Lesson 1 - Business Evolution
Welcome
to the full Sharestutor course. After completing the course you will understand
how shares and derivative products such as warrants work. You will understand how
to make money even if the markets are going down. You will understand and be
able to "read" the economy. You will be able to do technical analysis
and use it to predict in which direction a share price is heading. And much
more!
But
for now, let's explain what shares are based on a simple example:
PETE'S
BUSINESS EVOLVES...
Pete
is 18 years old, and has just left school. He still lives with his parents, and
has very little expenses of his own. He gets a great idea for a business:
Realizing that many of his friends have difficulty in finding jobs, he contacts
an overseas employment agency who are advertising stacks of jobs. He becomes
their marketing partner in
However,
Pete realizes that operating from his parents’ house, not having a fax machine
or computer, and not having money to advertise his business, are all limiting
factors to his business. His R4200 per month income is just enough to pay his
small car he bought, his new cellphone, and the R500 rent his parents are now
charging him.
PETE'S
BUSINESS EVOLVES...
Pete
needs to make a plan to grow his business. If he had a fax, he could save time
traveling to a Post-Net to send faxes. He could use that time to market his
services. If he had a computer, he could type the CV’s faster, instead of
waiting for his father to stop working on his laptop in the evenings. Pete gets
a quote on a computer and a fax for R7000. Since he does not have cash, he
cannot afford it. The bank won’t loan him the money, since he’s got enough debt
on his car already.
The
above example is a simple, typical example of a company that would want to list
on the stock exchange. Companies issue shares on the stock exchange to get more
money, in order to expand, so as to be more profitable
Pete
does a similar thing than to issue shares on the stock exchange. He draws up a
business plan with a market analysis and financial forecasts and a plan on how
he will run and operate his business with the fax and computer. He calls a
family meeting, and explains his plans. He says to them:
“This
is the plan to expand this business: I will offer you the opportunity to get a
portion of this business. For that portion of the business, you will have to
pay R2000. All you have to do is to buy into the business. You don’t have to do
any work. We will use your money to make more money, and reward you on an
ongoing basis, for the investment you have made. The portion of the business
you will get for R2000 is 9%. In future, you will be entitled to 9% of the
dividends we pay out to our investors. If you want to get more exposure to our
profit, you can buy 2 shares, at R4000.”
In
essence – this is what a listing on the stock exchange is all about... let's
continue to go deeper
PETE'S
BUSINESS EVOLVES...
4
of Pete’s family members decides to take up the offer, because they believe
Pete’s business has a lot of potential. Ownership of Pete’s company is now
divided as Follows
|
Shareholder |
Percentage of shares |
|
Pete |
55% |
|
Icy |
9% |
|
Melissa |
18% |
|
Roger |
9% |
|
Ivan |
9% |
Melissa
decided to buy two of the initial share offerings. After 6 months Pete has used
his computer for advertising on the Internet, for creating a template for
professional CV’s, launched an Email marketing campaign, and to print
invitations to seminars on how to find work in the
Pete
has been able to do 20 placements per month at R1400. The results are that Pete’s
income for the 6 months since selling the shares and buying the equipment, has
grown from R25200 the 6 months prior, to R168000.
PETE'S
BUSINESS EVOLVES...
Pete
decides it’s time to reward his investors, and announces that he will pay his
investors a dividend of R2000 per share in two months time. The declared
dividends looks like this:
|
Shareholder |
Percentage of shares |
Divided paid out |
|
Pete |
55% |
R12222 |
|
Ivy |
9% |
R2000 |
|
Melissa |
18% |
R4000 |
|
Roger |
9% |
R2000 |
|
Ivan |
9% |
R2000 |
Melissa
is very pleased with her dividend. She sees that Pete is running the business
well, and she would like to get more exposure to this wealth-generating
business. She approaches Ivan, and offers him R2000 for his share. Ivan is happy
with the R2000 dividend he is receiving, and does not want to sell. However,
Melissa knows that the next dividend is likely to be about R3000. She offers
Ivan R2500 for his share. Ivan realizes that this is even more than he paid for
the share, and decides that he will gladly take the capital gain of R500. He
sells his share to Melissa for R2500.
