How Do Stocks Work? And Other Stock Market for Beginner Questions

Posted on May 19, 2021 |

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Know How Stocks Work and What to Consider Before Buying Stocks That Make More Money!

It turns out, investing in stocks is more than just scrolling through a bunch of memes on Facebook. Who Knew, right?

Stocks or Stonks, Shares or Equities. Whatever you want to call them, in this video, I’m going to give you a step by step to investing in stocks from how investing works to comparing stocks and the five questions to ask before buying your next stock.

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How to Invest in Stocks to Get You Started Making Money

Nation, I am loving this series on how to invest. We started last video with how to invest your money, looking at the different investments and returns. In this video, we’re going deeper into how to invest in stocks to get you started making money in the stock market!

And there is no better way to make your money work for you! I’ll show you how investing works to make money along with how to compare stocks and then take you step-by-step to picking stocks to buy! Towards the video, as a bonus, I’ll also reveal a five-point checklist to buying stocks. The five questions you need to ask yourself before you buy a single share of stock!

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The video is part of a four-part series in partnership with The Motley Fool to help you get started investing. I’ll be putting all four videos into a special playlist on the channel called ‘Ultimate Guide to Start Investing'.

As a bonus, I’m going to help get you started with a free report, The Top 5 Stocks in My Own Portfolio! These are the five biggest stock positions I’m holding, stocks to benefit from the biggest trends over the next decade.

It’s an exclusive report only available through the link I’ll leave in the video description below. I won’t be sharing these in a video so click through and get your free report.

Stock Market Basics You Need to Learn Before Investing

We’re going to start with the basics here like what are stocks and how does investing work to make money but I’ll leave a clickable index in the video description if you want to skip around.

Stocks are an actual ownership of a company, even if it’s just a one-millionth share of the company, it is a right to all the future cash flows distributed to investors. This is more important than most investors understand. Investors get so excited about stocks, how fast the share price can rise sometimes, that they don’t even consider the company behind it. In fact, one of the greatest investment managers, Peter Lynch said, It’s easy to forget sometimes, a share is not a lottery ticket, it’s a part-ownership of a business.

So yeah, you can take your chances, invest along with this guy and hope your stock becomes an internet meme but that’s the lottery ticket mentality. Eventually the dice are going to land on snake eyes and that type of investing is going to crap out.

How investing really works to make money is by finding the best companies in their industries and becoming an owner, riding the company’s competitive advantage to higher profits and dividends.

The 3 Types of Stocks and How They are Different from Each Other

I’m going to show you how to do that, how to compare stocks but first let’s talk about the types of stocks, how they can be separated for comparison.

Because there are over 5,000 stocks traded in the U.S. markets alone, trying to look at all of this at once would make you go cross-eyed…believe me I’ve tried.

So instead, you group stocks into different categories and compare them in those to find the best for your money, the companies that stand above all others.

Let’s look at two of these ways to group stocks then I’ll show you how to compare stocks and first here is going to be by company size or market cap. Market capitalization is the total market value of the shares, so it’s the share price times all the shares available and investors usually think of this in four sizes; Mega-cap companies are those worth more than $300 billion so you’ve got the huge companies like trillion-dollar Apple and Facebook. Large cap companies are pretty big too though with a size from $20 billion to $300 billion. Then you’ve got mid-cap which is generally $2 billion to $20 billion and small cap stocks are $300 million to $2 billion.

And it’s an important distinction because of the different opportunities in each of these levels. Smaller companies have faster growth rates so a lot of times, the stock price has the potential to rise faster but they’re also riskier. Large cap companies are more established and stable but might not have the growth. So picking stocks by market cap can be a great way to dial in how much risk you want in your portfolio.

You can also compare stocks by sectors of the economy, groups of companies that provide a common service or product. Here are the 11 stock sectors, broad groups like financials and consumer discretionary, and within each sector are industries or groups of companies competing in the same product So within the consumer discretionary sector, the third one down on the left here, you have the auto industry, hotels, restaurants, apparel; all those companies making the things that we don’t necessarily need but buy anyway. By comparison, the consumer staples sector is industries like packaged foods, beverages, household and personal products.

Comparing stocks across sectors or even industries is important because a lot of times, you can get a sense of what sectors are going to do better depending on the economy. For example, heading into 2021, I saw that interest rates would be rising, economic growth would boom and inflation could start to be a problem. Going off that, I positioned our Bow Tie Nation portfolio in shares of banks, energy companies and those in the materials sector.

