Introduction to investing

Introduction to Investing

John Price

What is investing?

• If you invested $10 000 in the S&P 500 in 1950, it would have grown about 10% compounded per year.

• The investment would be worth about$1 000 000 in 45 years.

Year Principle

1950 $10 000.00

1951 $11 000.00

1952 $12 100.00

1953 $13 310.00

1954 $14 641.00

1955 $16 105.10

1965 $41 772.48

1975 $108 347.10

1985 $281 024.40

1995 $728 904.80

2005 $1 173 908.47

What is investing?

$-

$500,000.00

$1,000,000.00

$1,500,000.00

$2,000,000.00

$2,500,000.00

$3,000,000.00

$3,500,000.00

9%

10%

11%

What is investing?

• Warren Buffet is the wealthiest investor in the world.

• His return has been about 23.5% compounded over 50 years.

What is investing?

• Buffett practices a philosophy of investing called value investing.

• The father of value investing is Benjamin Graham.

What is investing?

• Stock is partial ownership of a business.

• When you buy stock, you become a partial owner of the business.

What is investing?

• If you're an investor, you're looking on what the business is going to do, if you're a speculator, you're commonly focusing on what the price of the business’s stock is going to do, and that's not our game.Warren Buffett, Berkshire Hathaway Annual Meeting 1997

What is a business?

• A business exists to maximize profits for its owners (stockholders).

• The managers of a company are responsible for this goal.

What is a business?

Board of Directors

Stockholders Management

What is a business?

• The board of directors controls a company.

• The board may include:

1. Officers (President)

2. Officers of other companies

3. Former government officials

4. Academics

What is a business?

• Revenue is what a business makes.Revenue is also called sales.

• Profit is what a business keeps.Profit is also called income or earnings.

What is a business?

• All businesses own assets which produce revenue for the business.

What is a business?

• An asset is anything which has economic value.

• Something has economic value if people are willing to pay you for it.

• Examples:– Cash

– Inventory

– Property, Plant and Equipment

What is a business?

• There are two ways a business can raise money to buy assets:

1. A business can take debt.

2. A business can sell ownership.

What is a business?

• Liabilities are debt.

• Equity is a contribution by the owner/owners.

What is a business?

Liabilities

• Raised by borrowing

• Have to be paid back

• Exist for a fixed time

• Do not give up control of the business

• Create expenses

Equity

• Raised by selling ownership

• Does not have to be paid back

• Exists for an indefinite time

• Gives up some control of the business

• Do not create expenses

Question

• Can a business have more liabilities than equity?

What is a business?

• There are two important financial statements, the balance sheet and the income statement.

• The balance sheet shows assets, liabilities and equity.

• The income statement shows revenue, expenses and profit.

What is a business?

• The Value Line Investment Survey is the best source of financial information for the value investor.

What is a business?

• All profit belongs to the owners (stockholders). They can do one of two things with it:

1. The owners could decide that the business should keep the profit. This is called retained earnings.

2. The owners could decide that they should keep the profit. This is called a dividend.

What is a business?

• The owners of most companies usually only take a very small piece of the profits in dividends.

What is a business?

• The business needs money to expand. It can use retained earnings instead of taking debt or selling more ownership.

• The business pays taxes on its profits, and the investor pays taxes on his dividends.

• This is double taxation.

What is a business?

• A buyer pays $100 000 for a house.

• The buyer borrows$80 000 from a bank.

• The buyer makes a$20 000 down payment.

• The owner rents the house for $1 000 per month.

• The mortgage costs $600 per month.

• The owner makes $400 per month.

What is a business?

Balance Sheet Income Statement

Revenues

Rent $12 000

Expenses

Interest $7 200

Income

$4 800

Assets

House $100 000

Liabilities

Mortgage $80 000

Equity

$20 000

What is a business?


Revenues

Rent $12 000

Expenses

Interest $7 200

Income

$4 800

Assets

CashHouse

$4 800$100 000

Liabilities

Mortgage $80 000

Equity

$24 800

What is a business?


