Investing is the act of acquiring resources in order to generate a return. When people
discuss investing now, they are usually talking about one of two major ways of investing:
through debt or through equity. You can invest in debt by purchasing bonds, either from a
company or the U.S. Treasury. You can invest in equity by purchasing stocks on a stock
In general, investing in equity is riskier than investing in debt. If a company ceases to
exist, whether through bankruptcy or otherwise, its assets get distributed across its debtholders
and equity holders. Since all debt has a defined value, while equity is simply a portion of the
business, debtholders are paid first. Equity holders have a residual claim on the company’s
assets. This is why equity is more risky than debt; because equity holders aren’t guaranteed to
be paid. However, this also means that investors will expect a higher return from equity, since
there is more risk involved.
Note that so far, we have only discussed accounting equity, or book value of equity. This
is the number on a company’s balance sheet that makes the math and accounting work out. On
the other hand, investors usually trade on the secondary market, where shares of a company
are assigned values by investors.
When investors invest in equities, they hope to predict the “true value” of a company.
They do this by attempting to predict what the book value of equity will be in the future. This
means that stocks will rarely equal the actual book value of equity for a company.
Investing in stocks requires that you trade on a stock market. In the US, the two major
stock exchanges are the New York Stock Exchange (NYSE) and the Nasdaq. On average,
stocks tend to grow in value over time. A common estimate for how the market is doing is the
S&P 500, which measures the stock performance of the 500 largest companies listed on stock
exchanges in the US.
Investors in hedge funds or asset management companies will look to beat the market,
or achieve a higher return than the market. While it can be simple to make money on the market
by simply investing in an index fund, it is not easy to beat the market. In order to beat the market, you have to invest in stocks that you believe are undervalued. It is hard to find these stocks, because active investors are doing the same exact thing every day, and once an undervalued stock is discovered, people will buy more of it, driving stock price up and no longer making it undervalued. The idea that stocks are almost always fairly valued is called the
Efficient Market Hypothesis
What are the NYSE and Nasdaq actually trading? They are trading ownership of a company. Consider Amazon. Amazon has split ownership of its company into half a billion shares, each of which will get paid a proportional amount of Amazon’s profits. However, there is a difference between what the Nasdaq says Amazon’s value is and what accountants say it is.
To get the market’s value of Amazon (market capitalization), we multiply the
number of shares by the price of each share. To get accountant’s value of Amazon at (book
value of equity or shareholder’s equity), we look at Amazon’s balance sheet. The difference
between the two prices is due to the expected profits that Amazon will make in the future.
Investors predict the true value of a company by considering its cash flows. Because all
excess cash goes to equity when accounting, a company’s cash flows are extremely important
to investors. Cash flow is defined as the difference between the amount of cash gained by a
company in a certain period and the amount lost. By predicting cash flows for future years, an
investor will be able to know the value of a business in the future.