Introduction:

How do stock market professionals decide which companies are the best to invest in?

The answer is that they use many different calculations to measure and compare the performance of different companies. These are used to evaluate which stocks and shares are good investments. The names of these calculations are commonly used by professionals and in articles/blogs about stocks and shares, but unless you have worked in the stock market, they can be a little confusing to understand.

In this online exercise on stocks and shares, we will both look at and explain the common calculations that are used to measure the performance of different companies and their shares. Knowing these is important when both understanding advice about stocks and shares and when choosing a good stock or share. In addition, we will also look at some financial vocabulary you need to know if you want to understand what these calculations mean.


Exercise: Explaining stock market calculations

In the following conversation between two friends, Peter explains to Juan what he needs to think about when choosing which stocks and shares to buy.

From the context, try to guess what the meaning of the words/phrases in bold are. Then do the quiz at the end to check if you are right.

Juan:'You told me to speak to my stockbroker about which shares that she would recommend me to buy.'

Peter:'Yes.'

Juan:'Well, it was like she was speaking in a different language to me. All these terms and words she was telling me. For example, she told me that there are two different types of stocks/shares I can buy, preferred stocks and common stocks. What is the difference between the two?'

Peter:'Preferred stocks, which are called preferred shares here in Britain, are a type of share where the owner of them is paid a fixed dividend by the company. So you're guaranteed a dividend unless the company has very bad financial problems. With common stocks, which are also called ordinary shares here in Britain, the dividend can change depending on the company's performance or on how much the company wants to give its ordinary shareholders.'

Juan:'She also mentioned something about the yield of the share.'

Peter:'The yield is how much money you earn from the share's dividend on each dollar or pound you have invested in a stock or share. To find out what the yield of a share is, you have to divide the yearly dividend for each share by the amount you paid for the share. So, if a share cost you $2.50 and the yearly dividend is 15 cent, you divide 15 by 250. So the yield for the share is 6%. It is used to show how much money you will make. It's a way to compare the different returns or money you could receive/make from investing your money in different companies' shares or from other types of investments.'

Juan:'But that only measures the dividends and companies don't normally give all their profit to their shareholders as a dividend. So is there a way to measure how a company is performing by looking at its full profit.'

Peter:'Yes. If you want to measure the performance of a company then you just divide the net profit of the company (after taxes) by the total number of the company's outstanding ordinary shares (the shares that are sold on the stock market and are not preferred stocks/shares). Normally, this calculation is done with the dividend which the company pays to preferred stocks removed from the net profit number. This is called the EPS, which means the 'Earning Per Share'. So if the annual net profit of a company is $110 million and it has paid a dividend on preferred stocks/shares of $10 million, the net profit you use in a EPS calculation would be $100 million. If the company has 20 million ordinary shares on the stock market, then the EPS for this company is $100 million divided by 20 million, which is $5. This is normally used to see how much a company is growing. Investors and analysts normally compare the EPS of a company over different years to see if there is any change in the company's level of growth.'

Juan:'But different shares have different prices. For example, one share in the company Tromp plc costs $15 while one share in the company TwoWorlds plc costs $25. Is there a way to compare which company is doing better on the value of its shares and not on just the number of its shares?'

Peter:'Yes, you can use the P/E ratio, which is the 'Price to Earning ratio'. You calculate it by dividing the price of the share (one share in Tromp plc costs $15) by the EPS of the company (for example $5). So, the P/E ratio for Tromp plc is $15 divided by $5 = 3. A low P/E ratio for a company (1-70) means a company is making a good level of profit in comparison with its share price and that the share price could be undervalued and may rise. A high P/E ratio(100 or above) means a company isn't making a good level of profit in comparison with its share price and that the share price of the company is overvalued.'

Juan:'What does the equity of a company mean?'

Peter:'Basically, equity means the amount of money which the owners of a company would be left with if they had to close down their company. To find out what the equity of a company is, you simply have to find out what money it has in the bank, plus the things it owns and could sell if it had to close down (like property, machines, patents, the products it hasn't sold etc...). These are called a company's assets. Then, you have to find out how much money the company owes/has to pay to other people (like loans, taxes, rent, money to suppliers etc...). This is called a company's liabilities. To find out a company's equity, you just subtract the company's liabilities from its assets. For example, if a company's assets are $575,000 and it's liabilities are $400,000, its equity is $575,000 minus $400,000, which is $175,000.'

Juan:'It sounds a little too complicated for me to calculate.'

Peter:'But you don't have to calculate it. Every company has to give this financial information each year in a report. It's called a balance sheet. So you can find a company's equity by looking in its balance sheet.'

Juan:'But why would I need to know what a company's equity is? How would it help me decide which shares to buy?'