Revenues

Rent $12 000

Expenses

Interest $7 200

Income

$4 800

Assets

House $104 800

Liabilities

Mortgage $80 000

Equity

$24 800

What is a business?


Revenues

Rent $12 000

Expenses

Interest $7 200

Income

$4 800

Assets

House $100 000

Liabilities

Mortgage $75 200

Equity

$24 800

Question

• What is then the effect of profit on equity?

What is rate of return?

• Investors seek to maximize their rate of return.

investment total

profit totalr


%101.01000$

100$r

%101.010000$

100$r

%1001100$

100$r


• Knowing the rate of return allows investors to compare two investments.

• Which is better?

– Stock A’s rate of return = 10%

– Stock B’s rate of return = 20%


• Since you cannot control the profit an investment makes, the price you pay determines the rate of return.


• How much would you pay me to get $1 100 one year from now?

• If you paid $1 000, your profit would be $100. What is the rate of return?

%101.01000$

100$r


If you paid $950… If you $1 050…

%8.15158.0950$

150$r %8.4048.0

1050$

50$r


• This is how a bond works; you pay me X today, and I pay you Y in future.

• The rate of return is easy to calculate.


• There are two ways to get a return from investing in stocks:

1. Capital gains

2. Dividends


• Warren Buffett’s first business was a pinball machine which he purchased for $35.

• He asked Sarge, the owner of a local barber shop for permission to put the pinball machine in the shop.

• Sarge agreed for 20% of the revenue (sales).

• After the first day, Warren finds $10 in the machine.


Balance Sheet

Assets $43

Cash $8

Pinball Machine $35

Liabilities

$0

Equity

Paid-in capital* $35

Retained earnings $8

Income Statement

Revenue

$10

Expenses

$2

Profit

$8

*money contributed by investors

Question

• Would you sell this business for $43?

• If not, how much?


• The market value depends on the expectations for future earnings.

• If the business earns $8 per day for a year, retains 100% of earnings and never borrows money, it would add $2 920 in equity.

• In ten years, it would add$29 200 in equity.

• How predictable is the business?


• If a business uses profits to buy more assets, it should make more profits the next year.

• This means equity in the business should grow, if the company is growing earnings.

• Equity of a company tends to grow at a compounded rate.


$8 per day

$8 per day

$8 per day

$8 per day

$8 per day

$8 per day

$8 per day


If profit is positive…

Profit

Assets and

Equity

Revenue

If profit is negative…

Loss

Assets and

Equity

Revenue

decreasedecrease

decrease

increaseincrease

increase


• If the price you pay determines the rate of return you get, what are some indicators of rate of return?

1. Earnings per share

2. P/E ratio

3. Equity (Book value) per share


goutstandin shares total

earnings totalshareper earnings

• Earnings per share is the most important measure of performance.


• The price-to-earnings ratio is a measure of investors future expectations for a company.

shareper earnings

price shareP/E


Bull market Bear market

• Investors are optimistic about future earnings.

• Stock prices are inflated

• High P/E ratios

• Investors are pessimistic about future earnings.

• Stock prices are depressed

• Low P/E ratios


• The book value per share is equity per share.

• It says what a stock is worth in the accounting sense.

share ofnumber

equity totalshareper Book value

Question

• Why is book value per share usually lower than the share price?

What makes a good investment?

1. Does the business have a competitive advantage?

2. Are earnings per share strong and going up?

3. Does the company earn a high rate of return on equity?

4. Does the company have too much debt?

5. Does the business have to spend much on

operations?


• A competitive advantage is like a moat.

• It acts as a barrier to entry into a market.

• It’s what one business does better than it’s competitors.


