A primer on stocks; Three R's (rates, returns, and risks) of buying shares
New York — Suppose you had bought the stock of MCI Communications five years ago at $1 per share. Today, the stock is selling at at $35 per share. a 3,500 percent increase. Congratulations.
But, suppose, you also had bought Ford Motor Company stock at $50 per share five years ago. Today, Ford is selling for $16 3/4 per share, or a decline of 66 .5 percent. Too bad.
Welcome to the stock market, a world that historically has befuddled even brilliant investment advisers. It is a world Forbes magazine found could best be conquered by throwing darts at the stock list. Through this method, the Forbes ''dart portfolio'' appreciated by 50 percent between 1967-1977. At the same time , the Dow Jones industrial average added 6.5 percent and the Standard & Poor's 500 index gained 11 percent.
Most money managers barely beat the averages. Recently, in fact, Computer Directions Advisers, a Silver Springs, Md., company that keeps track of how institutional investors' portfolios are doing, reported that some 281 banks, running $15.7 billion, after reinvesting dividends had made only 6 percent per year over the ten years ending Nov. 31, 1981. Per year, the S&P 500 was up only 7.6 percent and the Dow average 5.7 percent.
Whether or not the returns will improve over the next 15 years is anyone's guess. However, Andrew Tobias in his book, ''The Only Investment Guide You'll Ever Need,'' noted: ''Over the long run -- and it may be very long -- stocks should outperform bonds.'' And, he adds, ''Unlike bonds, stocks offer at least the potential of keeping up with inflation.''
Well, maybe over the long run. But, recently stocks have not been a good inflation hedge. Furthermore, investors have developed a certain reluctance to take risks. And there is no doubt there are risks, ranging from uncertainties about the direction of the economy to political hot spots.
Because of the risks, investing in common stocks is different than investing in a savings account. When you invest in the stock market, there is no guarantee you will ever get your money back. Rather, you are investing in a company, becoming a part owner of the business. If the business is good, management may share some of the proceeds by issuing a dividend. And, even if they don't declare a dividend, you may still see the company's stock go up since other investors may wish to become part owners of the company. Or, if business is very bad, the company may elect to enter bankruptcy - leaving the shareholders with little or no investment.
Investors buy shares in a company primarily because of their expectations about the company's future. Thus, investors have been buying shares in MCI Communications because they expect the telecommunications business which MCI is in to expand. Thus, even though the company is expected to earn only $1.25 a share for its fiscal year ending March 31, the stock sells at 28 times earnings. This price-to-earnings multiple (P-E) is high since investors believe the company's growth prospects are excellent.
However, in the case of Ford Motor, the expectations are less rosy. Ford is expected to report a loss of $2.53 a share for the year ending March 31. Thus, it doesn't have a current P-E. Historically, it has sold at 7 times earnings, a far less robust P-E than MCI.
Price-to-earnings multiples vary greatly, reflecting investors opinions about both companies and industries. Sometimes a company that is a leader in an industry has a higher P-E than other companies in that group. However, the group as a whole may be viewed as dull, tarnishing the prospects for the leaders as well. (A price-to-earnings multiple is simply the current price of the stock divided by profits for the latest 12 months.)
Differences of opinion about the prospects of a company are common. John Dorfman notes in his book ''Family Investment Guide,'' ''Predicting the performance of a stock's price is even harder than predicting future dividends. . . .''
However, there are various theories about how best to figure out a company's value. Sidney Rutberg in his book, ''Playboy's Investment and Financial Planning Guide for Singles,'' counsels, ''When you buy a stock, look to the underlying values -- essentially, the book value, earnings power and prospects and past record -- rather than trying to play the ups and downs in the market. . .moving in and out of the market will make money only for your stockbroker.''
And Mr. Dorfman in his book recommends:
* Research the industry, not just the stock. It helps to know the competitors of the company you are buying.
* Look at a company's sales. Track sales for at least a five-year period. How does its sales growth compare with its competition.
* Examine earnings patterns over at least a five-year period. Look at both earnings and earnings per share. If they vary, find out why.
* Check out the company's profit margins. Are they keeping up with earnings per share? How do they compare with the competition?
* Look at a company's reported cash flow. Explains Mr. Dorfman: ''You should look at cash flow because it provides a useful cross check on the validity of the earnings figures you analyzed earlier. There are a variety of accounting techniques that have the effect of enlarging reported earnings. But 'paper earnings' may not be enough; companies also need cash, to pay for salaries, taxes, dividends, and reinvestment.''
* Read the footnotes in the annual report, including the extraordinary items. Sometimes a company sells a division, or a factory, to get a big short-term jump in its earnings, which may also have negative long term consequences.
* Make sure the annual report is not ''qualified'' by the company's accountants. If it is ''qualified,'' the company may be disagreeing with its accountants on how best to report its earnings.
Even when you consider all of these factors, there is no guarantee the your stocks are going to go up. As Andrew Tobias noted in his book, ''What a stock is worth depends at any given time on the alternative investments that are then available.'' If stocks are vying with money market funds, and interest rates are high, they still might not go up.