Shares represent part ownership in a company. Shares, stocks, equities used in this context all refer to the same thing.
Shareholders as part owners of a company have ownership in the company’s assets and earnings and can have a vote in the direction of the company.
Shares are limited liability meaning the maximum amount that normal shareholders can lose is the amount of their investment, creditors can’t come after shareholders in the event of bankruptcy.
In the event of liquidation, shareholders are last in the hierarchy of recipients. The shareholders will only get paid any return on their shares in an insolvent liquidation after all creditors get paid in full.
Why Do Companies Go Public?
Companies may take their shares public in an IPO: Initial Public Offering, in order to raise money to fund their growth. Once shares are traded on a security change investors can buy and sell shares.
There are two primary ways to make money from equities: Dividends and capital gains.
Capital gains are generated by the art of buying low and selling high. With normal market movements a companies share price will fluctuate up and down. Over the long-term shares have on average trended upwards.
By buying stock in a company and selling at a higher price we have realized a capital gain.
There are many reasons ar company’s share price may increase in value, both rational and irrational.
To first understand the basics of why a share price may change in value we have to remember that a share represents part ownership in a company. That means shareholders are part owners in the assets, revenues, and profits of the business.
Some of the reasons we may see a share price increase include:
- The company grows revenues and profits
- The company has a strong asset position which is increasing
- Investors have a high sentiment for the company
- The company may exceed investor expectations on any metric
- Supply and Demand: Many people want ownership of the company
One thing that we have to remember is that markets can be and often are irrational. This means despite positive signals from the company, the share price may not respond or even fall.
We believe that in the short term markets are often irrational with many irregularities, but over time the market is efficient at valuing shares.
“In the short run, the market is like a voting machine-tallying up which firms are popular and unpopular. But in the long run, the market is like a weighing machine-assessing the substance of a company.”Benjamin Graham
Putting it into practice. If we use this example and Buy shares at $20 and later sell at $40 we have made a capital gain of $20 per share.
If we held 100 shares we would have made $2000
A company may choose to distribute excess capital to its investors. This is called a dividend. Ordinary shareholders will receive an equal value of dividends per share. Thus if a company issues $10 in dividends and you own 100 shares, you would receive $1,000
Paying a dividend isn’t an obligation of a company. And not all companies will pay a dividend.
Dividends are an opportunity for a company to share its earnings with shareholders.
By doing this a company can entice investors, and encourage further investors making it easier for them to raise more capital if needed in the future.
Remember as shareholders we are part owners of the business, which exists to benefit its owners.
Dividends are generally paid by larger companies with limited future growth prospects. Smaller companies with aggressive growth may be able to use the cash more effectively to generate further gains for investors.
Australian shares are generally well known for their dividends. We have an imputation credit system or ‘franking credit’.
In Australia, our banking sector is renowned for paying large dividends, with all four of the big banks having an extensive dividend history and policy.
Australia’s imputation credit system or ‘franking credit’ is designed to stop the double taxation of investors’ money.
If a divided is fully franked it means that the corporate tax rate (30%) has already been paid on those earnings. Thus this is passed down to investors in the form of franking/imputation credit and helps to reduce an investor’s tax liability.
Dividends are often refered to as Fully Franked, Partly Franked, or Unfranked:
- Fully franked – 30% tax has already been paid.
- Partly franked – 30% tax has already been paid on the franked part of the dividend.
- Unfranked – No tax has been paid on the dividend.
Partly franked dividends are given a franked amount expressed as a percentage. This tells us what portion of the dividend the corporate tax rate has already been paid on.
If a dividend is 70% franked the corporate tax rate (30%) has already been paid on 70% of the dividend we receive.
If a dividend is full-franked the corporate tax rate (30%) has been paid on the entirety of the dividend.
Thus at tax time if we have a tax rate under 30% we will be eligible to receive part of the franking credits back, either as a tax offset or cash refund.
In order to receive the franking tax offset, you must hold your shares “ at risk” for details for a minimum of 45 calendar days. The shares must also be:
- Purchased BEFORE the ex-dividend date
- In your possession ON the ex-dividend date (although you can sell them on the ex-dividend date)
The franking credit system only applies to tax paid in Australia, hence ASX-listed companies that operate overseas may often pay partially franked or unfranked dividends.
Cum-Dividend: The period of trading between the dividend announcement and the final day of dividend eligibility. If you purchase during this time you are eligible.
Ex-Dividend: The period between being no longer eligible and the date of receiving the dividend.
Record Date: A day after Ex-Dividend date to account for the T+2 settlement period.
Payment Date: The date payment is debited to your account or applied to you dividend reinvestment plan.
