Episode 4

Making money from shares; ratios, prices and what to look for.

Welcome to Finance & Fury! …Is it better to actually make money or take money?

Today we’ll be discussing whether it’s better to actually cooperate with companies or compete with them, and the best ways to actually make money of your own. And specifically we will be discussing shares and what to look for when you want to buy shares as well. Because when looking for the best companies to own and how to pick them, it’s all about picking the best company to cooperate with. And we’ll run through the different methods of people use, whether it’s protest, plunder or profit. We’ll discuss a lot of the metrics around which shares to buy and which should actually work better for what your goals are in the long term.

Firstly, what is a share? Share, stock, it’s really all the same thing depending on which country you’re in and what you call it. It’s simply an ownership in a publicly listed company. And companies are a separate legal entity set up to operate (normally) businesses. Most companies that have listed on the ASX, which means that they’ve had a private company and they’ve reached a point where they can actually put that publicly available for everyone else to buy because they’ve got to a point where they’re big enough to justify it. Because, to list on the ASX, it costs quite a bit of money. And most of the company is currently on there were small businesses that started off, grew over the years, and then got to the size that they could list and have external investors rather than just a few individuals who privately owned the business. And that’s where most of these companies have come from, where they’ve been startups that have just grown really, really, well and provided a service that people really want. There are the exceptions to that, such as the previously state-owned ones like Telstra and the banks that got listed when they no longer were owned by the government.

But, when you buy a share, what are you getting for it? Well you’re simply owning the business. If you buy a share in a company, say Telstra, Commonwealth Bank, and any of them, you’re technically buying a part ownership in that business. Because rather than being privately owned, it can now be publicly owned by anyone. And what you get for buying a share? Well, being an owner in a company, you’re entitled to some profits. If the company makes profits then they can pay those out to you in the form of a dividend. So, you get some income from the share. You also get voting rights. If the board aren’t doing a good job or there’s something going on behind the scenes that the shareholders don’t like, they can vote the board members out and they can actually have a quite a substantial influence over these companies.

Then, the thing that you hope to get most of all from a share, is actually sharing in the company’s success, where as they grow and increase their profits, you’ll profit off that as well being the owner of the share.

Before going further, we need to clear something up. The board of directors – they’re the ones in control, really, of a lot of the decisions of the company – around who the management team is and a lot of the decisions they make. They have one job – it’s making shareholders happy. If you own a share, the board of directors in the company by extension really only has one job beyond just providing what service they do, and that’s to make shareholders happy.

So, they’re meant to provide the best service to the public to get the most amount of profit and do the best job that they can for the business, on the shareholders behalf.

And that’s through making the company do well. And they’ve got a lot of important decisions to make around what’s the best use of the profits. Because if a company earns an income, pays its tax, then it has profit left over – and it can either reinvest that into the company, or pay you a dividend.

And that’s important for the board of directors to actually get right. Because if they don’t shareholders aren’t happy and when there’s the choice of either investing internally in a project or paying investors a dividend, it really has to come down to what’s going to get the best return. Where, if you as the board of directors, see a project to invest in, that could make maybe 10% in a year, or 12%…Or you could pay that out as dividend, which shareholders might value higher than that, it’s better to pay them the money. And we’ve seen many, many, cases of poor, poor, management getting this decision very wrong. Where they think that it’s a great new opportunity to go into – new and exciting fields outside of what the company actually specializes in – and the use of those profits into a poor investment decision actually really hurts the share price and hurts the shareholders.

So, shareholders don’t get happy and then that’s when they sell the shares. If people are selling shares as the shareholders, that actually has a pretty bad effect overall. And that’s where looking at what a share really is and how to profit off it is the best way to cooperate because you’ve got two options really – competing or the cooperate. And you see people trying to compete with these companies at the individual level a lot and that’s where they’re trying to plunder them almost, with like cyber hacks, unfortunately old-time sieges don’t work on companies these days – you can’t set a moat up around a castle, wait for them to starve it out, and then take all their stuff. There’s laws, regulations, so plundering it’s not really a good option to make wealth off companies anymore. So cooperating with them is really the best option, where if you purchase those shares you’re buying the shares to get a profit from the company, and, it’s being an owner. And if you don’t like a company, what should you do? Should you protest and want to change it? or should you get so stinking rich that you can own at least 51% of the company? Because if you really want to drive change, rather than shouting at others to do it, just make so much money you can earn 51% of the company… then guess what… you’re in control of those board of directors and you can make some pretty big changes in a business. Which companies do you want to compete with then? None. You really don’t want to compete with companies at that level, you prefer to cooperate really, because if you’re cooperating then you’re sharing in its successes. And the ones that do well grow in value and pay you an income that increases over time.

How do you select those? You can choose to be the stock picker, where you can look at what may affect the share price. And there’s really four key factors that might affect share prices, and really its inherent in nature, because the shares’ price is based around supply and demand.

If the share itself has a very, very, high demand, the price will go up. It’s all around how many people are buying it that affects the share price. Plus, the supply of the shares on the market. If there’s a lot of available shares to purchase on the market and people don’t really want to purchase them, the price will go down and you see that when you see share price collapses. That’s people dumping the shares – selling them. So, the price goes down quite a bit.

But what you want to look for is, first of all, the inherent value of dividend, which is inherent in nature, so it’s actually trying to forecast what the future dividends are gonna look like. And that includes the franking credits attached to them, the yields of the dividend, and stability and growth of the company as well, where if it’s been able to grow the dividend consistently every single year, year on year, that’s a good sign, that’s a good inherent value of a dividend where it’s likely to increase growing every single year. And especially with franklin credits and a decent payout ratio, that’s very valuable to investors.

The next one is the inherent value of the future earnings of the business. So how well can the company grow itself to increase their earnings. Not so much just to payout to dividends but to also reinvest and grow the company, because if you’ve got a business where it’s highly competitive, which a lot of companies are, they need to keep growing and doing something different which requires them to grow their earnings first.

There are external factors, such as market forces, economic factors, politics, even just recently is expropriation of property in South Africa, is a very big risk. If you’re in a business owning farms then that is something to look out for, where it’s got to be in a safe legal environment that is doing fairly well for the share to be fairly safe and secure. Because people who own shares can freak out very easily. It’s not safe and secure and they’re worried and there’s a lot of instability or uncertainty, then that can cause the market to spook, and that’s not really a company you want to cooperate with. Because again when you’re cooperating with companies you share in this success but you share in the loss as well.

And one big thing to look for is the management. It holds all those three factors together, where if the management’s doing their job properly, they’re able to increase the inherent value of the dividends over time and they are able to increase the value of future earnings. And hopefully mitigate any external factors.

There’s things called ‘ratios’ with shares. They’re only based around the balance sheet.  And if anyone’s ever looked at a share, or even just gone to the ASX website, you’ll see a little summary of things called PE’s, EPS, DPS – just acronyms for days. The PE is the price to earnings ratio, and it’s the value of a share in its price to the earnings that underlay it. It’s really just a good measurement of profitability of the business, where the price of the share to the earnings is given as a multiple. Say for instance, Commonwealth Bank, PE of 12. It means that the price is 12 times greater than its earnings per share. So, what’s the profit of each share, and what’s the price. And it gives you a multiple of that, and the lower that is, technically the greater, what’s called a value share is. If you can buy a share with the PE of 4, then technically there’s only four profit years there before you make up the full value of the share back. Compare that to Amazon – PE of 330. But that’s where it gets murky again, where it’s simply a balance sheet measurement.

And when you look at the balance sheet, it only gets updated four times a year. The price gets updated every day. And the price gets updated when people sell it. If there’s future expectation that the earnings will drop heavily, then the price will drop well in advance of the actual news coming out, and the balance sheet being updated.

And that’s where there’s anomalies going on in the market and we’ll go through those all in a minute, because the EPS is the next one that really affects the PE, where if the earnings per share or EPS is the per-share profit that’s being earned by the company.

If you buy one share you’re entitled to part of that earnings per share in the dividend per share. So how much profit is paid to you? And that again gets fairly squirrely when trying to look at what’s the best ratio to go for, with how much does the company reinvest, and how much do they pay to you? Because, with mining companies – very [high] capital expenditure companies that have to spend a lot to make money, technically they don’t pay much out in dividends compared to what they reinvest. But when you compare that to cash cows like Telstra (well up until recently Telstra was, not so much anymore), but they prefer to pay profits, because they’re in stable businesses that they don’t really need to invest more in, so the management there decides well there’s no point in us trying to reinvest a lot of this income because it’s not going to actually help investors as much as just paying them dividend.

The last one is a yield. It’s the dividends of that dividend per share as a percentage of the price. So, a lot of these metrics are just the price by something else. What the earnings are, what the dividend is…and they can be good or bad. They’re very easy methods of just taking a snapshot look at a company and thinking “oh well that’s either overvalued, so, Amazon at a PE of 330, technically is a massive growth company where it’s not earning so much of a profit, and that’s out of management decision just so they don’t have to pay tax. But if you’re not really earning much of a profit then the share price has gone up a lot in that case of anticipation of future profits. And PE of 330 is fairly massive. And the good and the bad of it is just ratio traps, where previously we went through that the earnings are updated roughly every quarter, but investors inherent value – what they put on to these metrics – goes up and down every single day. And, if the share price was constant up until every quarter when the ratios really get updated, then everything will be fine but unfortunately the price changes as the ratios or the underlying metrics of them, stay the same. Here’s an example. You look at a share it’s got a yield a 16% on dividend, which means that if you put a dollar into that you should be getting 16 cents back. That’s a pretty good dividend yield. But now imagine that the company has actually just dropped 75% in price. And that’s off future expectation of them not making much money next year. Guess what, the update in earnings comes out and that dividend yield of 16% has now just gone back to 3%. Because the 75% drop in price happened before the earnings got updated.

