Juan:'You told me to speak to my stockbroker about which shares that she would recommend me to buy.'
Juan:'Well, it was like she was speaking in a different language to me. All these terms and words she was telling me. For example, she told me that there are two different types of stocks/shares I can buy, preferred stocks and common stocks. What is the difference between the two?'
Peter:'Preferred stocks, which are called preferred shares here in Britain, are a type of share where the owner of them is paid a fixed dividend by the company. So you're guaranteed a dividend unless the company has very bad financial problems. With common stocks, which are also called ordinary shares here in Britain, the dividend can change depending on the company's performance or on how much the company wants to give its ordinary shareholders.'
Juan:'She also mentioned something about the yield of the share.'
Peter:'The yield is how much money you earn from the share's dividend on each dollar or pound you have invested in a stock or share. To find out what the yield of a share is, you have to divide the yearly dividend for each share by the amount you paid for the share. So, if a share cost you $2.50 and the yearly dividend is 15 cent, you divide 15 by 250. So the yield for the share is 6%. It is used to show how much money you will make. It's a way to compare the different returns or money you could receive/make from investing your money in different companies' shares or from other types of investments.'
Juan:'But that only measures the dividends and companies don't normally give all their profit to their shareholders as a dividend. So is there a way to measure how a company is performing by looking at its full profit.'
Peter:'Yes. If you want to measure the performance of a company then you just divide the net profit of the company (after taxes) by the total number of the company's outstanding ordinary shares (the shares that are sold on the stock market and are not preferred stocks/shares). Normally, this calculation is done with the dividend which the company pays to preferred stocks removed from the net profit number. This is called the EPS, which means the 'Earning Per Share'. So if the annual net profit of a company is $110 million and it has paid a dividend on preferred stocks/shares of $10 million, the net profit you use in a EPS calculation would be $100 million. If the company has 20 million ordinary shares on the stock market, then the EPS for this company is $100 million divided by 20 million, which is $5. This is normally used to see how much a company is growing. Investors and analysts normally compare the EPS of a company over different years to see if there is any change in the company's level of growth.'
Juan:'But different shares have different prices. For example, one share in the company Tromp plc costs $15 while one share in the company TwoWorlds plc costs $25. Is there a way to compare which company is doing better on the value of its shares and not on just the number of its shares?'
Peter:'Yes, you can use the P/E ratio, which is the 'Price to Earning ratio'. You calculate it by dividing the price of the share (one share in Tromp plc costs $15) by the EPS of the company (for example $5). So, the P/E ratio for Tromp plc is $15 divided by $5 = 3. A low P/E ratio for a company (1-70) means a company is making a good level of profit in comparison with its share price and that the share price could be undervalued and may rise. A high P/E ratio(100 or above) means a company isn't making a good level of profit in comparison with its share price and that the share price of the company is overvalued.'
Juan:'What does the equity of a company mean?'
Peter:'Basically, equity means the amount of money which the owners of a company would be left with if they had to close down their company. To find out what the equity of a company is, you simply have to find out what money it has in the bank, plus the things it owns and could sell if it had to close down (like property, machines, patents, the products it hasn't sold etc...). These are called a company's assets. Then, you have to find out how much money the company owes/has to pay to other people (like loans, taxes, rent, money to suppliers etc...). This is called a company's liabilities. To find out a company's equity, you just subtract the company's liabilities from its assets. For example, if a company's assets are $575,000 and it's liabilities are $400,000, its equity is $575,000 minus $400,000, which is $175,000.'
Juan:'It sounds a little too complicated for me to calculate.'
Peter:'But you don't have to calculate it. Every company has to give this financial information each year in a report. It's called a balance sheet. So you can find a company's equity by looking in its balance sheet.'
Juan:'But why would I need to know what a company's equity is? How would it help me decide which shares to buy?'
Peter:'Only using the amount of a company's equity to know which shares to buy isn't normally used. But there is a commonly used calculation to measure how well a company is being managed/run which uses a company's equity. It's called the ROE or the 'Return On Equity'. It basically compares a company's equity to its net profit/earnings. It shows how well a company is using its resources to make profit. You calculate the ROE by dividing a company's net profit by its equity. You then times the result by 100 to find the ROE. So if a company's net profit/earnings is $120,000 and its equity is $400,000, then the company's ROE is $120,000 divided by $400,000 x 100, which is 30%. If a company has a ROE percentage of 10% or above, it shows that the company is being managed/run well and efficiently. If the percentage is below 10% then it suggests that the company isn't being run as efficiently as it could be and may not be a good company to invest your money in.'
Juan:'Are there any ways that you can measure the risk of investing in the shares/stock of a company. I know the ROE shows you if a company is being managed well or badly and suggests that there is a risk of losing your money if a company has a low ROE.'
Peter:'Yes, there is another calculation which is used to measure the risk of investing in a company by measuring how large a company is. This is called the market cap. Normally, the larger a company is, the lower the possibility/chance that the company will go bankrupt or close down. You find what the market cap of a company is by multiplying the total number of the company's shares by the share price. So, if a company has 100,000,000 shares and the current price of each share is $12. The market cap for the company is 100,000,000 x 12, which is $1.2 billion. The market cap is used to rank/rate companies as 'large cap', 'medium cap' and 'small cap'. A company is rated as 'large cap' if its market cap value is $12 billion or over. A company with a market cap of $2 billion or under (as in the above example) is rated as 'small cap'. So, if you bought shares in a company which is rated 'large cap' there is in theory a lower risk that you'll lose your money than if you bought shares in a company rated 'small cap'.'
Juan:'Thanks for explaining all these ways to calculate if a company is doing well.'