Investing and the Stock Market for the Lost Gen-Z
“Stonks can only go UP,” scream the plethora of GameStop fanatics on various message boards like Reddit, Twitter, and YahooFinance (of all places). You can’t help but be amazed by these people’s brazen disregard for their own finances. Nintendo Switches purchased by the dozen and donated to children’s hospitals and hundreds of gorillas adopted as a joke only scrape the surface of what this year’s stock market mania has accomplished. Seeing strangers seemingly “win the lottery” on the stock market, you can’t help but think: How can I get in on this too?
With the advent of commission-free (read: free!), mobile stock-trading platforms, such as Robinhood, and borderline-cult communities of advanced and beginner traders, such as WallStreetBets, taking a dip into the market has never been easier. Previous generations could only dream of the accessibility to investing that is offered today: no need to deal with a broker, pay ridiculous commission fees on purchases and sales, or solely rely on a financial advisor. However, there are traders such as ControlTheNarrative (popularly known as “GUH” in online communities) that have shown that brazenly leveraging your entire savings account on a homerun bet is sure to backfire at some point. This article will serve as a guide to you, the Gen-Z retail investor, and help explain some essential concepts of this lucrative hobby. It will describe the differences between early and modern markets, explain and define basic market mechanics, and provide further readings on the subject to help you on your investment journey.
The Early Market
Stock is a term used to represent ownership of a company. Investors are commonly known as stockholders or shareholders. Shareholders own “shares”, or percentages, of a company, effectively representing a percentage of a company’s total revenue and debt. As a company becomes more or less valuable, so too does its stock to better represent its value.
The Dutch East India Co. issued the world’s first paper shares in 1602, allowing investors to conveniently sell, buy, and trade these exchangeable commodities. Almost 200 years later, the market on Wall Street, which has become synonymous with the stock market, opened for business in New York, eventually renaming itself to the New York Stock and Exchange Board in 1817.
Before the advent of the internet, buying and selling stock was a battle of physical endurance. In the 20s, brokers would stand in line, shouting orders and passing paper shares around on a first come, first served basis. News was still predominantly disseminated with newspaper, and at least hours behind current events. The 70s weren’t much better. Investors would call their broker with their order, who would also be pushing their own hard sell to make commission on larger and larger stock purchases.
The Modern Market
Fast forward to modern times, the internet has revolutionized the stock trading landscape. It is now easier than ever to access information on investing and become wealthy without ever needing the guidance of a financial advisor. Buying and selling of stock is now primarily online, allowing you to trade stock from the comfort of your home. The internet has brought forth the rise of the retail investor. As of December 2020, retail investors, or non-professional investors, collectively own over $29 Trillion worth of equity, over 58% of the total U.S. market. This growth has spurred massive advancements and discussion on the future of investing for the average consumer.
Unfortunately, along with the rise in personal freedom in investing due to the internet, investing has now become a battle between individual investors and market-trained, artificial intelligence. Yes, robots control the market. With the click of a button, institutional and corporate investors can trade millions upon millions of U.S. dollars in a fraction of a second. These trading robots scour world news, corporate finance reports, and message boards and leverage decades of trading history and statistical analysis to make the most optimal trades faster than you can Google “Tesla stock price.”
For the modern investor, the odds are stacked against you. Fortunately, they always have been. That’s why there are libraries-worth of literature on how to “beat the market.” Some of those authors have been successful, some not much so. However, by educating yourself, you will at least be better able to make well-informed decisions and not only increase your capital gains but also lower your potential losses. The section below is an extremely brief overview of market terminology and mechanisms.
Supply and Demand
You’ve heard it once, and you’ll hear it again to perpetuity. Supply and Demand is the root of all economics, and by extension, the key to the stock market. As of the writing of this article, Tesla Inc is currently trading at $749.34 per share at a price/earnings (P/E) ratio of 1,175.54, meaning that for every dollar that Tesla earns, the overall market is offering to pay Tesla $1,175.54 for it. On paper that sounds ridiculous. However, when you factor in that Tesla’s share price has grown over 1000% in only the past two years, you realize that you’ve only scraped the surface.
There’s a common saying: the market determines the price of goods. In layman’s terms it means that people are willing to pay for things if they believe that it’s worth it to them. This concept applies to virtually any consumer good, including fashion, artwork, and electronics. Your NBA basketball signed by Michael Jordan could be exactly the same as millions of other basketballs out there, down to the material used and the pattern of the stiching; however, if it’s the exact ball that a collector needs to finish their collection, you know that they’d be willing to pay hundreds or thousands of dollars to buy it from you.
The market operates in much the same way. Except, instead of valuing company stock based on if its signed by Michael Jordan, the market values a company based on its historical performance, financials, growth forecast, and public perception, among other factors. A company’s market cap is a simple measure of how much a company is worth currently. Take a look at the company summary for GameStop:
Conservative perspectives would argue that GameStop is egregiously overvalued at $180 per share; however, that’s only one side of the story. The value of a company is based on how many shares of a corporation that have been authorized, issued and purchased by investors and are held by them, otherwise known as shares outstanding. Multiplying the share price of a company by the shares outstanding gives us the market cap. At 70.77 million shares outstanding, the company’s equity is worth $12.67 billion.
