Blue chips are established high-value companies offering well-respected and widely utilized products or services. These stocks are general components of the biggest market indexes, such as the Dow Jones Industrial Average, S&P 500, NASDAQ-100 in the US, and TSX-60 in Canada.
These companies generally have stable earnings, a solid balance sheet, and a good credit rating.
In 1923 Oliver Gingold classified stocks on the Dow Jones Industrial Average index that traded above $200 per share as “Blue Chips,” named after the color of the highest value chips in a poker game.
Poker players bet with white, red, and blue chips. The important distinction is that a high price tag (stock price) doesn’t necessarily make a company a blue chip. A blue chip company is generally highly valued based on its market capitalization (value of the company in the market). These stocks generally pay dividends, but many do not, such as those in the tech sector.
In addition, these companies are leaders in their industry and sell products or services that most people know, such as Coca-Cola.
» MORE: Find the best stock brokers for trading blue chips
Generally, a blue-chip stock is stable and has consistent earnings that demonstrate growth. This steady nature makes them an attractive choice for investors during a market downturn relative to other stocks. The stability of blue chips is the reason they are considered a generally good long-term investment.
Although these blue chips are powerful, some blue chip companies are not immune to a downturn in the economy! They might take a hit; however, they are known to bounce back faster and weather the bear markets. They will have taken fewer losses because of how stable and strongly financed they are.
The 2008 financial crisis caused the bankruptcies of Lehman Brothers and General Motors, proving that even the biggest companies can take a hit during periods of uncertainty.
A company’s balance sheet will tell you its total assets and how that relates to its liabilities and shareholder equity. A balance sheet is essentially an overall indicator of a company’s health at a given moment in time.
The 3 parts of a balance sheet are Assets, Liabilities, and Shareholder Equity.
Assets are listed on a balance sheet in order of liquidity, meaning how easy it would be to sell them quickly. Two types of assets are current and non-current/long-term. Current assets can be converted to cash within 1 year. Long-term assets cannot be converted to cash as quickly and are seen as fixed or intangible, such as land or intellectual property.
Assets include but are not limited to:
Conversely to assets, liabilities denote a company’s overall debt. This is an important characteristic of any balance sheet in that it simply tells you whether or not the company is profitable, for one thing.
This is not an exhaustive list, but liabilities on a company’s balance sheet will include:
Shareholder’s equity tells us a business’s overall net worth. It tells us how much money investors have put into a company and how much overall profit it made (added to retained earnings). It’s broken down into three categories on a balance sheet: common shares, preferred shares, and retained earnings.
Blue chips must have a large market capitalization and usually have low debt (or can at least easily afford the debt). In other words, the company has enough equity compared to debt. Blue Chips are often large-cap companies with $10 billion or more in market valuation. Also, they are a leader in their sector or industry, but that doesn’t mean there aren’t multiple blue chip companies in every industry.
Blue chips possess no debt or a healthy level of debt (debt can be bonds, business loans, accounts payable, etc.). This provides a blue chip stock its investment-grade bond rating (the stock is rated to have a low risk of default). The liabilities of the blue chip company tend to be manageable, but it’s not always the case.
A blue chip company may be heavily in debt but still have a good credit rating. Companies can lose blue chip status if their credit rating lowers to junk bond status. This means the company issuing the bonds is struggling financially and has a high risk of defaulting.
A bond default happens when the issuer (the company selling the bond) cannot make interest or principal payments in the set period. Usually this happens when the company runs out of cash to pay bondholders.
ROA is an indicator of how much profit a company can produce based on what it holds as assets.
The formula: ROA = Net Income / Total Assets
It is a way to measure a company’s efficiency. Specifically, ROA measures how effectively the company’s management team uses the company’s assets to generate earnings. ROA is calculated as a %, and the higher it is, the better.
Remember shareholders equity from our balance sheets? One characteristic of blue chip stocks is the return on equity.
The formula: ROE = Net Income / Shareholders Equity
Return on Equity (ROE) comes out as a percentage, which measures a corporation’s profitability to the company’s equity.
A common way for investors to determine a good ROE (also depends on the sector) is knowing that the long-term average ROE of the S&P 500 is at about 14%. Anything below 10% is considered “poor.”
Blue chip stocks are always highly liquid. This means that there are many investors and traders buying and selling the security.
Many blue chip companies issue dividends as part of their payout to shareholders. However, a company can still be categorized as a blue chip without having any dividend payouts. For example, the three dominant tech giants Google, Facebook, and Amazon have never paid a dividend, preferring to reinvest profits back into the organization for more growth. Shareholders are okay with this as these companies thrive on innovation and need to finance their initiatives.
Blue chip stocks are by no means a quick way to make money as an investor as they tend to be stable and grow more consistently. One thing you should watch for is whether or not a blue chip issues dividends. This is important as it will greatly affect your portfolio and your investment strategy.