A Quick Guide to Basic Stock Terms

After Hours is an editorial column more loosely covering our thoughts on a variety of topics in finance.

What is a stock?

A stock is a security (a tradable financial asset) representing a share of ownership in a business. A stock is sometimes also called a “share” or “equity”.

A person who buys shares of stock in a business is a “stockholder” of the business. Through his equity stake, the stockholder gains a say in a business’ operations and claims on its residual cashflows (essentially whatever money is left after expenses and debts have been paid).

Businesses need money to operate. Businesses need money to grow. Although, in theory, businesses can choose to get this money from their own operations, they can also choose to raise money through debt financing (by taking out loans or issuing bonds) or equity financing (by offering shares of stock).

What is debt financing?

Debt financing is when a business borrows money from banks (through a loan) or investors (through a bond issuance). The business promises to pay back the money he has borrowed plus interest. Sometimes, the business is also asked to put up some of its own assets as collateral in case it defaults. If a business is having trouble paying down a loan, lenders could potentially run after its assets to cover what they lent out. However, when a business takes out a loan, it sacrifices nothing in terms of ownership and it is only expected to pay back the principal on the loan plus interest.

What is equity financing?

Equity financing is when a business sells shares of its own stock to investors. A business is then able to raise money from the new capital put up by new investors. A business is not liable to pay back equity investors in the event of a collapse. However, what equity investors sacrifice in terms of safety of capital can be richly rewarded when a business does well. This is because equity investors gain a claim on a business’ residual cashflows in exchange for the capital they put up.

In raising money from equity investors, businesses can offer common stocks or preferred stocks.

What is a common stock?

A common stock is a stock in its most traditional sense. An investor who buys common stock gains ownership in a company and the possibility of dividends (when a business distributes a part of its profits to equity investors). In effect, common stocks allow for full participation in a business’ success but also full participation in the event it fails.

What is a preferred stock?

A preferred stock is a sort of cross between a common stock and a bond. An investor who buys preferred stock is paid a more secured and predictable dividend than one who buys common stock (assuming of course that the company has enough cash to do so). This is because a preferred stock investor is paid his cashflows before the common stock investor. (Although the company must, of course, pay lenders before preferred stock investors.) However, preferred stock investors do not gain any real control of a business and they usually don’t earn anything beyond the dividends promised to them. A business is also not necessarily required to redeem (buy back) its preferred stocks to cover the capital put up by preferred stock investors.

How do I use a stock screen?

After Hours is an editorial column more loosely covering our opinions on a variety of topics in finance.

The ugly truth is that it is impossible to go through the financial statements of all available companies in the world’s stock exchanges. There is just not enough time. And although the potential for reward could be higher if you sift through each and every one, that would still mean sifting through a lot of dirt.

This is where stock screening comes in. It’s just easier and more straightforward. You pick a few criteria, making sure none are too restrictive, and then you exclude any stocks that do not meet this criteria. It is neither the most graceful practice nor the most thorough, but it quickly cuts down your universe of stocks to a smaller, more manageable group.

We have adapted some criteria borrowed from Chapter 14 (“Stock Selection for the Defensive Investor”) of Benjamin Graham’s The Intelligent Investor to serve as a starting point for any who wish to employ stock screening into their investment research process.

  1. Debt-to-Equity Ratio must be less than 1.0.
  2. Total Debt-to-Net Working Capital Ratio must be less than 1.0.
  3. Current Ratio must be more than 2.0.
  4. Company must have consistently paid out annual dividends over the last ten (10) years.
  5. Net Income must have grown by at least 33% compared to ten (10) years prior.
  6. Price-to-Earnings Ratio must be less than 15.0.
  7. Price-to-Book Ratio must be less than 1.5.

7 Peter Lynch Quotes on Investing

During his thirteen-year stint as manager of the Fidelity Magellan Fund from 1977 to 1990, Peter Lynch managed to post 29.2% in average annual return, cleanly beating the S&P 500 stock market index by more than double over the same period. This phenomenal track record effectively cemented his position as one of history’s greatest investors.

Although also a proponent of value investing, Peter Lynch seemed more an advocate of straightforward fundamental analysis as a practice. He insisted on only investing in what you know which often meant performing the necessary legwork to research companies as thoroughly as possible.

More recently, Peter Lynch has commented on the “mistake” of passive investing, citing that he believes active investors have beat the market for years and would continue to do so.

In line with this, we have collected seven of our favorite Peter Lynch quotes on investing below.

“Stocks are not lottery tickets. There’s a company behind every stock. The company does well, the stock does well.”

Peter Lynch

Neat’s Notes: In the words of our lord and savior Lou Mannheim (Wall Street, 1987): “Stick to the fundamentals. That’s how IBM and Hilton were built. Good things sometimes take time.”

“If you spend fourteen minutes a year on economics, you’ve wasted twelve minutes.”

Peter Lynch

Neat’s Notes: Lynch makes reference to economics “in the broad scale” in which one attempts to discern uptrends or downtrends in whatever aspect of the economy. Lynch largely wanted to avoid “economic predictions”, preferring to stick to “economic facts” which meant actual numbers measuring things that have actually happened.

“If you can’t explain to a ten-year-old in two minutes or less why you own a stock, you shouldn’t own it.”

Peter Lynch

Neat’s Notes: In the words of whomever: “Keep it simple, stupid!”.

“You can take advantage of the volatility in the market if you understand what you own.”

Peter Lynch

Neat’s Notes: Lynch also pointed out that if a stock went down by a lot from when you bought it, you would be in a better place to know the best thing to do if you understood what you owned as opposed to, say, quickly selling out in a panic.

“You can’t get too attached to a stock. The stock does not know you own it.”

Peter Lynch

Neat’s Notes: Yes.

“Avoid long shots. I bought about thirty long shots in my life. I’ve never broken even on one.”

Peter Lynch

Neat’s Notes: We would also like to add that it is usually unwise to go headlong into something without conducting at least some sufficient amount of personal research.

“It’s always gonna be scary, there’s always gonna be something to worry about, and you just have to forget all about it. Cut it all out and own good companies and turnarounds. Study them and you’ll do well.”

Peter Lynch

Neat’s Notes: We think this quote best encapsulates Peter Lynch’s whole mindset with regards to investing. Simple and no nonsense. We also hope it can help guide you towards achieving 29.2% average annual returns over the next thirteen years.

Peter Lynch’s 1994 lecture on investing may also be of interest to those keen on getting more stock-picking tips from the man himself. We at Neat’s have watched it 3,906,483,290 times—still substantially less than the USD14.0 billion Lynch was managing at one point for the Fidelity Magellan Fund.