Compare GameStop with one of its biggest brick-and-mortar competitors, Best Buy. At $118.88 per share, one would argue that it’s the obvious, better buy since its ‘cheaper’. Don’t fall into this mistake. Though Best Buy’s $118.88/share is lower than GameStop’s $180/share, at a market cap of $29.73 billion, Best Buy is worth (based on equity) more than double GameStop. At this point, a smart investor would need to consider the growth prospect of both companies. If, theoretically, $40B is the absolute max an electronics brick-and-mortar store can grow to, a $100 investment into Best Buy would net you, at most, $34.54 in profit. However, if GameStop somehow were to grow to $40B to match Best Buy (a growth of about 200%), your $100 investment would net $215.70 profit.
This type of analysis — albeit, grossly simplified — is known as relative valuation. Both relative and absolute valuation methods exist to help an investor find the best company to invest in, based on known factors. Both methods are briefly discussed below.
Company Valuation Methods
The ultimate goal of investing (unless if you’re a short seller) is to purchase a stock when its price is at its lowest and sell once it’s reached as high of a price as it can go, otherwise known as buying high and selling low. Valuation is the analytical process of determining the current or projected worth of a company. There are two main methods for company valuation: absolute and relative. These methods exist to help investors determine the ‘fair value’ of a company. If a technique determines a company to be undervalued — that is, the company is selling at a price significantly below what is assumed to be its fair value price — an investor would be encouraged to purchase shares and sell them later for a profit. The opposite is true if a technique determines a company to be overvalued: sell shares if you own them or decide not to buy them in the first place.
Absolute valuation methods attempt to find the intrinsic or “true” value of an investment. Absolute valuation utilizes a company’s fundamentals — its financial history, management performance, and growth forecasts — to value a single company. According to Investopedia.com, the valuation models that fall under the scope of absolute valuation include the dividend discount model, discounted cash flow model, residual income model, and asset-based model.
Between the two, absolute valuation is theoretically the simplest investing method. For example, if a company’s share price is below its “true” value, put money into the company. If a company’s share price is above its “true” value, take your money out and put it into something else. In practice, however, finding the intrinsic value of a company is a hefty and relatively subjective task with an infinite number of combinations of complex mathematical models. That’s why companies pay quantitative analysts, or “quants”, a cool 6-figures to run those numbers for them.
Fortunately, the field of fundamental analysis has decades of history and research behind it, allowing even beginners to dip their toes into the field. Explaining fundamental analysis techniques is beyond the scope of this article but interested readers should refer online for texts. Books by reputable names like Benjamin Graham or even a “For Dummies” book would place you on the right track for absolute valuation techniques.
Relative valuation methods are an alternative to absolute valuation methods. Instead of valuing a company’s intrinsic value, companies are valued by comparing them to their competitors or others in their industry. Varying metrics and benchmarks are used to rank companies across an industry average.
The most common relative valuation measure is the price-to-earnings (P/E) ratio. This ratio is expressed as a multiplier of a company’s earnings, or net profit. A wide swath of an industry is taken; companies that fall under the average P/E ratio labels them undervalued — a good buy. The opposite is true for a higher-than-average P/E. Let’s revisit the GameStop and Best Buy scenario above:
As a disclaimer, we’re using the quarterly EPS for demonstration purposes (common practice is the Wallstreet or TTM, or trailing 12 months, EPS). At a glance, we have $3.10 and $1.26 in earnings per share for Best Buy and GameStop, respectively. If we use Best Buy as an industry peer, GameStop would have been an incredible investment back in January 4th. At an EPS of $13.69, it trailed far behind its main brick-and-mortar competitor. Since January, however, the price of GameStop has soared far beyond its 2021 low, and when compared to Best Buy, you wouldn’t believe GameStop to be a viable investment.
That’s when the magic of relative valuation begins. When you compare GameStop to an ordinary electronics store like Best Buy it does not bode well for the current price of the company; however, when you switch the lens and value GameStop as an e-commerce business, the EPS gap diminishes significantly. See, the greatest challenge for investors using the relative valuation method is picking the right metric to compare companies with. Will my company pivot its market strategy? Do I compare Company A with Company B or with Company X, Y, Z? Is 60X a fair value of EPS for the industry? These questions are largely dependent on the investor to answer and can greatly shift the overall perspective of a company’s value.
Diversification is the concept of not putting your eggs all in one basket. Risk management is the name of the game for investing and gives you confidence that your entire portfolio won’t sink if a big-time CEO makes an unfavorable tweet. Diversification can be achieved through different methods, including between different types of assets — real estate, bonds, stocks, etc. — or within investing in different industries within a security — commodities, technology, etc.
Research has shown that having a well-diversified portfolio across 25–30 different stocks yields the best returns and lowers the risk of holding any individual security. In fact, some assets like Exchange Traded Funds (ETFs) specifically track companies across a broad index. $VOO has within it 509 stocks, taken directly from the S&P 500: the top 500 largest U.S. publicly traded companies. A dollar put into 500 of the largest U.S. companies thoroughly reduces your portfolio’s risk (and potential returns). That’s why some authors like Burton Malkiel of “A Random Walk Down Wall Street” base their strategies around ETF-heavy investments.
What has been discussed in this document is nowhere near what the investment world has to offer; however, hopefully it’s enough to help you understand the thinking and rationale that goes into making investments.
To further help you, I’ve listed both terminology and resources that you should research independently and have been helpful in my own investment journey. Best of luck, and happy tendies.
- Expense Ratios
- Index/Mutual Funds
- Interest Rate
Resources and References: