Saturday, June 23, 2012

Viable Stock Market Investment - Part I

Let’s look at stock market investments as buying part of a company. A concept used by some of the best investors in the world. If you buy a part of a company, then you are not in for the short haul. However, buying part of a public company contrary to buying a private company puts you on the sidelines as far as directing company operations and financing  is concerned– that is done by corporate management and your phantom representative, the ‘board of directors’.

I say ‘phantom’ because does the board really represent you?  You have a symbolic vote at the AGM as to who is on that board and many directors are often not even significant shareholders. Do they represent you or are they buddies of management?

Still, as ‘owner’ of a portion of a public company, it is important to understand its numbers. Financial statements are not the ‘end all’ of corporations. Good corporations are also characterized by a dominant market position within their segments as determined by branding, product or service quality and consistency. Add to that the skills and reputation of its management and board of directors, and… also of its entire staff.

Truly, management and the board are only setting overall corporate direction; they are the leadership that, often through example, set the corporate culture. But it is ultimately the quality of their staff that leads to the execution of corporate direction. If management is out of touch with its staff and sets unrealistic targets and promotes corruption and dishonesty within the company the staff will respond in a negative way and the company will likely go do the drain.

So it is not only the numbers that make or break a company, it is the entire synergy of good finances, good management and good staff that creates or maintains good branding, good quality products and/or services with excellent market position that separate an excellent company from one that is poor or mediocre. Some of this can be found in the numbers; that is the easiest spot to start to evaluate a company and its potential as a stock market investment.

What we are looking for is a combination of healthy leverage, growth revenue, profits, and future potential. We’re looking at how these numbers are translated into investor cash flow, i.e. dividends, and appreciation. The dividend is the bird in the hand; appreciation is the flock in the bush - the speculative part of the investment. Both combined result hopefully in a desirable return on investment.

The cash flow (dividends) we need to live from; to reinvest and to avoid forced sales. Those same down turns not only are times we, investors, must survive; we also need them to buy excellent companies at a good price.  The latter is not critical but it is desirable; even an investment bought at the peak of a market will throw off profits when held for the long term. Although the ROI may be somewhat lower than if bought at the bottom of a market, its returns are not disastrously lower as we discussed in earlier posts on several occasions.

Are you ready for the numbers?  Not quite yet. Many companies have been started with excellent boards and managers and with talented staff and good finances. Yet many failed – companies need the wind in their back, especially in the early years. The wind or the environment in which these companies grow that is the economy - the macro-picture.

There needs to be a market for a company's products, the market could be a new market for an innovative product that has, in the near future, limitless growth or it could be a mature market that grows not more than GDP. There are two forms of GDP: there is nominal and there is real GDP. The real GDP is nominal GDP corrected for inflation.  When working with leverage, inflation can prove very beneficial and thus we should look at both types of GDP. Also, inflation and interest rates are linked.

So we’re assuming a product producing company (in fact services are products too), whose owners have invested a certain amount of equity in the company, i.e. shareholder equity. We call this equity sometimes ‘book value’ or ‘net asset value’. When the equity is brought into the company by shareholders, the company’s book value is divided by the number of shares and expressed as the book value per share. 

This is different from the share price, which is the price offered in the stock market. The share price is, as we have seen in other posts, a kind of unpredictable thing based not only on corporate fundamentals but by many other factors including market and investor psychology at the time. Book value is the equity per share that is actually invested in the company it is used to buy company assets and fund its operations.
In our simplified company financials, we will run four cases as shown in the tables below. Also shown below are the inflation rate, Interest rate, real GDP and nominal GDP values that impact the company. Finally displayed are the number of shares and the share equity underlying each share. Multiplying the equity per share with the number of outstanding shares results in the company’s total shareholder equity at the time the company was founded (year 1).

If company shares are traded, the share price varies dependent on what investors pay for them in the stock market. If, for example, the shares traded at a certain point in time at $18.50 then the company’s corresponding market cap(ital) would be 10 million shares times $18.50 or $185 million dollars. Obviously, our example company is not Apple, which has currently a market cap of $542 Billion or just over half a trillion dollars while Microsoft is ‘only’ a quarter of a trillionJ.
Click inage to magnify

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