On Ex-Dividend day new investors are no longer eligible to receive the dividend payment. Thus the share is actually worth less to them. As such the market will bid down the share price to reflect the value of the company to new investors.
It is common to see the share price fall around the value of the dividend on Ex-Dividend day. As such investors would theoretically be in a similar situation if they received the dividend or if they were brought on Ex-Dividend day and brought at a lower share price.
- Interim: A dividend that is announced following the company’s interim results.
- Final: A dividend that is announced following the company’s final results.
- Special: A dividend that is announced outside of an expected period
The Dividend Yield Ratio shows how much a company pays out in dividends each year as a percentage of the current share price.
|Dividend Yield=||Total Dividend|
|Current Share Price|
The dividend can be expressed as Net or Gross Dividend Yield. The gross dividend yield takes into account the franking credits.
A share with a high dividend may seem attractive but we don’t recommend buying a share-based solely on its dividend yield.
A dividend yield may be artificially inflated due to:
- A recent drop in share price
- Poor future prospects
- A once-off special dividend
When assessing the dividend yield we should assess the overall financial health of the company as well and ensure their dividend payout ratio is sustainable and they have a strong balance sheet to support dividends.
Dividend Payout Ratio: The ratio of the total amount of dividends paid out to shareholders relative to the net income of the company, Source: Investopedia
Chasing dividend yield isn’t always the most suitable option. As dividends are the company’s earnings being paid out to shareholders this means that the underlying assets of the company is being reduced by the amount of the dividend.
We see this in practice on Ex-dividend day as the share price usually falls by the dividend amount as new investors are no longer eligible to that capital. Not only does this directly reduce the balance sheet of the company but it also reduces the ability of the company to use these funds to further grow the company.
In theory, if there were two identical companies and one paid a dividend and the other didn’t the shareholder leave as is returns would be identical. A good practical example of this is the Australian and American stock markets. Australia is well known for having high payout ratios and high yielding dividends, whereas the US is more known for having growth companies that reinvest their earnings.
Below I have attached the returns of both markets (ASX all ordinaries index (XAO), S&P 500 index (INX), ASX 200 Net total return index (XNT)) over time as well as a diagram that describes the returns of the ASX index with all dividends reinvested (utilizing a DRIP)
How A Company is valued, and why Share Price Doesn’t Dictate Value
Many of us have heard the phrase from our mates or even renowned investing fools “The share price is really cheap” or “5 Stocks for under $5”. This is a common misconception. But we can’t make it any clearer:
Share Price Doesn’t Equate to Value
A companies share price is proportional to the Market Capitalisation divided by the Number of shares outstanding.
The fact that a company’s share price is $5, $500, or 5 cents, tells us nothing by itself. Let’s take the example of Apple. Apple has a market capitalization of around $2.42 Trillion and around 16.53 Billion shares outstanding. Giving it a share price of $146.14.
If apple increased its shares outstanding via a share split, to the point it had 2.42 Trillion shares, the share price would be $1. It’s that simple.
|Share Price=||Market Cap|
There are a lot of classes and subclasses and abbreviations and schemes you can invest in.
Prophet keeps it simple. We consider three main groups: Equity, Cash, and Other.
Equity has a large group of components but simply put, involves investing in companies in exchange for ‘equity’.
Cash is any money market account, these are generally low risk, high liquidity, but low returns- think a savings account or term deposit.
Other is any other investment classes (property, bonds, etc.).
Here at Prophet, our focus is equities. This graph shows why:
We see since 1988 Australian equities have returned 9.1% per year. Cash at just 6.1% and property at 8.5%. Property Vs Equities from BetaShares will help here.
So, equity has offered similar returns to property and even outperformed property in recent times. Equity is also a more easily achievable and more liquid investment than property.
The red area represents CPI or inflation, this means that on average we must achieve at least 2.8% to beat inflation and maintain or grow the value of our money. So, ask yourself how much your savings account earns you.
Analysing Alternative Asset Types
- Income Assets
- Government Backed*
- Lower Returns
- Opportunity Risk
- Default Risk
Bonds can offer a good source of income and some are considered risk-free. But for most investors, we also need to consider how bonds have performed in the past compared to shares. We need to consider the risk of missing out on greater returns.
Bonds are different to equities. By investing in bonds, you don’t become a part-owner of an entity instead you issue a loan to an entity which may be a company or a government.
Bonds generally work by paying a stated interest rate, the coupon rate. The value of bonds can change over time as the supply and demand dynamics of certain bonds change.
Governments and companies may issue bonds when they want to raise money for a particular reason.
