This module covers the most basic principles underlying share investing. These are the basic principles one should understand before studying investment methodologies or individual companies.

If you have never studied accounting or finance, or even if you need a refresher, this the module for you.

 

What is covered?

-What are you actually buying when you buy a share?

-What are earnings per share and dividends per share

-The principle of discounting

-The four types of valuation methods

-Expectations: Theory vs. Reality

-Test yourself

 

 

Introduction

Let’s say you have R100,000 to invest, and you have two options:

Option 1: Deposit it in the bank for 10 years earning 5% interest

Option 2: Buy a business for R100,000. The business currently makes a profit of, 5,000 per year after tax. By reinvesting the profits back into the business, the profit grows at 15% each year.

Which option should you choose? Let’s have a look at the two options.

 

Option 1

If you put in the bank it will earn compound interest, and the growth will look like this:

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

How did it get to R162,889? Well, every day you earn interest and then you earn interest on the capital and the accumulated interest.

This is compounding and is calculated using the “future value” formula:

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Option 2

Now let’s look at the business. In the first year, it earns a profit of R5,000 after tax. This is invested back into the business and the following year, the profit is 15% larger and is R5,750. By the tenth year the profit is R17,589.

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

At a 5% interest rate, to earn R17,589  in a bank account, you would have to have R351,788.

On the other hand, the R100,000 you deposited in the bank is now R162,889 and is only earning R8,144.

So even though you are not taking your profits out of the company it has the potential to generate much higher earnings than your bank account. This is because the company is compounding its profits at a faster pace than the bank account is.

 

Earnings per share and dividends per share

In the above example, we looked at buying a company for R100,000 and that company earns a profit of R5000. Let’s say we don’t reinvest all of that profit, but take R2000 out of the company. That’s a dividend. So the company is selling at R100,000, has earnings of R5,000, retained earnings of R3,000 and pays a dividend of R2,000.

Now if we were to get 1,000 people together and each buys an equal share, we would split the company up as follows:

 

 

 

 

 

 

 

 

 

 

 

 

 

 

What you actually buying when you buy a share?

When you buy a share listed on an exchange, you are buying a share of a company.

When you buy a share in a publicly listed company you receive the right to:

• Attend general meetings and vote on major issues. Each ordinary share is worth one vote.

• Receive dividends. The directors will declare a dividend, usually be a fixed percentage of earnings.

• Receive annual reports and inspect statutory documents.

• Receive a liquidation dividend in the case of the company being liquidated. If the company is wound up or liquidated the creditors are paid first, and the remaining assets are sold and proceeds distributed to shareholders.

 

As a shareholder, you do not have a say in the day to day running of the company. Shareholders vote directors onto the board, and the board runs the company.

 

Shareholders own a share of the economic value of the company. The economic value of a company is a combination of the value of its assets, its ability to generate earnings in the future and its ability to pay dividends.

 

Some terminology

Shares in issue: The total number of shares issued by a company.

Shares outstanding: The number of issued shares held by shareholders. Shares owned by the issuing company itself are excluded from this number.

Market capitalization: The market value of a company based on the last traded share price. To calculate the market cap, you multiply the number of outstanding shares by the share price.

 

The principle of discounting

When you buy an investment asset, you are really buying a stream of future positive cash flows. These can be in the form of dividends in the case of shares, rental income in the case of property or coupons in the case of a bond. If you sell the asset in the future, that is also a positive cash flow.

 

To compare these future cash flows to the price we are paying for the asset we need to calculate the present value of the cash flows. The R100,000 we deposited in the bank was going to grow to R162,889 over ten years. The present value calculation is the inverse of the future value calculation. So if we apply it to the R162,889, we will come back to a present value of R100,000.

 

The rate we use to discount future cash flows is the discounting rate and represents our opportunity cost.

If we invest in an asset, we are missing out on an opportunity to earn risk-free returns in a bank account or by buying a government bond. The rate we could have earned elsewhere is our opportunity costs and is the rate at which we discount those cash flows.

