Sunday, January 19, 2014

Basic stock investing compared to fixed income

When investing in stocks, people are overwhelmed by ratios and widely diverging views of ‘experts’. But in principle all you do is buying an interest in a business. There are numerous businesses in this world and many are doing very well thank you!
As an owner of a common stock or share, you own part of a business. That typically means, you own part of the business assets but also of the liabilities.  The purpose of the business is to use its assets to sell products or services for a profit and you as one of the business owners get a part of the profits. Profits go up or down all the time but hopefully over time the business grows and with it the profits grow. Liabilities are owed taxes, shareholder loans and debt to third party lenders (creditors). Normally, you as owner would be responsible for those liabilities, e.g. if debt wasn’t paid the lenders can go after you personally. 
However, when you are incorporated the business is considered to be a legal entity or legal person by itself; just like you or me are. No not quite, owning another person is considered slavery and today, in most countries, that is considered illegal. Owning an incorporated business is obviously different in this regards – besides if you own a small incorporated company, you’re likely to work for that company rather than the other way around as would be the case with slavery. Of course, when the company grows overtime, you are likely to hire staff and there may come a time that you no longer have to work for the company but just collect its profits.
You could even own your company together with other partners or sell parts of the company to investors outside your normal sphere of influence with whom you share the profits. If those other investors are not active in the day to day business and if they count in the hundreds or even millions then your company has probably taken the step of 'going public’ and it’s shares of ownership trade on one or more stock markets.
My father owned a sporting goods store, which was a business that was profitable over many years until his retirement. My family lived of my father’s income as an employee of the company and of parts of the profits that were paid out as distributions or dividend. The rest of the profits were reinvested in the business for growth and for expansion like the purchase of a sewing machine to produce tents for camping. My father started out as the sole proprietor but overtime using reinvested profits he grew the company and finally my father incorporated. By the time my father was in a position to expand to multiple stores he was too old and the banks didn’t want to help finance this further expansion. Since me and my siblings were not interested in running the company, my father retired and folded the business.
But whether you own shares in my father’s company or in a publicly traded company, the principle remains the same. Share owners or stock holders own a company to make a profit and use these profits to expand and/or to pay out part of the profits to live off or to invest elsewhere.  Also, profits can be used to buy out partners and divide future profits amongst less owners (each remaining owner thus getting a larger part of the profit pie). In publicly owned companies we call this 'share buybacks'.
How much was my father’s store worth?
Well, like any investment, say like a GIC or a bond, it depends on its yield!  How much money does it make?  If I just put money on a bank account the interest I make is my return (with the expectation of getting also my invested money back in one piece). If I am willing to make a long term commitment of not taking my money out for a year or for several years then my money can be used for mortgages or business loans. This represents a more desirable form of money than that in a savings account and it is also a bit riskier for me to lend that money out over a longer time span. Thus I will be paid a higher interest rate.

Now, when money is lend then the interest rates of the loan typically does not change. However, if I put that same money into a working interest of a company, then instead of a fixed income stream, I’ll get a share of the profits and in theory these profits may grow without limits. Yes it is risky, but with corporate growth my share of the profit grows and so does the value of my share of the company.

Thus the question arises how much is that share worth?  Would you be happy to get the same return as when you put the money in a savings account or GIC? Heck No. Running a business is risky! So you want a higher return. Also, part of your profits are reinvested and you never will see that money in your own wallet unless you sell your share in the company. Thus, yes the value of your company grows but what is in it for you?  That part of the company’s profits paid out to you is called dividends and the ratio of dividends divided by the value of your share of the company is called dividend yield.  If you take the company’s total earnings (i.e. including that portion that is used for reinvestment) then we’re talking about ‘earnings yield’ rather than dividend yield.
 Investors like Warren Buffett compare the earnings yield with that of the interest paid on a 10 year loan to the government which is typically considered one of the safest sources of investment return. Investors, of course, want to have a little bit of a ‘risk premium’ for investing in a company rather than in the government Thus, if a 10 year government loan or bond pays 4% interest then an investor in a company may want to have an earnings yield of at least double that; say 10%.  As a rule of thumb, many investors would like to have an earnings yield of 10% or in other words, they like to get $1 earnings for every 10 dollars invested in a company. That ladies and gentlemen is called the Price (of a share)/Earnings (of a share) or P/E ratio.
Typically, a company is worth 10 times its net earnings. Now, please, tell me: If a company earns $1 per year per share and if you paid for a share a P/E of 10, then what would cause that $10 share to go up in value? Right! For the share price to increase in value the earnings per share will have to increase. So if my profits margin does not change and next year I would sell 10% more in goods, then my profits would increase by 10% as well. Using a P/E of 10, then my company would be worth 10x $1 plus the 10 cents in profit increase = 10 times $1.10 or $11.
Say, I sell a product, say ‘macaroni and cheese’ which everybody eats at least twice a week and absolute no more (when eating too much they get sick of it - ‘macaroni and cheese’ poisoning) then I could only increase my profits if the population grew. In more general terms, I would only sell more if the economy grew, i.e. GDP or Gross Domestic Product. Gross Domestic Product defines the amount of stuff our economy produces per year and typically the profits of our companies cannot increase more than the economy; say 4mto 5% per year.  Thus, if a company’s value equals 10 times its earnings and if those earnings do not grow more than the overall economy then the share price would increase typically by 4 to 5%. 
 If you could forecast how much a company earns over the next 25 years (or its life) and you wanted to earn every year 10% (P/E = 10) then you can calculate what that company’s intrinsic value is. How to calculate intrinsic value was presented in an earlier post – click here
In summary, when investing money into your savings account, in a GIC, or in a loan, you fix your return equal to the interest rate but when you invest in a corporation and buy ownership you share in its profit which has the capacity to increase almost infinitely (or… decrease to a unlimited loss).  That is where the idea of increased return with increased risk comes from. But avid readers of this blog know that not all risk is created equal and neither are companies. Thus, although a P/E of 10 may be a general acceptable number for evaluating a company’s value, in the real world this ratio may vary widely between companies and we will talk about that in future posts

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