Person 1: Any tips on stocks?
Person 2:How about Rio Tinto.
Person 1:How much is it?
Person 2:About 80 dollars.
Person 1:80 dollars? That's too expensive.
The questions is...how can Person 1 tell it is expensive? Well, if Person 1 didn't know much about the stock, he/she is most probably wrong.
That example above is probably one of the most frequent situations I have encountered. There's this theory that large and 'expensive' stocks are priced at high absolute amounts. To a certain extent it is true most of the larger companies today have share prices that are well above $10 (In America or Australia). But in terms of value, what does that absolute share price tell us?
When 1 does not equal 1
I am very sure many people know this but there are through my experiences who still make the same statement which is most certainly not true. One example. Exxon Mobil today trades at $68 and Chevron trades at $82. Two companies which are in the same industry practically doing the same thing. Which stock is better valued? Many people will jump right into Chevron, well because it is "cheaper". Is Chevron better valued? The answer is you cannot make any conclusion at this point. Why? The share price itself tells you NOTHING! It is preposterous how people make conclusions from the share price itself.
First of all, Exxon is a larger firm than Chevron. This means if the share price does indicate the size of the firm, it is BY CHANCE. Secondly, which firm is more profitable? Does the share price tell you anything about this, absolutely not! Before I move on to my next point. What if I told you Exxon Mobil makes $1bil a year in net income? Does this tell you anything? Again the answer is NO.
Why not, isn't $1bil a LOT of money?Yes it is, but to Exxon, is that amount good? The answer is you need a COMPARABLE amount. Comparing to earnings of the last few years is a good start, but comparing it's rate of return to market/industrial estimates is what really matters (This will be discussed later).
Alright, the real story is Exxon is TWICE as huge as Chevron in market value, has a higher profit margin than Chevron. And also, Exxon made $19bil last year. So did you get fooled by the previous $1bil earnings? It does sound really good but it means nothing unless you make a meaningful comparison. Exxon is LARGER and is MORE PROFITABLE but yet it's share price is lower. A well-informed investor would know Exxon has a superior finances but it is not the only factor on choosing a stock.Lesson, the share price amount tells you NOTHING.
Hypothetical example (which is unlikely to happen in reality unless for a very good reason). Chevron has 2 bil outstanding shares and trades at $82. Let's say the firm does a stock split of 2 for 1. This means for every 1 share held, the shareholder will now own 2 shares. It will actually be called a bonus issue in reality but the "bonus" is free shares in numerical terms but not free money. This means Chevron now has 4bil number of shares outstanding which is double the amount. What will the new price be? Theoretically, the price will be halved to $41 because assuming the firm's value did not change overnight, the price of its shares should not be different. But due to the split (which does not affect a firm's value), 2 shares will equal to the value of 1 share before the split, thus being priced at $41.
Now after the split, Chevron is "cheaper" compared to Exxon in absolute share price. If you still haven't understood the fundamentals, you would have thought what a wonderful opportunity it is to buy Chevron because it has gone down in price by 50%. If you read the few paragraphs before this, you would have known $41 for 1 share now is NO DIFFERENT to $82 for 1 share before the split. This means in the world of finance terms $41 EQUALS $82. The value of each share before and after the split are the same although they are priced differently. From now on, when you look at share prices, just remember they mean NOTHING when compared in absolute terms.
Percentage Matters
Percentage allows us to make meaningful comparisons. You can own a huge company, but if it does not make money, no one wants to buy a stake in your company. We live in a percentage game. Percentage returns matters a lot more than absolute returns. Whether Chevron is priced at $82 or $41, if the share price falls/rises by a certain percentage, that is what matters. Whether the movement was $1 or $10, the percentage change is what you should be looking for. From the previous example above, had you used a percentage return for let's say return on assets. You would have known a $1bil profit for Exxon is actually a terrible return. $1bil sounds good but it's not.
So if you were interested in buying into a managed fund, what are the relevant questions for you to ask? Plain simple, what are the returns you would expect as a percentage of your your investment. If the fund has not been outperforming the market itself and it has high exposure to equities, that is probably a negative sign. As you can see I've created another question, what are the returns relative to the market? That is probably one of the most important questions.
I have not been particularly good when assessing fundamentals of companies. But just a few ratios that are important. Return on Capital, Dividend Yield, Operating Margin and Historical Earnings. These ratios will allow you to make meaningful comparisons when assessing a company's financial. On the technical investing side I am even less knowledgeable actually. But what technical analysis does is it goes beyond the fundamentals to assess a company. Analyst usually plots graph of historical prices and compares it to market's return, volume and other indexes to spot trends to determine target prices, resistance level or to time the market's trend. I'm not going through these techniques as I don't know much for now. Maybe in the future.
The main point is knowing what the share price means and ways to actually determine share price value.
Rio Tinto, Exxon Mobil and Chevron does not make you rich. It is the knowledge about Rio Tinto, Exxon Mobil and Chevron that makes you rich.
~deyao~
