Are you new to investing? This is part one in a series, starting with all those questions about investing that you dare not ask because you thought it would be too simple.
A beginner's guide to investing in shares
In part one of this beginners guide to investing, we start with some simple terms you need to know. We all have to start somewhere, and a seasoned investor might know some of this stuff so well, that they forget that once upon a time they didn’t get the basics either. Apologies if you think some of this is too basic, but it’s unlikely that anyone new to investing would fully understand all these terms.
All companies, whether they are private limited companies or listed on the main stock market, have shares.
Each share represents a percentage ownership in the company. If a company had issued 100 shares, then one share represents one per cent of the company. If a company has issued 1,000 shares, then one share represents 0.1 per cent.
Usually shares confer voting rights on the shareholder (although not always) — these voting rights typically confer on the owners of the shares the right to dismiss board members and appoint new ones.
The shareholders can receive dividends on their shares — indeed this is supposed to be the financial benefit in holding them — although in practice the rationale for holding shares, as we shall see in a moment, is more nuanced than that.
Shareholders also have the right to sue a board for wrongful acts and to inspect corporate documents.
Shares are also transferable.
The bad news, from a shareholders point of view, is that if a company goes bust, they are usually last in line to receive a payment, and that payment is often zero.
The good news is that if a company grows, and pays out higher dividends, then each shareholder receives higher dividends.
Difference between a shareholder and creditor
A creditor typically lends money to a company, either directly in the form of a loan, or in the case of larger companies, via bonds, or by providing goods or services on credit.
The money they have lent may involve interest, but the loan repayments are typically fixed or fluctuate with prevailing interest rates.
Lending to a company is usually seen as lower risk than buying equity, for more than one reason:
- The loan repayments are agreed in advance, unlike dividends. They can vary with a company’s performance.
- Because creditors, especially banks, usually insist on various protections of their money leant in the form of security.
- Because if the company goes bust, loans are repaid before money is paid out to shareholders.
On the other hand, equity holds the potential of much greater returns in the long term.
From the point of view of an investor/creditor, see it in terms of reward/risk.
For example, a banks’ profit from lending to a company is a function of the interest rate that they charge. If many of these loans go bad, the bank will have a problem.
If instead an individual buys shares in several companies, and say as many as a half go bust, (which would be disastrous in the case of a bank making loans) but some of the companies do exceptionally well, the shareholder may still make a profit.
So for this reason, an investor in a company buys shares in the hope that those shares will offer growing returns, but takes the risk the company will go bust, and the shares become worthless, or that the company will not perform well, and the return on the shares become disappointing.
In short, lending is usually safer than buying shares but sees fixed return, investing by purchasing shares (also known as taking equity) has a much higher potential upside, but is quite risky.
The risk can be reduced by investing in multiple companies — this is why diversification is essential.
Share price and market value
So a share offers its holder the potential for dividends, but how is a share valued?
The simple answer to that is that the forces of demand and supply determine a share price.
And if you multiply the share price by the number of shares issued, you get the market valuation of a company or market cap.
In theory, a company’s valuation should be a reflection of expected future dividends discounted by a projection of interest rates into perpetuity to get a net current value.
Of course, knowing what future dividends will be is a guess, and no one knows what future interest rates will be.
But it is because of this equation, that a cut in interest rates should lead to an increase in share prices. And since interest rates are now expected to remain close to zero for the foreseeable future, the rate at which you discount future dividends is much less than before, and it is rationale to expect share prices to go up.
One more point about market valuation — it is different from the paper value of a company, which an accountant can calculate by deducting liabilities from assets.
On occasions, the market value of a company is less than its paper value; if this is the case then it suggests something odd. Either the company in question has very poor prospects, or the markets have got it wrong, and shares might be at a bargain price.
The P/E ratio is taken by comparing the valuation of a company either with its latest profits or expected profits over the following year. Usually, a P/E is based on projected profits, but strictly speaking, if this is the case, it should be referred to as a forward P/E.
Some analysts and journalist calculate a P/E differently, but the final number is the same. Instead of comparing net profits and market cap, they look at earnings per share and share price. It’s just a different technique for creating the same result, the difference is more semantic, but US analysis often puts more emphasis on earnings per share rather than profit.
In theory, a P/E ratio is an indication of whether a company’s share price is overpriced, about right or cheap. A P/E less than ten is relatively low, anything over 20 is on the high side.
But if a company is expected to grow fast, or has been growing rapidly for several years, a much higher P/E ratio is justified.
I think that a P/E is a good metric for an investor to consider when investing, but I prefer a quite different approach to picking a stock — but I’ll be coming to that in part four of this series. After all, if the P/E ratio is apparently quite high, it is because the markets expect high growth. The trick for an investor is deciding if they are right.