Peter:'Only using the amount of a company's equity to know which shares to buy isn't normally used. But there is a commonly used calculation to measure how well a company is being managed/run which uses a company's equity. It's called the ROE or the 'Return On Equity'. It basically compares a company's equity to its net profit/earnings. It shows how well a company is using its resources to make profit. You calculate the ROE by dividing a company's net profit by its equity. You then times the result by 100 to find the ROE. So if a company's net profit/earnings is $120,000 and its equity is $400,000, then the company's ROE is $120,000 divided by $400,000 x 100, which is 30%. If a company has a ROE percentage of 10% or above, it shows that the company is being managed/run well and efficiently. If the percentage is below 10% then it suggests that the company isn't being run as efficiently as it could be and may not be a good company to invest your money in.'

Juan:'Are there any ways that you can measure the risk of investing in the shares/stock of a company. I know the ROE shows you if a company is being managed well or badly and suggests that there is a risk of losing your money if a company has a low ROE.'

Peter:'Yes, there is another calculation which is used to measure the risk of investing in a company by measuring how large a company is. This is called the market cap. Normally, the larger a company is, the lower the possibility/chance that the company will go bankrupt or close down. You find what the market cap of a company is by multiplying the total number of the company's shares by the share price. So, if a company has 100,000,000 shares and the current price of each share is $12. The market cap for the company is 100,000,000 x 12, which is $1.2 billion. The market cap is used to rank/rate companies as 'large cap', 'medium cap' and 'small cap'. A company is rated as 'large cap' if its market cap value is $12 billion or over. A company with a market cap of $2 billion or under (as in the above example) is rated 'small cap'. So, if you bought shares in a company which is rated 'large cap' there is in theory a lower risk that you'll lose your money than if you bought shares in a company rated 'small cap'.'

Juan:'Thanks for explaining all these ways to calculate if a company is doing well.'


Now do the QUIZ below to make sure you understand the meaning of this vocabulary.



Quiz: How to understand stock market calculations

Below is a definition/description of each of the calculations/words in bold from the above text. Now choose the calculation/word from the question's selection box which you believe answers each question. Only use one calculation/word once. Click on the "Check Answers" button at the bottom of the quiz to check your answers.

When the answer is correct, two icons will appear next to the question. The first is an Additional Information Icon "". Click on this for extra information on the word/phrase and for a translation. The second is a Pronunciation Icon "". Click on this to listen to the pronunciation of the word/phrase and to do a pronunciation speaking test.

1. The name of the calculation which is used to show how large a company is, is called    
         

Market cap:
(noun) It is also called 'market capitalisation'. This calculation/measure is commonly used. Basically this calculation measures the size of a company (by finding the total value of all the company's shares owned by investors) and is used to show the risk of buying stocks and shares in that company.

It is calculated by multiplying a company's 'outstanding shares' (which means all the shares owned by investors/shareholders and which have not been repurchased by the actual company) by the current market price of the shares. For example, if a company has 250 million outstanding shares and the market price of the shares is $20. The 'market cap' of the company is $5 billion. People believe that the size of a company affects the risk an investor has of losing their money and the possible amount of profit (also called the 'return') that an investor could make. With large companies, there is less risk of losing your money than with small companies, but the probability of making a large profit (return) is lower with large companies than with small companies.

The 'market cap' is used to rank/rate companies as 'large cap' (companies which have a 'market cap' of more than $12 billion), 'mid cap' (companies which have a 'market cap' of between $2 and $12 billion) and 'small cap' (companies which have a 'market cap' of less than $2 billion). For example, Apple is a 'large cap' company. In Spanish: "capitalización bursátil".

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Market cap:

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2. The money and the objects that a company owns, are called    
         

Assets:
(noun) This is a financial word/term that means all the money and objects (e.g. buildings, brand names, products, machinery etc...) that a company has or owns and can be used or sold. The opposite of 'assets' is 'liabilities'. 'liabilities' basically means its 'debts', any money that a company has to pay to somebody else (e.g. loans, rent, invoices on goods it has received, taxes etc....).

To find out how much a company is worth (how much money you would receive if the company closed down) you have to subtract a company's 'liabilities' from its 'assets'. For example, if a company's 'liabilities' are €5 million and its 'assets' are €6 million. In theory, the owners of the company would receive €1 million after the company closes down. This €1 million is called the company's 'net worth' or 'equity'. The calculation to find a company's equity by subtracting a company's 'liabilities' from its 'assets' is done on a financial document called a 'balance sheet'. In Spanish: "activos".

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Assets:

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3. A different way to say 'profit' when talking about investing your money, is    
         

Yield:
(noun) A 'yield' basically means the 'profit' you make/earn (e.g. interest or dividend) from investing your money. This can be from buying and selling stocks and shares, bonds, investing in a company, putting your money in a bank etc... Normally, a 'yield' is measured as a percentage.

