A stock market investor receives the following tip: “WXLYQ is trading at $0.001 and is coming out with big news today! It should go to $0.02 by the end of the trading day! Get in now, while you still can!”
The investor does the math. “If I put in $100 at .001, I can buy 100,000 shares. If it goes to .02, I will have $2,000. If I put in $1,000 I can buy 1,000,000 shares and if it goes only to .01, half of what they predict, I will have $10,000!” The investor tells the tipster, “I’m in,” only to be scammed by one of the oldest tricks in the book, “pump and dump.”
Here’s how: The tipster already owns the stock WXLYQ and has sent the same tip to thousands, sometimes millions, of people. If a fraction of the recipients bite, it will create a small volume fluctuation. Traders who are on the lookout for such fluctuations will purchase the stock when they see the spike in volume. At the end of this chain reaction, the tipster sells all of his stock at .01, leaving the buyers with worthless paper; the stock reverts to .001 and remains at that price level until it is taken off the market (de-listed); and the victims lick their wounds with a tax write-off. You can write off up to $3,000 each year in tax losses.
While this is unethical and illegal, not much can be done about it because it occurs so frequently. The best way to avoid falling prey to such scams is to do your homework on every stock you purchase. The first question you should ask is, “does this stock earn money?” Earnings are a major measure of value in the stock market. Every stock trading on an exchange is required to report earnings four times a year. The earnings report is the single most-watched number on Wall Street. Each quarter, analysts give their estimate of how they feel a company will do for that quarter. The estimates are averaged and that average becomes the “consensus” estimate. If the company does worse than this estimate, they are almost certainly punished.
Earnings estimates, along with balance sheet variables and management quality, are key factors in the “fundamental analysis” of security values. Fundamental analysis attempts to determine the true value of a security. If the market price of the stock deviates from this value, one can take advantage of the difference by acquiring or selling the stock. Fundamental analysis may involve investigating a firm’s financial statements, visiting its managers, or examining how a particular industry is affected by changes in the economy.
You don’t have to be a stock analyst to conduct a fundamental analysis. Anyone can use such basic formulas as the price-to-earnings ratio or return-on-equity described below. In order to use these ratios effectively, they must each be compared with the average for the industry in which the stock being analyzed is grouped.
Price-to-earnings ratio compares the current price with earnings to see if a stock is over or under valued. For example, if the Starbucks PE ratio is 54.71, but the “Specialty Eateries” industry (the industry in which Starbucks is grouped) has a PE ratio of 30.4, this could signal that Starbucks stock is over valued and should be sold.
Return on equity measures the level of return a company’s management is able to obtain on the equity owner’s investment. On the day this article was written, for example, Starbucks had an ROE of 23.88 percent compared to the industry’s 21.7 percent. This means that for the time period measured, the management of Starbucks got a better return on its shareholders’ investment than the average return for the specialty eateries industry.
You can learn more about fundamental analysis at www.investopedia.com.
Technical analysis is a method of evaluating securities by analyzing statistics generated by market activity, such as past prices and volume. Unlike fundamental analysis, technical analysis uses charts to identify patterns that can suggest future activity. It takes only historical performance into account. Take a stock that trades at $6 per share, appreciates one year later to $10 per share, and then reverts the following year to $6. One who uses technical analysis might purchase the stock, saying that because of past performance it has formed a trend and will hit $10 the following year.
Once you do the research on the stock and decide to purchase it, you must then commit to a regular investment strategy, such as dollar-cost averaging, in which you invest a fixed amount of money at regular intervals, usually each month.
Dollar-cost averaging results in the purchase of extra shares during market down turns and fewer shares during market upturns. It is based on the belief that the market, or a particular stock, will rise in price over the long term and that it is not worthwhile (or even possible) to identify intermediate highs and lows. If you do the research on your stocks, you will be able to conduct dollar-cost averaging with high quality stocks.
Next: A strategy to make stock investment easier.
Ryan C. Mack is founder and CEO of Optimum Capital Management LLC, a wealth management firm in New York City. He can be reached at firstname.lastname@example.org.