Bonds have a set coupon rate, face value, and maturity date.
- The coupon rate is the interest rate that is paid on the face value.
- The face value is the initial value of the bond, usually, they are sold at a face value of $100. The actual value can change over time due to supply and demand.
When the bond matures (each bond will have a set maturity date) the face value amount will be paid back to the holder. Thus, if the investor purchases it above or below the face value they could stand to lose or gain money on maturity. Whilst they hold it, they will also collect the coupon.
Historic Trends and Expected Returns
To best illustrate the general bond trend across multiple US bonds I have used the data from Vanguards ETF: BND.
From this data, we can see the price growth of bonds has behaved in a similar pattern to metals. In 2008 we see the price increase before dropping off following the GFC. In 2020 we then see bond prices rise dramatically with the COVID recession.
Averaged over this period bonds capital gains have returned 1.25% per year.
To account for the actual returns of bonds, this graph account for the dividends paid out by the ETF, which are a result of the bond coupons. We can now see that actual bond returns have had decent positive growth, with very little volatility.
The total returns for bonds have averaged 5.63% per year over this time period.
Short-Medium Term >1 Year: From the above data, we can see that bonds have been relatively stable short-term investments due to their low volatility. We can see that statistically, bonds have had positive returns for timeframes over one year.
Bonds are generally considered a relatively safe investment. But bonds come in a range of risk factors. These are often quantified by rating agencies by terms such as AAA which is the highest rating.
These ratings rank the ability of the borrower (company or government) to pay the set coupon rates and to repay the loan at the maturity date. Many of the government bonds are AAA rating and are often used to describe the risk-free return rates.
Although Australian and American government bonds are high grade, other counties’ bonds have much lower ratings and have high risks of the borrower defaulting.
Bonds can be traded on most good brokerage sites. The bond market is extremely liquid
Australian government bonds which can be traded on the ASX are known as Exchange-traded Treasury Bonds.
- High Returns Recently
- Increasing Popularity
- No Historic Information
- No “Real” Value
Of course, we have to mention Cryptocurrency, the asset that has taken the world by storm. Prophet originally invested into bitcoin at around the $5000 mark and made impressive unrealized gains until finally selling out at just a few hundred dollars of profit.
But we sold because Cryptocurrency doesn’t meet our investing fundamentals at this time.
Cryptocurrency like gold and other commodities produces nothing. What I mean by this is that the only value these commodities have is the value we assign to them. This is largely driven by supply and demand, and on top of this there is no real use for cryptocurrencies which will likely impact demand in the future.
In comparison, a group of great companies over time will produce great profits and pay out excellent dividends to their shareholders and in turn will continue to grow and expand their business to produce higher earnings and further assets. A block of gold will sit in a safe and do nothing over time, the same principle applies to cryptocurrency.
If you own an ounce of gold now and you caress it for the next hundred years, you’ll have an ounce of gold a hundred years from now.Warren Buffett
All in all, it is still possible to make money off cryptocurrency, just like it is possible to make money off anything. However, given the above reasons I don’t see cryptocurrency as a wise and sustainable long-term investment going forwards.
Cryptocurrency Expected Returns
Bitcoin has averaged 408.8% over the last four years. The price has been extremely volatile.
Cryptocurrency is still a very new asset class. With crypto becoming mainstream in 2017 it is too early to gather accurate statistical data on its previous performance
Cryptocurrency Investment Timeframe
Short Term/Unknown: Cryptocurrency is a relatively new investment asset class. At this stage it is still yet to find its place and mature as an Investment. At the moment it is largely actively traded as a short-term investment strategy.
Most cryptocurrencies aren’t backed by underlying assets, commodities or earnings. As such the price of a coin is based solely on the supply and demand for its perceived earnings.
Most cryptocurrencies are set up to handle supply and demand in an extremely effective manner. However, one oversight is the general dilution and oversupply of the cryptocurrency market.
If you look up a list of cryptocurrencies you will realize there are now thousands. All of which do practically the same thing with minor differences.
Since the value of these currencies is theoretically only driven by supply and demand the oversupply isn’t supportive of constant and rising prices.
The definition of a currency is something that is very liquid and easily exchanged. This is not the case with cryptocurrency. Although things have improved Crypto is still relatively illiquid for a currency.
It was easy enough to buy the currency albeit after setting up an account after picking from many exchanges and paying relatively large brokerage price.
When I finally decided to sell, it took me ages to find an exchange that would let me transfer it to AUD and then withdraw this amount to my bank account.
On top of this, the security involved in setting up this account was over the top, the identification verification process was more stringent than setting up a bank account.