Some sources of

competitive advantage:

1. Cost advantage

– Produce goods at a lower cost

2. Differentiation

– Brand name

– Technology

– Switching costs


• You will see that we favor businesses and industries unlikely to experience major change. The reason for that is simple: We are searching for operations that we believe are virtually certain to possess enormous competitive strength 10 or 20 years from now. A fast-changing industry environment may offer the chance for huge wins, but it precludes the certainty we seek.Warren Buffet, Berkshire Hathaway letter to shareholders 1996


• The key to investing is not assessing how much an industry is going to affect society, or how much it will grow, but rather determining the competitive advantage of any given company and, above all, the durability of that advantage. The products or services that have wide, sustainable moats around them are the ones that deliver rewards to investors.Warren Buffett, Fortune Magazine December 1999


• If no firm has a competitive advantage, the industry will be very competitive.

• Prices will be driven as low as possible.

• Firms can enter and exit easily and profit marginswill be low.


• Profit margin is profit as a percent of sales.

revenue total

profit totalmarginprofit


• Is price the most important factor in the customer’s decision to buy?

• If so, the business may not have a competitive advantage.

Question

• What business can you think of which have a durable competitive advantage? Start with businesses which you understand.







operations?


Weak Earnings per Share

Year Earnings per Share

2000 $3.22

2001 ($3.02)

2002 $0.15

2003 $0.50

2004 $2.13

2005 $1.25

2006 ($1.50)

2007 ($0.19)

2008 ($3.13)

2009 $0.00

Strong Earnings per Share


2000 $1.48

2001 $1.60

2002 $1.65

2003 $1.95

2004 $2.06

2005 $2.17

2006 $2.37

2007 $2.57

2008 $3.02

2009 $2.93


• Average growth in earnings has been about 7% since 1970.







operations?


equity

incomenet ROE

• Return on equity is a measure of how efficient a firm is with the owner’s investment.

• The average return on equity has been about 12% since 1950.







operations?


• Look at total earnings compared to total long-term debt.

earnings total

debt term-longyears ofnumber


Coca-Cola Debt

years 8.1000,000,800,4

000,000,625,8

Ford Debt

years 11000,000,470,7

000,000,000,80







operations?


• If a business makes$1 000 000 every year, but has to spend$2 000 000 every two years to replace its assets in order to stay competitive, what happens to its equity?



Revenues

Rent $12 000

Expenses

Interest $7 200

Depreciation $2 000

Income

$2 800

Assets

Cash $2 800

House $100 000

Accumulated Depreciation

($2 000)

Liabilities

Mortgage $80 000

Equity

$20 800


• Depreciation represents how much a business must spend to replace their assets in order to remain competitive.

• If the ratio of depreciation to net profit less than one, the business doesn’t have to spend that much in order to remain competitive.

How to calculate rate of return?

• To calculate the rate of return of an investment, we need two things:

1. Current stock price

2. Prediction of future stock price


• To predict the future stock price we need:

1. Current stock price

2. Earnings growth rate

3. Historical average P/E ratio


• If earnings per share are $5.00 this year, what will they be ten years from now?


2011 $5.00

2012 $5.50

2013 $6.05

2014 $6.66

2015 $7.32

2016 $8.05

2017 $8.86

2018 $9.74

2019 $10.72

2020 $11.79

2021 $12.97


• Multiply future earnings per share by average P/E ratio.

• The result is a prediction of the future stock price.

Year Earnings perShare

Average P/E Ratio

Future Stock Price

2011 $5.00 15 $75.00

2012 $5.50 15 $82.50

2013 $6.05 15 $90.75

2014 $6.66 15 $99.90

2015 $7.32 15 $109.80

2016 $8.05 15 $120.75

2017 $8.86 15 $132.90

2018 $9.74 15 $146.10

2019 $10.72 15 $160.80

2020 $11.79 15 $176.85

2021 $12.97 15 $194.54

Priceshareper Earnings*/ EP


1Value Beginning

Value EndingRateGrowth Compounded

periods ofnumber

1


If you paid $100… If you paid $50…

1$100.00

$194.54 10

1

19454.1 1.0

10688.1

%88.60688.0

1$50.00

$194.54 10

1

19808.3 1.0

11481.1

%81.141481.0


• The average rate of return on common stocks since 1950 is about 10% compounded annually.


• Since earnings and equity grows at a compounded rate, the price of stocks tends to do the same.

Introduction to investing

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