high volatility. | Low-priced stock of a small or micro cap company. | Expect the value to rise if and when the company succeeds. |
Each term in Table 15.1 "Definitions of Stocks and their Roles in a Portfolio" names a stock’s relationship to the market and to investors. For example, an investor who wants to invest in stocks but wants to minimize economic risk would include defensive stocks such as Boeing (a large military contractor) in the stock portfolio along with some blue chips, such as Coca Cola or Proctor and Gamble. Implicit is its potential for price growth, risk, or role in a diversified portfolio.
Stocks can be characterized by their expected behavior relative to the market as