 

 

 

 

 

 

 

Present value of a series of cash flows

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Although these cash flows add up to R500, the present value at a discounting rate of 5% is only R432.95.

What if the R100 cash flows continued forever? The present value of each successive cash flow would be slightly less. If you added them up for 150 years, you would find that the total would be R1,999. After that, it would get closer and closer to R2,000, but never quite get there.

The present value for a perpetual (never ending) series of cash flows is the Future Value/discount rate. So for a series of R100 cash flows discounted at 5% it is R100/0.05, which is R2000.
Now let’s look at the company we are considering buying.

To calculate the present value of our profits we need to discount them by the 5% interest rate we could have earned in the bank. For each year’s profit, we discount by 5% for that number of years. The blue bars below are the profits at the time they are earned. The orange bars are the present value of those profits today.

 

The profits are still shown for the entire company. If we want to look at them on a per share basis, we just divide each profit by the number of shares.

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

If you add up the present values for these ten years, you get R73,915, which is less than the R100,000 we have to pay for the company. But, what about the following ten years.

Let’s say earnings stayed constant at R17, 589. Well, the present value of a perpetual series of R17,589 cash flows discounted at 5% is R17,589/0.05 which is R351,780. But that is the present value in year 10.So to calculate today’s value we need to discount that again for ten years.

PV = R351,589/(1.05)10  = R215,962

Add this to the R73,915 we calculated for the first 10 years and we get R289,877.

These earnings are not necessarily being paid out as dividends. In fact, we said that the profit for the business was being reinvested. Some of these proceeds might be paid as a dividend, but if the company is able to compound its earnings at a higher rate than the discount rate it makes sense to reinvest those profits.

So what we are really discounting is the cash generating ability of the company, even if that cash is being reinvested.

Note:

In the case of a listed share, the discount rate is adjusted to account for the risk of holding a share. This risk premium takes into account the volatility of the market and the company’s earnings.

 

The four types of valuation methods

Present value of cash flows or dividends:

Calculating the present value of all the future expected cash flows of a company allows one to compare them to the price of the share. If the share is trading at R100 and the present value of estimated future values is R120 the share represents an investment opportunity. However, this still needs to be discounted further to allow for the risk of investing in that share.

 

There are two common discounting methods:

• Discounted cash flows or DCF uses the company’s costs of capital to discount free cash flows in the future.

• The dividend discount model (DDM) calculates the present value of future dividends. Since dividends are the only thing an investor actually receives by buying a share, this is a very tangible way to value a share.

 

Discounting methods would be the most accurate method of valuing an asset if future cash flows were certain. The reality is that there are numerous assumptions to be made. Future profits, the opportunity, cost (discount rate), and cost of capital all need to be estimated. Discounting methods are therefore the best estimate of the present value of the earning potential of a share.

 

Price multiples:

There are numerous price multiple methods used to compare a company’s share price to its value as a company.

Price earnings multiple (PE): This is probably the most common method around. It is simply the share price divided by the earnings per share. What we are really saying is that if a share is trading at a PE of 10, the share price is ten times the current profit of the share.

Some of the other multiples or ratios:

Price to sales: the company’s shares price divided by total sales per share

EV/EBITDA: Enterprise value divided by earnings before interest, tax, depreciation and amortization.

Price to book: Price divided by the book value of the share.

PE/Growth: The PE multiple divided by the earnings growth rate.

 

Multiples are useful for comparing similar companies. Companies with different growth rates and in different sectors tend to trade at different multiples.

 

Price multiples can also be useful for comparing a share to the overall market or comparing a sector to the overall market.

 

And, multiples can be useful to compare a share to its price and earnings history. Going back to our company example, here is a hypothetical price chart and the resulting PE ratios.

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Over the past 100 years, the SP500 index PE has traded as low as 7 and as high as 70 with an average of 15.5.

