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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.
• ...
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%
1...
What is investing?
• Warren Buffet is the
wealthiest investor in
the world.
• His return has been
about 23.5%
compounded o...
What is investing?
• Buffett practices a
philosophy of investing
called value investing.
• The father of value
investing i...
What is investing?
• Stock is partial
ownership of a
business.
• When you buy
stock, you become a
partial owner of the
bus...
What is investing?
• If you're an
investor, you're looking on
what the business is
going to do, if you're a
speculator, yo...
What is a business?
• A business exists to
maximize profits for its
owners (stockholders).
• The managers of a
company are...
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. Offic...
What is a business?
• Revenue is what a business makes.
Revenue is also called sales.
• Profit is what a business keeps.
P...
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
...
What is a business?
• There are two ways a
business can raise
money to buy assets:
1. A business can take
debt.
2. A busin...
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 con...
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 bala...
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 owner...
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 m...
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 ...
What is a business?
Balance Sheet Income Statement
Revenues
Rent $12 000
Expenses
Interest $7 200
Income
$4 800
Assets
Hou...
What is a business?
Balance Sheet Income Statement
Revenues
Rent $12 000
Expenses
Interest $7 200
Income
$4 800
Assets
Cas...
What is a business?
Balance Sheet Income Statement
Revenues
Rent $12 000
Expenses
Interest $7 200
Income
$4 800
Assets
Hou...
What is a business?
Balance Sheet Income Statement
Revenues
Rent $12 000
Expenses
Interest $7 200
Income
$4 800
Assets
Hou...
Question
• What is then the effect
of profit on equity?
What is rate of return?
• Investors seek to
maximize their rate of
return.
investmenttotal
profittotal
r
What is rate of return?
%101.0
1000$
100$
r
%101.0
10000$
100$
r
%1001
100$
100$
r
What is rate of return?
• Knowing the rate of
return allows investors
to compare two
investments.
• Which is better?
– Sto...
What is rate of return?
• Since you cannot
control the profit an
investment makes, the
price you pay
determines the rate o...
What is rate of return?
• How much would you
pay me to get $1 100
one year from now?
• If you paid $1 000, your
profit wou...
What is rate of return?
If you paid $950… If you $1 050…
%8.15158.0
950$
150$
r %8.4048.0
1050$
50$
r
What is rate of return?
• This is how a bond
works; you pay me X
today, and I pay you Y in
future.
• The rate of return is...
What is rate of return?
• There are two ways to
get a return from
investing in stocks:
1. Capital gains
2. Dividends
What is rate of return?
• Warren Buffett’s first business
was a pinball machine which
he purchased for $35.
• He asked Sar...
What is rate of return?
Balance Sheet
Assets $43
Cash $8
Pinball Machine $35
Liabilities
$0
Equity
Paid-in capital* $35
Re...
Question
• Would you sell this
business for $43?
• If not, how much?
What is rate of return?
• The market value depends on
the expectations for future
earnings.
• If the business earns $8 per...
What is rate of return?
• If a business uses profits to
buy more assets, it should
make more profits the next
year.
• This...
What is rate of return?
$8 per day
$8 per day
$8 per day
$8 per day
$8 per day
$8 per day
$8 per day
What is rate of return?
If profit is positive…
Profit
Assets
and
Equity
Revenue
If profit is negative…
Loss
Assets
and
Equ...
What is rate of return?
• If the price you pay
determines the rate of
return you get, what are
some indicators of rate
of ...
What is rate of return?
goutstandinsharestotal
earningstotal
shareperearnings
• Earnings per share is
the most important
m...
What is rate of return?
• The price-to-earnings
ratio is a measure of
investors future
expectations for a
company.
sharepe...
What is rate of return?
Bull market Bear market
• Investors are optimistic
about future earnings.
• Stock prices are infla...
What is rate of return?
• The book value per
share is equity per
share.
• It says what a stock is
worth in the accounting
...
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 goin...
What makes a good investment?
• A competitive
advantage is like a
moat.
• It acts as a barrier to
entry into a market.
• I...
What makes a good investment?
Some sources of
competitive advantage:
1. Cost advantage
– Produce goods at a
lower cost
2. ...
What makes a good investment?
• You will see that we favor businesses and
industries unlikely to experience major change.
...
What makes a good investment?
• The key to investing is not assessing how much
an industry is going to affect society, or ...
What makes a good investment?
• If no firm has a
competitive advantage,
the industry will be very
competitive.
• Prices wi...
What makes a good investment?
