Dumb economics question!

[Jaggy Bunnet]

Your concern for stock price as opposed to dividend yield, and your apparent concern for future cash flows without regard to the time window in which they appear.

Nothing wrong with that, of course. As I said, no one is purely a growth or a value investor. But since P/E tends to be much more directly meaningful to an investor concerned with next quarter's cash flow as opposed to stock price an indefinite number of quarters from now, the analysis of stock price vs. interest rates is more easily presented from an unreasonably and unrealistically pure value investment standpoint. Think of it as the financial equivalent of "neglecting air resistance" in a physics problem.

Fair enough, I didn't think I had taken a position on growth or income but I guess focussing on share price is an implicit growth position.

Going back to the original question, I think we both failed to correct a slight misunderstanding in the original post:

Price/Earnings ratio is the share price multiplied by the number of shares in issue (market capitalisation) divided by the post tax earnings for the period.

The measure that cj.23's dad was talking about (the ratio of dividends to the share price) is different. This is the dividend yield and is normally expressed as a percentage.

A quick numerical example. A company has 100 shares that trade for $100 each. It makes profits after tax of $800 and pays a dividend out to its shareholders of $500, keeping the balance to reinvest in the business.

Price earnings ratio is number of shares (100) * share price ($100) / Earnings (800) = 12.5

Dividend yield is dividend per share ($5) / share price = 5%

cj.23 - this site is quite good as a glossary of investment related terms:

http://www.investorwords.com/

 

[Francesca R]

Your concern for stock price as opposed to dividend yield, and your apparent concern for future cash flows without regard to the time window in which they appear.

Hence the catch-all theory is that the correct value for a share is the present-value of all expected future cash flows it will generate for its owner. There is no reason to prefer dividends over share price appreciation except insofar as these are differently treated by tax laws.

 

[Francesca R]

I've just been reading about Bonds - you can convert them to discounted shares at a future date, but have not got the hang of this yet.

Those are "convertible bonds" which come in a variety of flavours, some rather engineered and wacky. Most corporate bonds are not convertible.

I assume the advantage of companies issuing them is that they don't have to pay interest on the cah raised, but surely they will devalue your shares when cashed in???

They typically do pay coupons but the coupon (and the yield) is lower than that for regular bonds because the right to convert has positive value. They will not devalue other shares because the right to convert them to shares is publicly known and market prices factor in known information.

Last foolish question for now -- What is a stock split? It looks to me like you double the shares and halve their value, diluting them massively. Why would you do this?

You (an investor) don't do it. The company does, just to change the number on the share price as Tippit said. You don't get a choice.

 

[Jaggy Bunnet]

A stock split is a purely cosmetic action where the aggregate shares outstanding of a business are increased by some amount so as to reduce the price per share. Unlike public equity offerings, or the Federal Reserve diluting the purchasing power of our money, it is not dilutive because the ratio of the split is applied to each shareholder equally.

The purpose is to create demand for the stock by reducing it's apparent price to naive investors, or to keep share prices in line with convention.

Just to add, there can be sensible reasons for wanting your share price not to get too high.

If the share price was very high (for example Berkshire Hathaway's share price is over $100,000 per share) then it limits those able to invest in the company.

Also, many companies operate some form of scheme where employees can buy shares (often in a tax privileged manner). If the price of each share is high, then this can mean that some employees cannot afford a single share.

 

[drkitten]

A stock split is a purely cosmetic action where the aggregate shares outstanding of a business are increased by some amount so as to reduce the price per share. Unlike public equity offerings, or the Federal Reserve diluting the purchasing power of our money, it is not dilutive because the ratio of the split is applied to each shareholder equally.

The purpose is to create demand for the stock by reducing it's apparent price to naive investors, or to keep share prices in line with convention.

It has a slight effect in increasing the liquidity of the stock as well; many brokers are unwilling to handle "odd lots" (purchases that are not an exact multiple of 100 share) or charge premium fees to do so. It is therefore cheaper for me to buy 100 shares at 50 than 50 shares at 100. Reducing the stock price makes it easier to buy or sell shares in 100-packs -- thus more people do so.

 

[cj.23]

I'm almost tempted to get some shares - I know I can't afford it but I could put my birthday money in to them and enjoy the gamble. have never bought a lottery ticket (well three times when faced with vet fees - won twice, so I got lucky, the third time put me off), but here I could just hang on ot them and see what happens. I can easily get company financial annual reports and have a look, off the net, right?