And you can see how it’s paid off with shares of the banks, Citigroup and Wells Fargo up 73% and 60% through April. Energy has gone even further with shares of Diamondback Energy up 175% since last November.

In fact, this is one of my favorite ways to invest, just watching the trends in different sectors then picking the best stocks in those sectors or industries I think can outperform over the next year or two. And it’s so much easier, being able to start at that big picture and focus on just a handful of stocks instead of trying to pick stocks from thousands available in the market.

Now that we have an idea of what to compare, let’s look at how to compare stocks to find the very best in a group or sector.

And as we’re looking at some of the ratios and ways to compare stocks, always remember, you want to be comparing stocks within the same industry or sector. You see, a lot of these ratios are going to be very different across the sectors. For example; the price-to-earnings or PE ratio could be in the 20s or even 30s and higher for fast-growing tech stocks. By comparison, for bank stocks it might be less than 15-times on a price-to-earnings basis.

Now comparing that PE ratio of a tech stock against a bank stock, you’d think the bank stock is hugely cheaper and the better investment but you’re not comparing apples to apples. That bank stock might be expensive compared to other bank stocks and the tech stock could be inexpensive versus other tech stocks. So always use these ratios and stock comparisons against similar companies.

3 Ways to Compare Stocks

I’ll show you three ways to compare stocks and then walk you through an example, and first we start with price multiples like the price-to-earnings ratio.

Price multiples take the company’s share price or its total market cap and compare it to a point in the financials like its earnings or sales or cash flow. It tells you how much investors are paying for that company for its earnings or sales, so what is the cost of the stock for its level of earnings.

For example, if we see Tesla made $0.74 a share last year in earnings and the stock is at $685 per share, then that would be a price-to-earnings ratio of 925-times. We can also look at it on a sales basis, so we see that Tesla has a market cap of $660 billion. Remember, that’s the total value of all the shares in the market and we see that the company made sales of $31.5 billion last year so $660 billion divided by $31.5 billion is 20.95-times on that price-to-sales basis.

Now what you need to remember is that a PE ratio or a price-to-sales ratio alone doesn’t tell you if a stock is cheap or not. You have to compare these ratios against something else to tell you that.

And there are two ways you use the price ratios. First, you can compare them against another stock. So is that 21-times price-to-sales ratio for Tesla more or less expensive versus shares of Ford or GM. You can also compare a company’s price ratios against its own history. Is the 21-times price to sales multiple higher or lower than where Tesla has traded in the past?

Doing this comparison then helps you get an idea if one stock is more or less expensive versus its peers or how the shares are trading versus their own history, are they more or less expensive now than they usually are?

Next here, I like to compare the sales and earnings growth of a company against its competitors.

And this is an important step after using those price multiples because it can go a long way to explain why one stock may look more expensive than others but may still be the better stock to buy.

For example, if we look at Tesla sales over the last few years, we see it’s growing revenue by more than 28% a year. That’s $31.5 billion in sales last year divided by $24.5 billion the year before. We also see that grew its operating income by 24-fold over the last year to almost $2 billion.

So if we compare that to say General Motors which saw an 11% drop in sales last year and operating income growth of just 20%…we see why those sky-high price multiples for Tesla compared to the other automakers might not be so ridiculous.

Finally here, before I show you how to use these to compare stocks and that five-point checklist, is the operating margin or profitability of the company.

And all you out there in the Nation know, this is probably my favorite measure to compare stocks. The operating margin is the operating income divided by revenue. So it’s the sales the company collects on minus its cost of materials and all the operating costs to run the business. So what’s left is the core profitability of the business.

Now you’ll hear a lot of investors talk about the net margin or earnings, that bottom-line profits. I like the operating margin better because it’s the core profitability without the effect of taxes or debt on the earnings.

Now let’s put this analysis in action to compare stocks to buy and I’ll show you how to do it on two stocks, AutoZone, ticker AZO, and O’Reilly Automotive, ticker ORLY.

We’ve got two stocks in the same industry, auto parts suppliers, and I think some positive market forces ahead…but which is the better stock to buy?

For our two stocks, we’ll first go to the statistics tab, and I’ll be using Yahoo Finance here but you can find these on any investing app, so going to AutoZone and scrolling down, we first see that it trades for a price-to-earnings of 19-times and a price of 2.5-times the sales it booked over the last year.