Dividends versus yield
Dividends are what a company pays out to shareholders. Yield is what the dividend works out per share as a percentage of the share price.
So, if the share price suddenly falls and dividends are unchanged, that means the yield will have gone up.
Yield versus growth
As a general rule, companies with strong growth potential tend to pay lower dividends, after-all, to achieve this potential growth, they might need to invest heavily, and dividends might detract from their ability to do this. These are called growth stocks.
Companies operating in mature industries, with less growth potential, tend to pay out higher dividends.
With interest rates so low, some companies appear quite attractive as investments to beat interest rates on savings.
So-called income investors, which is to say, investors who like to draw an income from their shareholdings, perhaps to fund their living expenses in retirement or supplant income from their job, will usually select high yielding companies.
Investors with a longer time horizon, perhaps to build a nest egg for retirement in 20-years time, often select shares growth stocks.
Of course, it is not unusual to find companies that do both — they payout high dividends and see rapid growth — Apple is a good example of such a company.
Share buybacks are superficially similar to dividends; the main differences relate to the motivation behind buybacks and practical difference.
A share buyback is when a company, instead of paying a dividend, buys shares from shareholders. This doesn’t necessarily deplete the value of shares. Indeed the opposite is often the case. Instead, it merely means that the total number of shares issued falls, and each shareholder may own fewer shares, but their percentage ownership of the company is unchanged.
So why might a company apply share buybacks backs rather than pay dividends? A common rationale for a buyback is that it is seen as a one-off payment.
The markets don’t like it when companies reduce dividends. So if a company has an exceptional year, or perhaps sold an important asset, rather than using surplus cash to pay a dividend which the markets may expect to continue, they buy back shares. In a way, a share buyback is like a signal by a company saying “this is a one-off payment.”
Private companies and public companies both have shares. The difference is that shares in a public limited company tend to have broader ownership — typically shares are owned by the public. A PLC is subjected to much more stringent regulations than a limited company, and it has to publish periodic reports of the value of business for use by shareholders.
Shares in nearly all PLCs are listed on a stock exchange. One notably exception tho this in the UK is John Lewis Partnership— shares in this company are owned by staff.
A stock exchange provides a market for selling shares listed on the exchange. The UK has the London Stock Exchange and a submarket AIM, which is typically made up of smaller companies.
The main stock markets in the US are the New York Stock Exchange and the NASDAQ, which is dominated by technology stocks such as Apple, Amazon, Microsoft and Facebook.
The larger companies listed on a stock market are form indexes — in the UK there is the FTSE 100, which is broadly made-up of the 100 largest companies listed on the exchange. The next 250 form the FTSE 250. The US has the Dow Jones Industrial Average, which aggregates the performance of 30 largest companies listed on US stock markets. The NASDAQ Composite is made up of stocks listed on the NASDAQ. The S&P 500 aggregates the top 500 US companies. In recent years, all these indexes have been dominated by the performance of a handful of techs. The market cap of the S&P 500 is around $30 trillion. Between them, Apple, Microsoft, Amazon, Alphabet/Google and Facebook are worth almost $7 trillion. So the performance of these five companies has a massive impact on the S&P 500.
Other leading stock exchanges around the world include;
- DAX in Germany
- CAC 40 in France
- Nikkei 225 in Japan,
- Hang Seng in Hong Kong,
- CSI in China
- Sensex for India.
IPO stands for initial public offering; it refers to when a company first lists its shares. Companies usually raise money as part of an IPO, although on occasions they don’t, instead they opt for a listing, to give liquidity to shares, perhaps so early-stage investors can sell their shares.
A rights issue occurs when a company issues more shares to raise money. One consequence of a rights issue is that existing shareholders see their percentage stake in a company diluted. On the other hand, the money raised can help a company grow — the maxim it is better to own 50 per cent of something than 100 per cent of nothing, applies here.
Some other metrics to look at
There are many metrics an investor should look at when judging a company’s shares.
My favourites includes comparing the ratio of a company’s assets to liabilities — you ideally want the ratio to be greater than one, and current assets to both liabilities and current liabilities. Other ratios include the ACID test, which compares liquid assets with current liabilities.
I also like to see how a company’s profit and revenue has grown over the previous five years. It is not a perfect test, after all, past performance does not mean future performance will be similar, but it gives something of a clue.
The Share Centre has balance sheets from which you can work out the asset liabilities ratio I describe and five-year revenue and profit/loss performance of hundreds of companies listed on the London Stock Exchange.
In part two, I look at the two main motives for investing and why these motives should influence the investing approach you take.
These views are those of the author alone and do not necessarily reflect the view of The Share Centre, its officers and employees.