Note
that Pete had nothing to do with this transaction. The only change he will have
to make, is the change of banking details for Ivan’s share to Melissa - when
the next dividend is paid. The above is what a transaction on the stock
exchange is all about
We've
looked at how Pete's business evolved from a one-man-show, to a share-issueing
entity. Lets place what we've learnt into context of the Stock Exchange. Lets
refresh the basics of what we've learnt.
Companies
list on the Stock Exchange to be able to issue (sell) shares to the public. The
capital raised by the issue and selling of shares is used to expand their
business and be more profitable. People trade (do transactions) on the Stock
Exchange after such a listing to get exposure to the profit the company is
making for them, without them actually working for it.
Before
a company can list on the Stock Exchange, it must comply to a set of strict
rules, determining how much profit they must make before they can list, what
percentages of shares they can retain, etc.
Some
important points to remember about companies and their shares are:
-
You can hold shares in a company listed on the stock market.
- Companies list to gain more capital for growing their business.
- Each share represent a portion of ownership in the company. The more shares,
the larger the portion of the company you own.
- When a company makes a profit, each shareholder has a right to a share of
that profit in proportion to the amount of shares they own.
- The slice of profits paid to shareholders, is called a dividend.
- The amount of the dividend is not fixed,
- The directors of the company decides which part of the earnings are retained
for future expansion, and which part can be paid to shareholders
- After the initial issue of shares by a company, the buying and selling of
those shares occur in total separation from the operation of the company.
The number of shares can become more in a few instances: The
company might create a share split. For example: ABC’s shares were trading in
the area of R30 per share during 2005. ABC decided to split each share in ten,
therefore multiplying the number of shares in issue by ten as well. The
shareholder that had one share worth R30, now had 10, worth R3 each, and still
valued at a total of R30. However investors seem more eager to buy shares at R3
each!
Company’s can also increase shares with a “rights-offer”. In
essence this gives existing shareholders to obtain more shares, usually at a
price lower than the current share price. For example: Company XYZ issued a
rights offer giving you the right to obtain 1 share for every 12 you owned. At
the time of the offer the XYZ share was trading around R22 to R23, and the
rights offer was to get shares at R17. This is one way to increase shareholder
value.
Another way to increase shareholder value is to do quite the
opposite of issuing more shares: A company can also buy back shares. To explain
how this creates value for the shareholder, we will use a simple example again:
Assume the shareholders in Pete’s Business traded around
some shares, so that their individual shareholding and value now looks like
this:
|
Shareholder |
Percentage of shares |
Rand Value |
|
Pete |
50% |
R5000 |
|
Ivy |
10% |
R1000 |
|
Melissa |
20% |
R2000 |
|
Roger |
10% |
R1000 |
|
Ivan |
10% |
R1000 |
Total |
100% |
R10000 |
Pete’s Business makes good money. Instead of paying dividends,
the business – as a legal entity – buys back Roger’s 10% share for R10000. The
10% of shares then gets destroyed. That means that the remaining shares make up
100% of the shareholders’ capital. Therefore the portion of total ownership of
the business increases for each shareholder:
|
Shareholder |
Percentage of shares |
Rand Value |
|
Pete |
55.55% |
R5000 |
|
Ivy |
11.11% |
R1000 |
|
Melissa |
22.22% |
R2000 |
Total
|
100% |
R8000 |
In essence, the 10% bought back, now gets apportioned to the
remaining shareholders, but not in terms of issuing them with shares. The
remaining shareholders still hold just as many shares in number, but the
decrease in the total number of shares in issue causes them to have a
proportionally larger piece of ownership of the business.
Practical section
Browse through today's paper (business section) and see if you
can find any articles regarding any of the companies you have selected as your
"lab rabbits". If not, try to find some articles about any company's
financial results, etc.
Then try and note within the article:
1. What products or services is this company involved in?
2. Do they own other companies or portions of them?
3. Are they
fully or partially owned by someone else?
4. What are the current market factors contributing to either
success or failure?
5. What are their biggest obstacles to future growth?
Lets move on to || Lesson 2>> , to get a feel for derivative products, which are the ones which can be used to make money even if share prices are falling!