'yield' has a very similar meaning to 'return', but there is a difference in what is included when they are calculated. With stocks and shares, the 'return' combines the 'dividend' (the extra payment you receive for owning a share) and the increase in the share's value on the stock market. With 'yield', only the 'dividend' is used to calculate it and not the increase in share value. For example, with shares in Apple, if you bought its shares in January 2009 when they had a price of $82.33 and then sold them in January 2011 when they had a price of $348.48, the 'return' on your investment would be be nearly 350%. But because Apple didn't pay its shareholders any 'dividends' on the shares they owned at this time, the 'yield' would have been 0%.

'yields' are normally used when people are comparing different types of investments to see which one offers the highest 'profit'. In Spanish: "rendimiento".

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Yield:

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4. A type of stock/share where the owner is guaranteed to receive a fixed dividend, is called    
         

Preferred stocks:
(noun) 'preferred stocks' are also known as 'preferred shares' (they are called this outside of America). On the stock market, you can buy two main types of stocks and shares in companies; 'common stock' and 'preferred stock'.

With 'common stocks' (which are the most common/normal type of share), the dividend (extra payment) is based on the company's profit performance (so if the company makes a large profit, you'll receive a large dividend. But if the company makes no profit, you'll receive no dividend). Also, with 'common stock', you can vote in shareholders meetings.

'preferred stock' is different. With 'preferred stock' you are guaranteed to receive a fixed 'dividend' for a fixed period of time (e.g. 10 years) and this dividend isn't based on the company's profits. Also, if the company goes bankrupt, people who own 'preferred stock' will be the first to receive the money from the selling of the company's assets (buildings, machinery etc...). But, people who own 'preferred stock/shares' can't vote at shareholders meetings.

So with owning 'preferred stock' you normally earn a constant return and there is less of a risk of losing your money than with owning 'common stock'. But although 'common stock' is riskier, if everything goes well with the company, you can earn a lot higher 'return' on the money you have invested in this type of shares than in shares that are 'preferred stock'. In Spanish: "acciónes preferidas/preferenciales".

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Preferred stocks:

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5. The money that a companys owes/has to pay to somebody else, is called    
         

Liabilities:
(noun) This is a financial word/term that means all the money that a company has to pay to somebody else (e.g. loans, rent, invoices on goods it has received, taxes etc....). It basically means a company's 'debts'. The opposite of 'liabilities' is 'assets'. 'assets' means all the money and objects (e.g. buildings, brand names, products, machinery etc...) that a company has or owns and can be used or sold.

To find out how much a company is worth (how much money you would receive if the company closed down) you have to subtract a company's 'liabilities' from its 'assets'. For example, if a company's 'liabilities' are €5 million and its 'assets' are €6 million. In theory, the owners of the company would receive €1 million after the company closes down. This €1 million is called the company's 'net worth' or 'equity'. The calculation to find a company's equity by subtracting a company's 'liabilities' from its 'assets' is done on a financial document called a 'balance sheet'. In Spanish: "pasivos/deudas".

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Liabilities:

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6. A calculation that is often used to see how much a company's profit is growing between different years, is    
         

EPS:
(noun) 'EPS' or 'Earnings Per Share' is a calculation that measures how much profit is being earned on each ordinary share of a company. The 'EPS' is normally used to compare how one company is performing over different years, to see if it is growing and by how much.

The calculation to obtain the 'EPS' is done by dividing the net profit/earnings of the company (after taxes) by the total number of the company's outstanding ordinary shares (the shares that are sold on the stock market and are not preferred stocks/shares). Normally, this calculation is done with the dividend which the company pays to preferred stocks/shares removed from the net profit number.

The 'EPS' isn't very useful to compare growth between companies, because it doesn't take into account the difference in share price. There are better calculations to use to compare performance between companies (e.g. The 'P/E ratio' or the 'ROE'). In Spanish: "ingresos por acción".

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EPS:

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7. The amount of money that is left in a company after subtracting a company's debts from the value of what a company owns and all the money/cash it has, is called    
         

Equity:
(noun) The word 'equity' has different meanings. In the context of financial English it means the amount of money which is left in a company after the company's 'liabilities' (all the money that a company has to pay to somebody else (e.g. loans, rent, invoices on goods it has received, taxes etc....)) are subtracted from the company's 'assets' (all the money and objects (e.g. buildings, brand names, products, machinery etc...) that a company has or owns and can be used or sold)). For example, if a company's 'liabilities' are €5 million and its 'assets' are €6 million. In theory, the owners of the company would receive €1 million after the company closes down. This €1 million is called the company's 'equity'. 'equity' is also called/known as a company's 'net worth' or 'shareholder's equity'. The calculation to find a company's 'equity' is done on a financial document called a 'balance sheet'. In Spanish: "patrimonio neto/capital accionario".