• Profit margin is profit as
a percent of sales.
revenuetotal
profittotal
marginprofit
What makes a good investment?
• Is price the most
important factor in the
customer’s decision to
buy?
• If so, the busines...
Question
• What business can you
think of which have a
durable competitive
advantage? Start with
businesses which you
unde...
What makes a good investment?
1. Does the business have a competitive advantage?
2. Are earnings per share strong and goin...
What makes a good investment?
Weak Earnings per Share
Year Earnings per Share
2000 $3.22
2001 ($3.02)
2002 $0.15
2003 $0.5...
What makes a good investment?
• Average growth in
earnings has been
about 7% since 1970.
What makes a good investment?
1. Does the business have a competitive advantage?
2. Are earnings per share strong and goin...
What makes a good investment?
equity
incomenet
ROE
• Return on equity is a
measure of how
efficient a firm is with
the own...
What makes a good investment?
1. Does the business have a competitive advantage?
2. Are earnings per share strong and goin...
What makes a good investment?
• Look at total earnings
compared to total long-
term debt.
earningstotal
debtterm-long
year...
What makes a good investment?
Coca-Cola Debt
years8.1
000,000,800,4
000,000,625,8
Ford Debt
years11
000,000,470,7
000,000,...
What makes a good investment?
1. Does the business have a competitive advantage?
2. Are earnings per share strong and goin...
What makes a good investment?
• If a business makes
$1 000 000 every year,
but has to spend
$2 000 000 every two
years to ...
What makes a good investment?
Balance Sheet Income Statement
Revenues
Rent $12 000
Expenses
Interest $7 200
Depreciation $...
What makes a good investment?
• Depreciation represents
how much a business
must spend to replace
their assets in order to...
How to calculate rate of return?
• To calculate the rate of
return of an
investment, we need
two things:
1. Current stock ...
How to calculate rate of return?
• To predict the future
stock price we need:
1. Current stock price
2. Earnings growth ra...
How to calculate rate of return?
• If earnings per share are
$5.00 this year, what
will they be ten years
from now?
Year E...
How to calculate rate of return?
• Multiply future earnings
per share by average
P/E ratio.
• The result is a
prediction o...
How to calculate rate of return?
1
ValueBeginning
ValueEnding
RateGrowthCompounded
periodsofnumber
1
How to calculate rate of return?
If you paid $100… If you paid $50…
1
$100.00
$194.54 10
1
19454.1 1.0
10688.1
%88.60688.0...
How to calculate rate of return?
• The average rate of
return on common
stocks since 1950 is
about 10%
compounded annually.
What is rate of return?
• Since earnings and
equity grows at a
compounded rate, the
price of stocks tends to
do the same.
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Introduction to investing

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Tri-County Technical College BUS 101 Introduction to Investing

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Introduction to investing

  1. 1. Introduction to Investing John Price
  2. 2. 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
  3. 3. 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%
  4. 4. What is investing? • Warren Buffet is the wealthiest investor in the world. • His return has been about 23.5% compounded over 50 years.
  5. 5. What is investing? • Buffett practices a philosophy of investing called value investing. • The father of value investing is Benjamin Graham.
  6. 6. What is investing? • Stock is partial ownership of a business. • When you buy stock, you become a partial owner of the business.
  7. 7. 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
  8. 8. What is a business? • A business exists to maximize profits for its owners (stockholders). • The managers of a company are responsible for this goal.
  9. 9. What is a business? Board of Directors Stockholders Management
  10. 10. 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
  11. 11. 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.
  12. 12. What is a business? • All businesses own assets which produce revenue for the business.
  13. 13. 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
  14. 14. 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.
  15. 15. What is a business? • Liabilities are debt. • Equity is a contribution by the owner/owners.
  16. 16. 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
  17. 17. Question • Can a business have more liabilities than equity?
  18. 18. 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.
  19. 19. What is a business? • The Value Line Investment Survey is the best source of financial information for the value investor.
  20. 20. 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.
  21. 21. What is a business? • The owners of most companies usually only take a very small piece of the profits in dividends.
  22. 22. 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.
  23. 23. 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.
  24. 24. 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
  25. 25. What is a business? Balance Sheet Income Statement Revenues Rent $12 000 Expenses Interest $7 200 Income $4 800 Assets Cash House $4 800 $100 000 Liabilities Mortgage $80 000 Equity $24 800
  26. 26. What is a business? Balance Sheet Income Statement Revenues Rent $12 000 Expenses Interest $7 200 Income $4 800 Assets House $104 800 Liabilities Mortgage $80 000 Equity $24 800
  27. 27. 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 $75 200 Equity $24 800
  28. 28. Question • What is then the effect of profit on equity?