If we scroll further down, we see management is able to produce a profit margin of 20.4% so again that’s the operating income divided by revenue for the operating profitability.

And under the income statement information, we see the company grew revenue by 15.8% and grew earnings by 15.6% in the most recent quarter versus the year before.

Now these numbers are all laid out pretty well but I might double-check them with the company’s financial statements, so actually looking at what it reported in operating income and earnings. I would also want to see what the sales and earnings growth was for the entire year rather than just the quarter.

To compare this against our other stock, O’Reilly, we see that it trades for a price-to-earnings of 21-times and a price of 3.2-times the sales it booked over the last year. So we can already see that AutoZone is the relatively cheaper of the two stocks.

If we scroll further down, we see management is able to produce a profit margin of 22% which is slightly above that of AutoZone but possibly not so high as to justify the shares trading more expensively.

But it’s when we scroll down to the sales and earnings growth for O’Reilly that we see more justification for the higher price ratios. O’Reilly booked nearly 25% sales growth last quarter and earnings that jumped 67% versus the same quarter last year.

So not only is management at O’Reilly Automotive able to turn those sales into higher operating profits but it’s growing sales at a much faster rate. Given those last two measures, the slightly higher PE ratio on shares doesn’t seem as high and I’d actually say O’Reilly would be the better buy at this point.

You’re set to start comparing stocks and investing to make money but I know all this can a lot to take in so I want to bring it all together with a five-step process, five questions really, you can use each time you go to buy a stock.

I’m going to draw on everything we just talked about for a quick and simple checklist to making sure you’re buying the best stocks that are going to make you money!

The first question to ask yourself is, What are the market or big picture trends favoring the broader group of stocks?

So we go back to that idea of starting with the sectors and types of stocks and then stepping back to look at the big picture. Is the economy growing or slowing down? Are investors optimistic about the stock market and what sectors or industries have done well over the past few months?

Part of this is going to mean knowing what the companies in an industry or sector do, just getting to know a little better how an industry like the social media companies or food packaging, how they work and what trends most affect these companies? Once you know that, you can use those bigger picture trends to focus in on the stocks that will benefit the most, narrow down your list of stocks to buy and then pick the best one.

Next here, Is the company growing its revenue and earnings faster than competitors?

Now the best stocks don’t always have to be the ones with the fastest sales growth or the ones blowing the doors off on earnings but it’s a good start. Every company is competing with its peers for a limited market. The ones that can grow their sales faster than the others are clearly demonstrating some kind of an advantage that earns them market share.

Along those same lines, is the company able to generate more operating profit from sales versus competitors?

It does a company no good at all to be booking more sales if it can’t turn those sales into profits, right? And the most critical part of that process from revenue to profits is how a company manages its operating costs, the core expenses it pays to run the business.

Next to those big picture trends driving all the stocks in the sector, this is the most important. A company can have average sales growth, be slightly more expensive than other stocks and everything else can be middle-of-the-road, but if it’s got a top-notch management team that can turn those sales into profits more efficiently…well, that’s like turning lead into gold.

This next question is one of my favorite because you can really find some undiscovered opportunities. What are the potential catalysts for the company?

This one takes a little more research but it’s a great step to take anytime you’re looking at a stock to buy. Here you’re reading articles on the company, you’re reading the most recent earnings report by management, all to the point of trying to get a feel for what’s next for that company.

Nation, this is where you really have the opportunity to make more money in stocks. A lot of what you’re going to find in terms of analysis on stocks is already baked into the stock price. But it’s this kind of, what’s next analysis, that will help you get ahead of the market.

So what products does the company have coming out soon? What is management saying about the company’s trend in market share or profitability? What is that next thing that can boost the stock higher?

With just those four questions, you’ve narrowed your list of stocks to buy. Of the ones remaining, ask yourself, How is each stock’s valuation on a price basis compared to competitors?

Now this doesn’t mean you always have to buy the least expensive stock, the one with the lowest price-to-earnings or price-to-sales ratio. What it means is using this question along with the others to see which stocks are priced fairly.

For example, if you find a company that is just blowing the doors off the competition in terms of sales growth and operating profit margin, then it would make sense that the stock trades at a higher price-to-earnings ratio. That company is going to be growing earnings much faster than its peers so investors should be willing to pay more for the stock.

So this one is going to be more subjective. It’s going to mean looking at everything else you know about the stock and the others in its group, and asking yourself if that price-multiple still makes the shares a good buy.