Thing is brokers fees ran at about £30 in the late 80's as i recall per transaction, so with only £50 I could feasibly invest not really worth it yet! Maybe one day.

cj x

 

[Francesca R]

I'm almost tempted to get some shares - I know I can't afford it but I could put my birthday money in to them and enjoy the gamble. have never bought a lottery ticket (well three times when faced with vet fees - won twice, so I got lucky, the third time put me off), but here I could just hang on ot them and see what happens. I can easily get company financial annual reports and have a look, off the net, right?

Thing is brokers fees ran at about £30 in the late 80's as i recall per transaction, so with only £50 I could feasibly invest not really worth it yet! Maybe one day.

cj x

[Not investment advice] Buying an index tracking ISA would be free of broker fees and also any income tax or GCT (not that CGT is an issue with small sums). Some of them carry very low management fees too [/]

 

[Tippit]

Just to add, there can be sensible reasons for wanting your share price not to get too high.

If the share price was very high (for example Berkshire Hathaway's share price is over $100,000 per share) then it limits those able to invest in the company.

Also, many companies operate some form of scheme where employees can buy shares (often in a tax privileged manner). If the price of each share is high, then this can mean that some employees cannot afford a single share.

Yes, but even this isn't problematic because there will be mutual funds that spring up for the sole purpose of making these shares affordable, as was the case with Berkshire Hathaway, until they created the Baby Berkshire (BRK.B) shares. As of today you can acquire a share of BRK.B for the modest sum of $3825 if you're so inclined.

 

[drkitten]

Yes, but even this isn't problematic because there will be mutual funds that spring up for the sole purpose of making these shares affordable, as was the case with Berkshire Hathaway, until they created the Baby Berkshire (BRK.B) shares. As of today you can acquire a share of BRK.B for the modest sum of $3825 if you're so inclined.

... assuming my broker handles odd lots. Or the modest sumof $382500 if I want to avoid the exorbitant commissions.

BRK.B is still not a very liquid stock -- check the sales figures yourself. Warren doesn't care especially (he's philosophically opposed to active trading and would actually prefer an illiquid stock), but lots of corporations DO care.

 

[blutoski]

1. What is the relationship between Interest Rates and the Stockmarket?

Two more aspects of the relationship that haven't been mentioned yet:

1. overall economy growth forecasting
Higher interest rates tend to mean less consumer spending, as loans get tighter. Companies that depend on discretionary income or mad money will be hit disproportionately - or maybe they won't - so their stocks are reduced in value. (ie: people aren't selling these stocks to buy bonds, but to buy 'safer' stocks - we're seeing some of this right now).



2. stock-specific crises
Just one example is here in Canada, Teachers Ontario wanted to take control of BCE (Bell). To do this, they created an offer of $56/share, but they needed to borrow cash to close the deal. If the interest rates went up too high, or if interest rates meant that the lenders couldn't come up with enough cash to lubricate the deal, then it would fall through. The 'real' value of BCE at the time of the offer was probably $46, so the share price reflected the probability of the merger being completed. The probability of the merger completion reflected the lending situation, which was partly dependent on interest rates.

BCE makes up a large portion of the TSX, so the index was impacted daily by this one company's relationship with borrowing rates.

 

[blutoski]

I'm almost tempted to get some shares - I know I can't afford it but I could put my birthday money in to them and enjoy the gamble. have never bought a lottery ticket (well three times when faced with vet fees - won twice, so I got lucky, the third time put me off), but here I could just hang on ot them and see what happens. I can easily get company financial annual reports and have a look, off the net, right?

Thing is brokers fees ran at about £30 in the late 80's as i recall per transaction, so with only £50 I could feasibly invest not really worth it yet! Maybe one day.

cj x

As a hobby within a fixed budget, buying stocks in one-offs makes about as much sense to me as lotto, but here's my advice for your situation:

hold off a bit until the market bottoms out more - nobody knows until after, of course, but it's clear that anybody buying right now is trying to catch a falling knife.

 

[cj.23]

Oh yes, I can see that! Still I'm not at all bothered about making money, I mean with the sums I have it's pretty much impossible, I'm just interested in how it all works and thought it might be amusing! If I wanted to make money I'd spend my capital on 1000 fliers advertising a ghost walk, and hope for a 1% take up. Charging £8 a head, and with no expenses except my time, I would make a £30 profit then -- 60%, in a week.

That is how I work, because I know nothing else. I do however think it would take an incredible amount of luck for me to ever make a 60% profit on any stock investment. It's purely for amusement, to give me as I said a tiny stake.

Thanks for all the good advice though! I will have to look up ISA's, they are the long term things which are tax free? I manage to be tax free -- I never earn enough in a year to have to pay any.

cj x