  29. 29. What is rate of return? • Investors seek to maximize their rate of return. investmenttotal profittotal r
  30. 30. What is rate of return? %101.0 1000$ 100$ r %101.0 10000$ 100$ r %1001 100$ 100$ r
  31. 31. What is rate of return? • 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%
  32. 32. What is rate of return? • Since you cannot control the profit an investment makes, the price you pay determines the rate of return.
  33. 33. What is 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 $100. What is the rate of return? %101.0 1000$ 100$ r
  34. 34. What is rate of return? If you paid $950… If you $1 050… %8.15158.0 950$ 150$ r %8.4048.0 1050$ 50$ r
  35. 35. What is rate of return? • 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.
  36. 36. What is rate of return? • There are two ways to get a return from investing in stocks: 1. Capital gains 2. Dividends
  37. 37. What is rate of return? • 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.
  38. 38. What is rate of return? 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
  39. 39. Question • Would you sell this business for $43? • If not, how much?
  40. 40. What is rate of return? • 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?
  41. 41. What is rate of return? • 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.
  42. 42. What is rate of return? $8 per day $8 per day $8 per day $8 per day $8 per day $8 per day $8 per day
  43. 43. What is rate of return? If profit is positive… Profit Assets and Equity Revenue If profit is negative… Loss Assets and Equity Revenue decreasedecrease decrease increaseincrease increase
  44. 44. What is rate of return? • 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
  45. 45. What is rate of return? goutstandinsharestotal earningstotal shareperearnings • Earnings per share is the most important measure of performance.
  46. 46. What is rate of return? • The price-to-earnings ratio is a measure of investors future expectations for a company. shareperearnings priceshare P/E
  47. 47. What is rate of return? 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
  48. 48. What is rate of return? • The book value per share is equity per share. • It says what a stock is worth in the accounting sense. shareofnumber equitytotal shareperBook value
  49. 49. Question • Why is book value per share usually lower than the share price?
  50. 50. 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?
  51. 51. What makes a good investment? • 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.
  52. 52. What makes a good investment? Some sources of competitive advantage: 1. Cost advantage – Produce goods at a lower cost 2. Differentiation – Brand name – Technology – Switching costs
  53. 53. What makes a good investment? • 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
  54. 54. What makes a good investment? • 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
  55. 55. What makes a good investment? • 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 margins will be low.
  56. 56. What makes a good investment? • Profit margin is profit as a percent of sales. revenuetotal profittotal marginprofit
  57. 57. What makes a good investment? • Is price the most important factor in the customer’s decision to buy? • If so, the business may not have a competitive advantage.
  58. 58. Question • What business can you think of which have a durable competitive advantage? Start with businesses which you understand.
  59. 59. 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?
  60. 60. What makes a good investment? 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 Year 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
  61. 61. What makes a good investment? • Average growth in earnings has been about 7% since 1970.
  62. 62. 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?
  63. 63. What makes a good investment? 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.
  64. 64. 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?
  65. 65. What makes a good investment? • Look at total earnings compared to total long- term debt. earningstotal debtterm-long yearsofnumber
  66. 66. What makes a good investment? Coca-Cola Debt years8.1 000,000,800,4 000,000,625,8 Ford Debt years11 000,000,470,7 000,000,000,80
  67. 67. 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?
  68. 68. What makes a good investment? • 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?
  69. 69. What makes a good investment? Balance Sheet Income Statement 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
  70. 70. What makes a good investment? • 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.
  71. 71. 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
  72. 72. How to calculate rate of return? • To predict the future stock price we need: 1. Current stock price 2. Earnings growth rate 3. Historical average P/E ratio
  73. 73. How to calculate rate of return? • If earnings per share are $5.00 this year, what will they be ten years from now? Year Earnings per Share 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
  74. 74. How to calculate rate of return? • Multiply future earnings per share by average P/E ratio. • The result is a prediction of the future stock price. Year Earnings per Share 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 PriceshareperEarnings*/ EP
  75. 75. How to calculate rate of return? 1 ValueBeginning ValueEnding RateGrowthCompounded periodsofnumber 1
  76. 76. How to calculate rate of return? 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
  77. 77. How to calculate rate of return? • The average rate of return on common stocks since 1950 is about 10% compounded annually.
  78. 78. What is rate of return? • Since earnings and equity grows at a compounded rate, the price of stocks tends to do the same.

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