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Education Module 2
Trading the stock market
DIFFERENT CLASSES OF SHARES
While all shares are evidence of ownership in a company,
not all shares, or equity securities as they are known, are
the same. Generally, shares consist of two main classes
or categories: ordinary shares and preference shares.
The different shares can vary greatly in the rights that
they offer shareholders and in the obligations that they
entail.
It is important to realise that there are many classes of
financial instruments (beyond ordinary and preference
shares) that are traded on the ASX and they all have
their own detailed characteristics. Some of these include
company options, fixed interest securities (such as
debentures and bonds) and derivatives (such as options
and warrants).
Industrial shares
Industrial shares are
shares in companies
that engage in the
production of goods or
services.
These companies are
involved in commerce
and industry, such
as banking (e.g.
Westpac Banking Corporation), construction (e.g. Leighton
Holdings), transport (e.g. Qantas Airways), insurance (e.g.
QBE Insurance), gaming (e.g. Crown Ltd), alcohol (e.g.
Foster’s Group) and media (e.g. Fairfax Media Ltd), just to
mention a few.
Resource shares
Ordinary shares
These are the most common form of equity securities.
Ordinary shareholders have the usual voting rights
at shareholder meetings, they have the right to a
proportionate part of the company’s distributed profits
each year (dividends), and they have the right to sell their
shares and accept or reject takeover offers. However,
in the event of a company’s liquidation, ordinary
shareholders usually rank last in priority.
The other sector of the market is the resources sector.
Resource companies are companies that are engaged in
the exploration and mining of the earth’s resources, such
as gold (e.g. Newcrest Mining), nickel (e.g. Mincor), iron
ore (e.g. Fortescue Metals), oil (e.g. Oil Search) and gas
(e.g. Woodside Petroleum).
An advantage of resource companies is that should the
company make a resource discovery that can be exploited,
the shares may experience dramatic growth.
Preference shares
Preference shareholders must be paid their dividends
before ordinary shareholders. And in the event of a
company’s liquidation, preference shareholders rank ahead
of ordinary shareholders in the distribution of liquidated
assets. There are many different forms of preference
shares.
SHARE TYPES
We will now look at the different types of shares. The type
of share is one indication of the risk profile of that individual
share.
Our stock market is made up of many different types of
shares, but they all fit into one of two major categories:
industrial shares and resource shares. Beyond those two
major categories, there are several sub-categories, such
as blue chip shares, speculative shares, mid-cap shares
and small-cap shares.
An obvious disadvantage is that should exploration go
unrewarded and prospects go unrealised, the share price
performance is likely to be dismal and, hence, an investor’s
nightmare. It is very important to realise that unrewarded
exploration is very common.
Furthermore, resource companies’ dividends are often
smaller than industrial companies (if they are paid at all)
and they are certainly less consistent. Many resource
companies tend to withhold much or all of the profits in
order to finance further exploration or the development of
further projects.
Also, any discovery that assists the share price is
unfortunately a wasting asset, which means that as the
resource is exploited over time, the value of this discovery
diminishes.
Some of the more in-depth types into which shares are
categorised are discussed below.
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Education Module 2 Trading the stock market
Blue chip shares
Blue chip shares are generally defined as shares in leading
companies that are considered to be of high quality in
terms of market position, earnings, dividend record and
financial strength. Large capitalisation alone does not
qualify a share as a blue chip.
As an investment opportunity, blue chip shares can
certainly be excellent. They generally make consistent
profits, out of which they consistently pay dividends to
shareholders. These dividends are also often fully franked,
which means that the companies often pay the tax on
profits for you.
There are no real disadvantages to owning blue chip
shares, except perhaps that their stability, whilst rewarding
in the long-term, is often not compatible with the large
short-term growth often sought by speculative investors.
(Speculators accept high risks in an attempt to earn quick
profits.)
This lack of volatility is an advantage to investors, but for
the speculator out to make a quick profit, these companies
often don’t provide the volatility that is sought.
Speculative shares
The opposite of blue chip shares are the speculative
shares. Various mining shares, or industrial hi-tech or
biotech shares, may fit this category.
This section outlines the different definitions that you will
hear used to describe a type of market. It is important
for investors to understand the terminology used in the
industry and to understand what type of market they are
working in.
The general strategies used in different types of markets
will vary and the risk profile of investments will also
change, depending on the type of market or market cycle.
Bear market
A bear market is a market in which prices go down. It is
essentially a period of generally falling prices, which is set
against a backdrop of pessimism.
Bull market
A bull market is a market in which prices go up. It is
essentially a period of generally rising prices, which
takes place in an environment of optimism and investor
confidence.