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Equity:

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8. A calculation that is often used to see if a share is under or overvalued, is    
         

P/E ratio:
(noun) The 'P/E ratio' or 'Price to Earnings Ratio' is a calculation used to evaluate the level of profit a company is making in comparison with the price of its shares. Because it takes into account the share price, it is commonly used by investors to compare stocks/shares between different companies. It basically shows which stocks and shares are a better investment.

It is calculated by dividing the price of the share (one share in Fingers plc costs $15, while one in Tyson plc costs €100) by the EPS (Earnings Per Share) of the company ($5 for both Fingers plc and Tyson plc). So, the P/E ratio for Fingers plc is $15 divided by $5 = 3 and the P/E ratio for Tyson plc is $100 divided by $5 = 20. In theory, the lower the P/E ratio a company has, the better the company is operating and the better the value of the share is. In the above example, shares in Fingers plc are a better investment than shares in Tyson plc.

Normally, companies who have a P/E ratio of between 1-70 are seen as making a good level of profit in comparison with their share price and their shares could be undervalued and their price may rise in the future. Companies with a high P/E ratio (100 or above), aren't making a good level of profit in comparison with their share price and their shares could be overvalued and their value may fall in the future. In Spanish: "ratio precio-ganancias".

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P/E ratio:

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9. The name of a financial report that shows the 'assets', 'liabilities' and 'equity' of a company, is called a    
         

Balance sheet:
(noun) A 'balance sheet' is a financial report/statement that shows what the financial situation of a company is. A 'balance sheet' shows both what a company's 'assets' (all the money and objects (e.g. buildings, brand names, products, machinery etc...) that a company has or owns and can be used or sold)) are and what its 'liabilities' (all the money that a company has to pay to somebody else in the future (e.g. loans, rent, invoices on goods it has received, taxes etc....)) are.

In a 'balance sheet', the company's 'liabilities' are then subtracted from the company's 'assets'. For example, if a company's 'liabilities' are €5 million and its 'assets' are €6 million. In theory, the owners of the company would receive €1 million after the company closes down. This €1 million is called the company's 'equity'. Although the information contained in a 'balance sheet' is useful for seeing if buying shares is a good or bad investment, a 'balance sheet' is normally used by investors to obtain the amount of a company's 'equity'. The amount of a company's 'equity' is then used in a calculation that measures how well a company is being managed called 'Return On Equity' (ROE). In Spanish: "hoja de balance".

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Balance sheet:

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10. A calculation that is used to show how efficiently a company is being managed/run, is    
         

ROE:
(noun) 'ROE' or 'Return on Equity' is a calculation that is used to measure how efficiently a company is being run/managed. It is used to compare the performance of different companies to see which company's shares are a better investment. It basically compares the net profit (after taxes) of a company to its level of equity (the money left in a company when you subtract how much money a company owes (called a company's 'liabilities') from the value of things it owns and the money/cash it has (called a company's 'assets')).

The calculation for 'ROE' is Net Profit divided by Equity and the result is multiplied by 100. For example, If a company's net profit/earnings is $2,000,000 and its equity is $13,000,000 then the company's ROE is $2,000,000 divided by $13,000,000 x 100, which is 15.4%. If a company has a ROE percentage of 10% or above, it shows that the company is being managed/run well and efficiently. If the percentage is below 10% then it suggests that company isn't being run as efficiently as it could be and may not be a good company to invest your money in. In Spanish: "rendimiento de la inversión en acciones".

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ROE:

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11. A type of stock/share where the dividend changes depending on profit performance, is called    
         

Common stocks:
(noun) 'common stocks' are also known as 'ordinary shares' (they are called this outside of America) or just simply 'shares'. On the stock market, you can buy two main types of stocks and shares in companies; 'common stock' and 'preferred stock'.

With 'common stocks' (which are the most common/normal type of share), the dividend (extra payment) is based on the company's profit performance (so if the company makes a large profit, you'll receive a large dividend. But if the company makes no profit, you'll receive no dividend). Also, with 'common stock', you can vote in shareholders meetings.

'preferred stock' is different. With 'preferred stock' you are guaranteed to receive a fixed dividend for a fixed period of time (e.g. 10 years) and this dividend isn't based on the company's profits. Also, if the company goes bankrupt, people who own 'preferred stock' will be the first to receive the money from the selling of the company's assets (buildings, machinery etc...). But, people who own 'preferred stock/shares' can't vote at shareholders meetings.

So with owning 'preferred stock' you normally earn a constant return and there is less of a risk of losing your money than with owning 'common stock'. But although 'common stock' is riskier, if everything goes well with the company, you can earn a lot higher 'return' on the money you have invested in this type of shares than in shares that are 'preferred stock'. In Spanish: "acciónes ordinarias/comúnes".

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Common stocks:

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