In 2009, when the stock market began to recover and show a certain amount of steady purpose everyone finally heaved a sigh of relief. But after Enron, Lehman Brothers and all those companies that seem better at cooking their books than actually doing anything productive, are you really sure that the company you have invested in is doing as well they say it is? It's just that at a time like this when the economy seems to be on the rebound, and the managers don't really have an excuse to give their shareholders for why their companies aren't doing so well, there is a real temptation for everyone to begin a nice rewarding journey down the path of alternative reality. Serious investors don't just take the company's word for it, or even the word of the company's stock market performance. They look closely at the company's books, to see how the company really claims to be profitable.

In fact, looking past even the balance sheet, and turning into real professional investigative analyst is what it takes these days to run a successful mutual fund or any brokerage firm. For instance, you're not supposed to just look at what a company's earnings are. What would you do with the company's "earnings"? They show cash items as well as non-cash items. If you just look at the earnings, the company can pull quite a bit of trickery there. For instance, the company is allowed to show as "expenses" each year a certain percentage of all the assets it owns. If the company spends $10 million this year on an office building, and it expects to use the building for the next ten years, they can write off $1 million each year as depreciation. This would come out of the earnings it made. If a company wanted to artificially dress up its earnings, it could just not care to take that million out. You need to be able to judge exactly what a company's earnings are, to be able to understand that the stock market performance in context.

To catch them at this one, you'll need to go back and study their accounts, to see how much they invested in assets, and how much they have been writing off every year. This way, you can actually find out which companies are the most responsible. Simple stock market performance doesn't really tell you enough anymore. An irresponsible company that holds to shortsighted policies may actually show better profits for a few years in a row than another more responsible rival. Home Depot for instance for long has been particularly responsible, even at the expense of short-term popularity in stock market performance. What you need to really look at is how much the company generates at the till - in cash flow. Once there is a lot of cash coming in, you can be pretty confident the company is doing well. Earnings don't really tell you that much.

Take an airline stock for instance. They have to spend a great deal on new airplanes, maintenance, operations. A popular airline for instance, spends about two dollars for each share it has out, while it earns only maybe two cents a share. The earnings are not attractive at all, because the airline has been spending money on its future. But then if you look at all the money it makes in ticket sales, it's pretty impressive. If you look at a railway company, like Union Pacific Railway, for every share they have out, they invest about four dollars in locomotives and such. But they only report about two dollars as depreciation. And they keep doing this every year. With so little depreciation for so much expense, they certainly have a way of looking better than they are in stock market performance. This is the way then to gauge the company's worth when you invest. Just looking at how well they do in the stock market will no longer do.

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The stock market is also known as the equity market where companies have access to capital and investors. Once investors had bought shares of the company, they look forward to potential gains of their investments in the future performance of the company.

Stock exchanges

With the exchanges as the main players, the stock market is like a big superstore, a buying and selling place where people buy stocks. These exchanges are where the buyers and sellers are matched.

The primary exchanges in the U.S. are the NASDAQ, the New York Stock Exchange (NYSE), all of the ECNs (electronic communication networks) and some regional exchanges like the American Stock Exchange and the Pacific Stock Exchange.

A few years back, all the trading was done in the traditional exchanges like the NYSE and the like. Now, almost all the trading is done through the NASDAQ which uses ECNs and thousands of other firms with access to the NASDAQ for trading.

Electronic buy-and-sell

Here is a sample on how a stock market transaction is done today. First, you open an account with say, E*Trade by sending E*Trade a $1,000 check. E*Trade then deposits the check into a trading account listed under your name.

You log on to E*Trade and place an order to buy 100 shares of stock in Company X. (The stock is currently trading at $5.) E*Trade uses its networks to tell NASDAQ and all its related networks that there is a demand for 100 shares of Company X.

NASDAQ finds someone who is willing to sell 100 shares of Company X and instantly facilitate the trading of stocks between you and the person selling the shares.

The data is sent to a clearinghouse where it is processed and the shares will now be registered to you. The actual stock certificates are held “in street names” and do not need to change hands, although you can request that the certificates be transferred to your name.

How stocks get valued

Stocks are valued two ways. One is created using some type of cash flow, sales or fundamental earnings analysis.

The most common is the P/E ratio (Price to Earnings Ratio). This valuation method is based on historic ratios and statistics. The aim is to assign value to a stock based on measurable attributes. The form is what usually drives long-term stock prices.

Supply and demand

The other valuation follows how much the investors is willing to sell them. Both of these values changes as investors change the way they analyze stocks. In short, the stocks are valued based on supply and demand.

If more people want to buy them, the price goes higher. Conversely, the more people that want to sell the stocks, the lower the price.

Market forces

In the short run, the market is driven by simple human emotions of greed and fear. In periods of prosperity, the market usually rises above its real earnings.

In tough times, political uncertainties and other negative factors, the stock market often performs worse than its underlying fundamentals. In the long run, however, the stock market is driven by several underlying economic, financial and global growth.

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