Sideways market
The term ‘sideways market’ is not a term that you will often
hear mentioned in the press, but the reality is that there
are times when the market moves sideways, and the trend
is neither clearly up nor definitely down for any consistent
period.
Speculators investing in these companies look for very
high rewards in return for investing in companies with no
consistent profits or dividends, and no real assurance
of success of any kind. The capitalisation of speculative
shares (especially during a boom) can get very high, but
the risky nature of these shares is what classifies them as
speculative shares.
Boom market
Mid-cap shares
The boom market is the point in the cycle when optimism
peaks, as it did, for example, during the 1999/2000 global
Internet/tech-boom.
Mid-cap (mid-capitalisation) shares can be either industrial
or resource shares. These companies are basically
medium-sized companies with a capitalisation generally
between $200 million and $1 billion. This is not a rule,
merely a guide.
Small-cap shares
Small-cap shares are generally the shares in companies
that are valued at less than roughly $200 million by the
market.
Nevertheless, these small-cap companies do, unlike many
speculative shares, generally have proper profit-generating
businesses. Investing in small-cap shares can definitely be
rewarding, but a higher level of risk needs to be accepted
by the investor in relation to their larger-capped market
cousins.
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MARKETS AND CYCLES
A boom market is the final phase of an exaggerated
bull market, when logic seems to go out the window
and certain stocks or sectors start moving with extreme
volatility. Market valuations of companies get to such a
high point, that it is impossible to find value in the market
and, consequently, this is a great time to sell.
Market crashes and corrections
When the market plunges, it is known as a crash or a bust
(or a correction if it is a smaller fall). This phase follows
the boom, and generally (but not always) precedes a bear
market.
A stock market crash is the phase of the market when
pessimism peaks and market valuations are slashed. The
two best examples of market crashes are Black Tuesday,
29 October 1929 and Black Monday, 19 October 1987.
In this kind of market environment, bargains are easy
to come by and, hence, this is a great time to buy. The
predominant emotion during a crash is one of panic.
PO Box 1524 Double Bay NSW 1360 Website www.rivkin.com.au Phone +61 2 8302 3600 / 1300 366 145 Fax +61 2 8302 3601 Email [email protected]
Trading the stock market Module 2 Education
Most investors try to sell at whatever price they can.
Participants in a crash are so desperate to get out, that no
consideration is made as to the price or value that is being
sold.
A correction differs from a crash only in the magnitude
and speed of the fall. Some say a drop of at least 10%
but no more than 20% constitutes a correction, but this is
only a guide. The terrorist attacks of September 11, 2001
on the World Trade Center are an example of a correction
as opposed to a crash. On the day the attacks occurred,
the S&P/ASX 200 index fell 4.3% and by two weeks later,
the market had fallen 10.1% in total.
Market Analysis
FUNDAMENTAL ANALYSIS
Fundamental analysis is basically the process of digesting
all the historical and current financial data of a company
and then arranging it into a series of benchmark ratios.
This is done in an attempt to assess a share’s fair value
and, hence, to predict future share price movements and
company performances.
Obviously, if fair value is greater than the current share
price, then one may want to purchase the shares in order
to realise a capital gain. If, however, fair value is lower
than the current share price, then one may want to sell
shares that are held, or a short selling strategy may be
pursued.
The financial data, which is ‘fundamental’ to the company
(hence the name), is usually sourced from a company’s
annual and semi-annual accounts, or from company
research. The process of creating this fundamental
data in the stock market is generally left to professional
analysts.
The company itself then often checks its work before
the broker publishes the information. The company may
release certain data, but it is generally fairly crude and
often needs changing (or normalising) before market
professionals will use it.
Technical analysis is founded on the assumption that
history repeats itself. Basically, past price patterns are
used to try and predict future price patterns. Due to the
predictive nature of this form of analysis, many market
participants are sceptical of it.
MARKET MEASURES
What follows is a very simple introduction to the
fundamental measuring tools used in the market. These
ratios and numerical indicators are used by participants in
the markets for primarily two reasons.
Firstly, they are used to try to calculate a fair value for
shares. Secondly, they are used as a tool for comparison.
Often investors (professional investors especially) are
interested in how different listed companies compare to
each other in terms of value.
Market value indicators
It is important to have an understanding of various market
value indicators, which are really just ways to analyse
shares and to assist in trying to evaluate the value of a
company or to compare one company against others.
Using information disclosed in company reports (which
can also be found in the financial pages of the newspaper,
or obtained via quality stockbroker research), one can
calculate a variety of measurements, or indicators, that can
assist in making informed investment decisions.
