Not all stocks are created equal. They vary based on their return and the investment style one takes when making purchases. Knowing these differences will allow you to make sense of basic financial nomenclature and strategy, and learn how to build different types and classes of stocks into your investment portfolio.
A growth stock is a stock you buy because of the growth you the company to experience (as opposed to the dividends you hope to gain). Growth companies are predicted to grow and demonstrate earnings increases at a faster pace relative to the rest of the market.
Despite the appeal of dividends, many of the most successful firms actually pay poor dividends. If you’re relying on dividends, your strategy is more akin to a real estate investment in so far as you stake your claim, hold it, and then let the investment appreciate in value over time. At first, these sorts of investments aren’t particularly profitable, but, after enough years pass, you’ll have an asset that’s much greater in value than when you first acquired it.
Classification based on stock classes
There are many different ways to categorize stocks. Some factors include their value, the privilege bestowed upon stockholders, and the investment strategies into which the stocks factor.
Classification based on market capitalization
A company’s market capitalization is its value. Knowing a company’s market capitalization often allows investors to make generalized assumptions quickly about a company’s size, success, and return on investment. Given that these are generalized assumptions, they may be wrong, but if someone tells you a company is worth over $10 billion dollars, you wouldn’t be wrong to guess that it’s big, doing well, and is likely a stable investment.
Large-cap companies have a value of $10 billion or more. A company of this size has likely been around for a while within a well-worn business territory. Putting your money into a large-cap company is unlikely to bring about large returns in the short run, but it’s a safe place to park your cash if you want consistent asset appreciation and dividends. Coca-Cola, Apple, and Ford are examples of large-cap companies.
Mid-cap companies tend to have a market value somewhere between $2 billion and $10 billion and operate within sectors that show the promise to experience quick growth. Not surprisingly, successful companies in these sectors are likely to be growing, as well. Mid-cap stocks carry more risk than large-cap counterparts because they are not as established or secure yet. At the same time, that is what makes them an attractive opportunity for some investors. Examples of mid-cap stocks include 3D Systems Corp (a maker of 3D printers) and the home appliance company Whirlpool.
Small-cap companies have a market value ranging from $300 million and $2 billion. A small-cap company may be at the start of its lifespan, serve a niche sector, or exist within a developing arena. Small-cap companies are said to be riskier investments because of their age, size, and the industries they serve. They are also more sensitive to market volatility given their limited resources. However, if you find the right company you could be rewarded handsomely for investing early.
Classification based on ownership
The difference between these types of stocks is based on the privileges that are bestowed to their owners.
Preferred and common stock
Common stocks get you a stake in a company and dividends. Common stocks come with the most risk but also hold the potential to give you the most return. This is thanks to capital growth. The downside of common stocks, though, is if the company goes bankrupt you’re not going to get any money back until after the creditors, bondholders, and preferred stockholders are paid.
Common stockholders get a vote in the company but preferred stockholders most of the time do not (although sometimes they do). The dividends that preferred stockholders hold are guaranteed forever. If the company goes bankrupt, preferred stockholders will get their money back before common stockholders do (although they will still have to wait for the debt holders to get paid). Some preferred stock are also callable, which means that the company can buy back stocks at any time for any reason, but usually at a premium.
Hybrid stocks are known as such because they combine aspects of two or more financial instruments. Most commonly, they have characteristics of both debt and equity. So, this may be a bond, which is a loan that you make a profit off of as its paid back, that’s also influenced by the price fluctuations of the stock. Hybrid stock are traded on exchanges or can be bought and sold through a brokerage. Their rate of return may be fixed or floating, and take the form of interest or dividends.
Stocks with embedded derivative options
An embedded option is a special condition that’s most often attached to a bond. It gives the holder or the issuer the opportunity to perform a specified action at some point down the line. An embedded option cannot be sold separately from its underlying security.
Classification based on dividend payment
Dividends are a portion of a company’s profits owed to investors. Dividends are paid on a quarterly basis. If you have enough stocks with dividends you can have a reliable income stream.
These are the companies you invest in because they’re expected to grow in capital as opposed to because of the dividends they promise.
These are stocks you invest in for the purpose of having a regular income stream. They are also known as yield stocks. The way you calculate a stock yield is by dividing the yearly dividends paid by the price of a share. So, if the company is going to pay $0.50 in dividends over the course of a year and it’s trading at $20 per share, then the dividend yield is 2.5 percent.
Classification based on fundamentals
Whether a stock is under or overvalued is determined by how the stock price compares relative to its intrinsic value. A stock’s intrinsic value is estimated by studying its financial records, which are helpful in forming an opinion about a stock’s earnings potential.
Investors and analysts do this by appealing to a stock’s P/E ratio (price-earnings ratio). The earnings are calculated using the earnings per share over the preceding four quarters. Once the P/E ratio is known, investors can figure out how much they need to invest for every dollar they expect to get back. A low P/E ratio suggests the stock is undervalued while a high P/E value would suggest that the stock is overvalued.
An overvalued stock is a stock that’s selling for more than it is worth, based on financial analysis.
An undervalued stock is a stock that is selling at a price for less than what it’s worth. Since one way to make money in the stock market is to invest in stocks that will increase in value over time, an undervalued stock is a great find.
Classification based on risk
Another way to classify stocks is based on the relative risk incurred when you purchase a particular stock.
A stock’s beta is a measure of its volatility relative to the market, or in other words, the risk you open yourself up to when you invest in a particular stock. A beta of zero means that stock is likely not affected by the overall trends of the market. A beta of less than zero means the stock is moving in the opposite direction of the market. A beta between zero and one means that it is moving in the same direction as the market, but with far less volatility. A beta of one means that the stock is moving in the same direction as the market, and matches the volatility of the market as well. A beta greater than one means that the stock is moving in the same direction as the market, but with significant volatility.
Blue-chip stocks are stocks that dominate their industries and enjoy both wide-spread name recognition and cultural cache. These are companies like Apple, McDonald’s, and Viacom.
Classification based on price trends
A good way to determine if a stock merits your investment is how it responds to changes in the market.
When the going gets tough, defensive stocks stay the same (more or less). That’s because they sell consumer staples, so theoretically demand will likely not go down just because the economy may be floundering. Such companies provide reliable dividends and stable earnings.
A cyclical stock is a stock that’s affected by the overall trends of the economy. They follow the market as it goes up and down. These stocks belong to companies that provide goods and services that people purchase or employ when they have the funds to do so, as opposed to goods and services that are purchased or employed irrespective of how the market is doing.
With an improved understanding of basic market terminology, you are now one step closer to making wise investment decisions. Of course, sometimes decisions that appear unwise can pay off, too. Either way, you now have the basic knowledge required to understand the different types and classes of stocks that make up a diversified portfolio.