Trading cryptocurrency also incurs a relatively large spread and a large brokerage fee. Hence it is clear that cryptocurrency is not an effective currency at this point in time.
- “Tangible” Asset
- Decent Returns
Precious metals are an often forgotten asset. Gold is obviously the most famous metal but investors may often also buy silver and platinum.
Precious metals are brought by some investors to add further diversification to a portfolio and hedge against inflation. All metal has its own unique risks and opportunities.
The value of gold is constantly determined by the market 24 hours a day. Gold trades predominantly as a function of sentiment rather than supply and demand. The amount of available gold far outweighs the amount from new mining supplies.
Factors that influence the price of gold include:
- Systemic financial concerns: When banks and money are perceived as unstable and/or political stability is questionable, gold has often been sought out as a safe store of value.
- Inflation: When real rates of return in the equity, bond, or real estate markets are negative, people regularly flock to gold as an asset that will maintain its value. Source, Investopedia
We can see evidence of these stimuli within the price graph. From the early 2000s-2008, we see a steady increase in gold returns with the rise of inflation. In 2008 we see a spike corresponding to the GFC. After this, we see the price rise and fall with inflation rates.
We see a massive spike in 2020 again corresponding to the COVID pandemic.
Unlike gold, the price of silver swings between its perceived role as a store of value and its role as an industrial metal. For this reason, price fluctuations in the silver market are more volatile than gold. Source, Investopedia
Again the share price has a similar trend to gold, whereas the same timeline events are evident in its returns.
Platnum has a larger reliance on supply and demand as well as sentiment compared to the other metals. This is due to far less of the metal is being mined from the ground annually.
Platinum is said to be the most volatile of the three metals.
Factors that Impact the price of Platinum Include:
- Platinum is considered an industrial metal. The greatest demand for platinum comes from automotive catalysts. After this, jewelry accounts for the majority of demand. Petroleum and chemical refining catalysts and the computer industry use up the rest.
- Because of the auto industry’s heavy reliance on metal, platinum prices are determined in large part by auto sales and production numbers.
- Platinum mines are heavily concentrated in only two countries—South Africa and Russia. This creates greater potential for cartel-like action that would support or even artificially raise platinum prices. Source, Investopedia
Returns for commodities are poorly documented compared to equities. We have calculated the average annual return per year for gold below. We see from the graph There are massive outliers within the period from 1970-1980.
From this period the worst performing year, we saw a drop of -32.15% and a peak of 133.41%. This has a much higher volatility than shares where we saw a range of -40.4%-39.60%.
When we take the median over the years to exclude outliers we see returns of 5.68%.
When we take this further and remove the best performing periods of gold (1970-1980 and 2008-2010) Investors have only averaged 1.46% per year.
Gold Investment Timeframe
Short Term: Over the long term investors have historically had poor returns when buying at peaks. Gold Seems more suitable for a short-term trading strategy.
When looking at the price graph of gold we can see there have been large periods of negative and neutral returns. We can see that investors holding from the period of 1980-2005 made no returns. Meanwhile, inflation and stocks far outperformed gold.
Again we notice from around 2010-2020 investors made no returns.
Due to this trend, it can be difficult to establish an investment timespan for Gold
The commodity seems better suited to short-term trading around recessionary periods. Historically investors that have brought at price peaks have had poor returns for 10+ years.
This is supported by our previous quote:
When we remove the best performing periods of gold (1970-1980 and 2008-2010) Investors have only averaged 1.46% per year.
Precious metals have tendered to be more volatile than equities. This volatility can subject investors to risk if they’re uneducated. However, with precious metals being a “real” asset, investors may be less prone to trade based solely on price fluctuations allowing them to hold through volatility.
Being a real tangible asset obviously brings about the risk of having to store and account for the commodity.
Gold has high liquidity within financial markets. The trading volumes of gold are similar to the total S&P 500 equities.
We can see there is obviously sufficient turnover the facilitate liquidity within the gold market. 50% of liquidity comes from OTC bullion trading. The remainder stems from futures, ETFs, and other gold markets.
Liquidity for an individual investor then stems from the physical action of buying and selling gold. OTC metals from retailers can also be quite expensive with an average spread of 10%.
This means your investment must appreciate by 10%, before even breaking even.
Welcome To Prophet Invest
Over this 10-part series, we will show you everything we have learned about ASX investing for beginners.
We are two brothers from Brisbane Australia, who started investing as soon as we were legally able to open a brokerage account. We have had some very good years and a few lessons.
Prophet Invest has the mission to share our thoughts with millions of people on all things shares, crypto, wealth, and property.
A lot of the information from this series was inspired by our best-selling eBook, available on special now.