For the sake of simplicity, we will use a fictitious company
in these calculations. Below are listed the information
components required for this exercise.
Company
Share price
Operating profit after tax
Dividends paid
Number of shares outstanding
Assets
Liabilities
Intangibles
ABC
$10
$250m
$50m
100m
$600m
$280m
$60m
TECHNICAL ANALYSIS
Dividend payout
In contrast to fundamental analysis, there is a system of
market predicting known as technical analysis. Technical
analysts hope to be able to predict and profit from future
trends by analysing historical price action.
This is the proportion of the annual operating profit after
tax that is paid out in dividends to shareholders. The
decision as to how much is to be paid out and how much is
to be retained is made by the board of directors.
Technical analysis is the process of looking at historical
price data, formatted into charts, and trying to predict
the future price action based on those charts. It also
involves the use of quantitative analysis, which assists in
investigating share price cycles and patterns.
Generally speaking, high-growth companies require more
working capital and have low payout ratios (or pay no
dividend at all) and mature businesses generally have
higher payout ratios, as they do not require reinvestment of
the profits in the business (more on this later).
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Education Module 2 Trading the stock market
The payout ratio is calculated by dividing the dividends
paid by the operating profit after tax, and is expressed as a
percentage.
Payout ratio = dividends paid ÷ operating profit after tax
= $50 000 000 ÷ $250 000 000 = 20%
irregular components to the profit result or a change in
accounting procedure.
When using EPS (earnings per share) and the other ratios
derived from EPS, it is critical to use the correct operational
income. EPS can be skewed by acquisitions, accounting or
tax changes and other one-off type influences, so using the
adjusted earnings is important.
Dividend coverage
The reciprocal of the dividend payout is known as the
dividend coverage. This is an indicator of how many times
the dividend could be paid from the operating profit after
tax, or rather how much after-tax profit is being used to
finance dividends.
This figure is often used to analyse the risk of a company
not being able to maintain its dividend in times of weaker
earnings. Obviously, the higher the dividend coverage,
the lower the risk of a company not paying its dividend to
shareholders in a period when earnings may come under
pressure.
Dividend coverage = operating profit after tax ÷ dividends paid
= $250 000 000 ÷ $50 000 000 = 5 times
Earnings per share = operating profit after tax ÷ number of shares outstanding
= $250 000 000 ÷ 100 000 000 = $2.50
Price/earnings ratio
The P/E ratio combines the earnings and share price
to create a comparable ratio between shares. This is a
fundamental measure of the attractiveness of one share
compared to others.
The P/E ratio also indicates how long it will take to earn the
value of the company, in profits.
For example, a P/E ratio of five times suggests it will take
five years for a company to generate its capitalisation in
earnings (assuming no change). Obviously, the lower the
P/E ratio, the cheaper are the shares.
Dividend per share
Dividends per share is the total dividend amount paid in
the last year, divided by the number of shares outstanding.
Dividend per share = dividends paid ÷ number of shares outstanding
= $50 000 000 ÷ 100 000 000 = $0.50
Dividend yield
The dividend yield is reflective of a share’s incomeproducing capacity. It is calculated by dividing the dividend
per share by the share price.
This figure is widely used to compare the income
component of different investments.
Dividend yield = dividend per share ÷ share price
= $0.50 ÷ $10.00 = 5%
P/E ratio = share price ÷ earnings per share
= $10.00 ÷ $2.50 = 4 times
Net tangible asset backing (NTA)
The NTA is expressed as a ‘per share’ figure, which
attempts to tell us how much each share would be worth if
the assets of a company were sold, all debt repaid and all
monies distributed to the shareholders.
The NTA does not include intangible assets such as
goodwill, although intangibles such as brand names are
often very valuable. If the NTA is greater than the share
price, the company may be undervalued.
NTA is a critical measure when considering the value of
shares. Very often, a company may be in an earnings
slump, but have a high NTA, which may underpin the share
price.
Earnings per share
Earnings per share are calculated simply by dividing
the operating profit after tax by the number of shares
outstanding. This is simply earnings, but by bringing it back
to a ‘per share’ basis, investors can compare it to the share
price.
It is important to understand that the calculation of
earnings per share is not always so simple. The EPS
calculation often requires adjustments for abnormal or
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Shares with a high NTA are generally lower risk than those
with a low NTA. Companies with a low NTA are more
dependent on short-term earnings for their share price
performance.
NTA backing = (assets – liabilities – intangibles) ÷ number of shares
outstanding
= ($600m - $280m - $60m) ÷ 100m = $2.60
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