 

Shares that are growing their earnings rapidly have much higher PE ratios than mature businesses. Technology shares with highly disruptive business models can have PE ratios as high as 500. At the other end of the spectrum, cyclical businesses generally have ratios that oscillate between 5 and 30.

 

Multiples are a useful method to normalise share prices – i.e.,. To express a share price as a function of the underlying company. A price multiple on its own doesn’t tell one much about a company. Low multiples may represent an opportunity, or they may mean the market doesn’t think the company has strong earnings potential going forward.

 

Intrinsic value

Intrinsic valuation looks at the most basic value of a company namely its tangible and intangible assets. Tangible assets include buildings, machinery, cash and other investments. Intangible assets include brands, patents, and goodwill. Valuing a company based on the value of its assets does not consider future earnings or earnings growth.

 

The intrinsic value of a company is really the liquidation value. If a company is liquidated the assets are sold, creditors are paid, and the remaining cash is distributed to shareholders.

 

If a company is trading at or below its intrinsic value, the market is no longer attributing value to the future earnings of the company. This doesn’t necessarily mean the market doesn’t believe the company will ever make a profit again – it may just mean the market prefers other shares.

 

Value investors will buy shares they believe are priced at below their intrinsic value. The logic is that the worst case scenario is that the assets will be sold, and the company liquidated, and they will still make a profit.

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Yield

Lastly, shares can be valued based on their earnings or dividend yield.

Earnings Yield: The earnings yield is simply the inverse of the PE ratio. It is the most recent earning per share figure as a percentage of the share price. A share with a PE of 20 has an earnings yields of 1/20 or 5%.

Dividend Yield: The dividend yield is the most recent dividend per share as a percentage of the share price. The dividend yield (or DY ) is useful for comparing the dividends generated by shares to other income producing assets such as property or bonds

 

Expectations: Theory vs. Reality

As you can see, there isn’t a right or wrong way to value an investment. This is why prices fluctuate. There is a range of methods and investors need to look at a variety of these methods to assess an investment.

When you buy a share you don’t get to liquidate the company and sell off the assets; you don’t get to decide how to invest the profit, and you don’t get to decide how much of a dividend to pay out.

You are buying an expectation of the how the market will value the share in the future. Fluctuating share prices reflect changing sentiment regarding companies and the economy.

The rates at which cash flows are discounted is another fluctuating variable. Inflation expectations affect a central bank’s interest rate policy, and this, in turn, affects the opportunity cost of investing elsewhere. If interest rates rise, the opportunity cost rises because cash and bonds pay a higher yield.

 

Test your knowledge

1. What is the future value of R100 in 5 year time using an interest rate of 8%?(Compounding annually)

a.50

b.R180

c.93

d.R95

 

2. Which is the cheapest out of the following shares?

a.Price R1000, PE 5

b.Price R50, PE 12

c.Price R1, PE 10

d.Price R20, PE 20

 

3. A company has just reported earnings of R50 million. There is 10 million share in issue. What are the earnings per share?

a.R50

b.R10

c.R1

d.R5

 

4. What is the present value of a never ending stream of R10 annual dividends if the discount rate is 7%?

a.R77

b.R182.85

c.R142.85

d.R700

 

5. A company reports annual earnings of R10 million. There are 1 million shares in issue trading at R120 per share. What is the price-earnings (PE) ratio?

a.15

b.10

c.12

d.8

 

6. If a company has a PE ratio of 15, what is the earnings yield?

a.12.4%

b. 6.7%

c.8.4%

d.4.2%

 

7. A company has tangible assets of R10 and intangible assets of R5 million. There are 1 million shares outstanding. What is the intrinsic value per share?

a.R 15

b.R 1.50

c.R 150

d.R 10

 

8.  If a share is trading at R50 and pays a dividend of R3, what is the dividend yield?

a.5%

b.15%

c.3%

d.6%

 

 

ANSWERS

1. c

2. a

3. d

4. c

5. c

6. b

7. a

8. d