Another example, company with a PE of 4 might look really, really, good. But again, it could just be off a massive price drop off of future expectation. So, there are traps with ratios where they can look very attractive, but outliers generally exist in financial markets for a reason. And it’s not a form of arbitrage or some profit for nothing that everyday investors can take advantage of because there’s a lot of sophisticated professional investors out there that if they saw a PE company of 4, they probably would know that it’s a good buy, but if they’re not buying it at 4, it’s probably a good indication it’s going to sink further. Or, when the earnings get updated, it’s going to go back to a PE of 20-something.

It’s very hard to be a stock-picker. You have got to do it a lot, and those ratios again, they’re just the most simple example. But when looking at what shares or what investments to cooperate with, it’s all about figuring out what you’re after. So, what your goals are, and what your target return, and what your timeframes are, will really determine what the best shares for you to purchase will be. Because if you’re approaching retirement and you want some safety and stability then what’s called a large cap share might work really well, where they’re big stable companies and they generally don’t have massive drops in price. Small cap though, the smaller startup companies, they might have massive future potential growth compared to your large caps because they’re stable now and don’t have much ability to increase than market share. But some small cap startup they might be able to generate massive, massive, massive growth.

Unfortunately, though there’s a high chance that they won’t and go in the opposite direction. So, it’s all about figuring out what you’re after first when you’re investing as to what shares to purchase, and it’s very easy to try and get a target return. And that’s the easiest option. Where you can purchase shares through indirect investments like managed funds, exchange-traded funds, listed investment companies, and just get a portfolio together of diversified investments across a number of different companies because if you’re the stock picker and you see a PE of 4, you see a dividend yield of 16, you put all your money on that company, and it gets rerated and then it all of a sudden drops another 40%, well that’s unfortunately a big loss to incur off trying to cooperate with the company that should be doing well.

And that’s where spreading the risk out across a lot of different companies really helps, but again it has to be the right environment, right target of what you’re going for. And you can own them in a number of different ways. You can get them indirectly – so buying through platforms, managed funds, exchange-traded funds, LICs, or, you can go through share brokering accounts like COMSEC or NAB trade.

There’s all different methods of doing this. But the most important thing is there’s just no crystal ball. No one can guarantee you that this is the next best share, next best company. People can have a good idea about generally the thematic trends of the market, if say, health care is becoming a big, big, focus of aged/retiree individuals then that could be a big growth industry. Or even legalized pot – there’s CAN, a company on the ASX, that have got some medicinal trials. They have grown massively off the back of that news, and that’s because the future inherent expectation of dividends and growth, off an industry like that. It’s pretty big when you compare it to what’s happened in Colorado and places in America. And with no crystal ball though, comes the risks of not getting it right …and it’s about just asking yourself what are you buying for? So, if you’re buying for income, look for companies that are your more cash cows – have high dividend payout ratios compared to their reinvestment ratios. And look for companies potentially that are growth if you’re in an early position, you don’t need an income because technically income off shares gets taxed. If you can buy a share that is fairly stable, doesn’t pay much income but is expected to grow quite a bit, that’s a good way to increase your net wealth position without paying a lot of tax until you sell the share. And looking for what good companies have, it’s all about just the management and decisions they’ve made over time, where you can look at the financial statements and just look year-on-year – are they increasing their revenue? Yes, tick. Are they increasing how much they pay out of that? Yes, tick. Are they still getting good return on investment? Because, what they used their profits for is to pay you or invest.

And if internally, they’re not getting a good return on investment for their money, then that’s a bit of a sign the management might not be doing their job correctly.

So as a brief summary, I think it’s much better to cooperate with companies than try to compete with them. You just buy them and profit off them. And again, if you don’t like the company, then out of spite, buy so much of it that you can just change it. And it can be very hard to do it well though. Especially if you haven’t tried to buy shares or never purchased shares before, and you’ve actually never experienced your first loss. It’s a very humbling experience. However next week, we’re going to talk about how to avoid that because I’ve gone through it, a lot of other people have gone through it, of having investments go down in value.

So, we’ll go through how to avoid this and protect yourself in the process while being able to gain good cooperation with growing companies, but not be caught with your pants down at the same time. I hope you enjoyed the episode and if anyone has any questions, like always feel free to go to financeandfury.com.au – hit us up on the contact page. Have a great week everyone, and I’ll see you next time.

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