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Types Of Markets Part 3: Shares Part 1

Part 1

 

Shares, Equities, Stocks all refer to the same thing, the partial or total ownership in a company.

For our purpose we are referring to the shares of a PLC (public limited company) meaning that shareholders have a limited obligation towards the debts of a publicly listed business. “listing” refers to the fact that the company has chosen to raise capital to grow the business via the stock exchange by offering parts of the issued share capital to initial investors via an IPO (initial public offering). Once the IPO is complete the business will list on the chosen stock exchange. The IPO is where the company will raise the necessary capital, once it lists on the exchange it no longer receives a direct benefit from the share price.

When the listing takes place, the IPO participants will sell their shareholding to the public and recoup the initial capital outlay (those participants can only sell at the market price available, therefore they take the risk that on listing the share price will be below their initial price to participate.

The company has two basic types of share, authorised share capital and issued share capital. Issued share capital refers to the shares that are available at the IPO and then publicly traded, authorised share capital refers to the total number of shares the company has available to issue. The usual procedure is to issue a percentage at IPO and hold the balance of the shares on its own balance sheet, this enables the business to raise more capital later through another share issuance into the market. Current shareholders are usually offered these new shares first at a discount to the final listing of the new issued share capital. That is one of the main mechanisms a company can use to raise capital later for further expansion or settlement of debt etc.

As a shareholder in a company you have the right to vote on important changes the company wants to make, for more detail you can follow this link to The law Reviews. Shareholders in ordinary shares are entitled to dividends should the company announce any. Preferential shares entitle shareholders to the dividend at a fixed rate, there are several different Pref shares so further investigation is required.

Valuing a company can be a long and laborious exercise, this fact often leads to new retail investors making the mistake of buying into a company that they know very little about and can leave them holding shares of troubled businesses.

There are some simple ratios to look at before buying into a business:

P/E ratio: current share price divided by Earnings (PE ratio) compares the profit of a company to its current market price and the result is in number of years of profit to attain the current share price.

A PE of 10 means 10 years of current profit to reach the current share price, now this is used to weed out potentially overbought companies from your watchlist but a high PE can also show that the market is pricing in very high future earnings/profits. E.g.: Apple inc has a PE of around 50 years, the question to be asked is “why does the market price in 50 years of profit today?” the reasons can be complex and are outside the scope of this article. A short explanation is that Apple is a technology company that makes devices and exclusive content for those devices and has now started branching out to self-driving cars alongside other futuristic technologies. This can lead investors to get ahead of themselves and price in too much future earnings and that leaves the price sensitive to any financial misses that the company experiences. The other reason that the PE is high is that the share price has fallen but new earnings have not been reported yet, therefore the ratio is based on the last reported earnings. Remember that this ratio is sensitive to earnings and price. If the share price remains stable and earnings drop the PE will also be high. I would recommend you do some manual calculations to understand the inter relationship.

EY: earnings yield is the percentage return an investor would expect to receive if the share is bought at the current price, in company profits. This enables a comparison to the risk-free rate of return offered by government bonds or cash deposits. The yield will go up and down based on the latest share price divided by the earnings from the last financial report. EY is a quick way to decide whether a company is worth looking at for a longer-term portfolio versus a cash deposit. If the ey is roughly constant over the last 3-5 years and the price is rising over the same period it shows some sustainability in profit generation. If the EY fluctuates widely then profits may be volatile or the share price is volatile, a comparison to the price chart will answer that question. If EY is dropping and share price is rising one can assume that the market is discounting future earnings, if the yield is rising and the share price is dropping the market may be expecting a reduction in earnings at the next release.

DY: Dividend yield is the percentage return, in the form of a cash pay-out, an investor can expect at the current share price. Companies share profits with shareholders in the form of dividends which encourages shareholders to hold the shares rather than trade them aggressively. DY can also be used to compare the stock to the risk-free rate.

These three ratios are simplistic measures of whether the company is worth investigating further. By comparing each company to its competitors then the sector index average and then comparing the sector to the main index such as the All Share Index (in S.A.) we can get an overview of the value of the specific company compared to other businesses.

A stock that has a significant difference between it and its peers must be investigated. If the PE ratio is significantly higher or lower than others the price chart should be viewed. If the PE is lower and the price is rising this can be a good sign that the company’s latest earnings were higher than expected and have been released recently. If the PE is lower and the price is falling it can be considered a bad sign and the market is discounting future losses. The opportunity is then transferred to the financial statements release date where we can see whether the consensus view was correct or incorrect, if incorrect there will be an opportunity to buy.

If the PE is higher and the price is rising the market is discounting future earnings and could be a good sign for future growth. If the price is falling this would show that recent results were poor and the market is reacting to the disappointment.

When looking at yield ratios compared to the price chart, we would consider the history of the yields versus the share price. If the yield is dropping over the year, then rising on the financials release date it shows that the market is underestimating the growth of the business as the percentage return on investment changes dramatically after the financials are released.

Yields that drop over the year show that the price is rising and yields that rise show that prices are dropping (true for bond yields that you would see and hear on financial shows). High yields become attractive when they are well above the risk free rate of return  or other yields with similar risks.

Bear in mind that there are many ratios out there and each one on its own is not enough to value the potential returns. They are quick ways to decide whether something is worth looking at over something else, the above three in conjunction can open investment ideas for further research.

As a long-term investor, you have to look at many things to decide whether or not to buy into an investment: the expected time length of the investment, the expected return over time, the cash flow potential of the investment (e.g., dividends, interest etc), expected capital gain etc.

It is generally a good idea to learn how to read and interpret financial statements so that you can also understand any fundamental analysis that you read. Next week I will share some technical analysis techniques that go along with the above ratios.

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