Now is a very exciting time for shares and the share market. You’re probably thinking, "how can it be exciting with the global financial economic crisis woes unravelling and the ASX hitting 5 year lows?". While no one knows exactly when the world's share market will hit the bottom, we can safely say that the market is closer to the bottom than top.
What we can learn from history is that equity markets moves in cycles and following the downturns, we always seen recoveries. For example:
- 1987 Share market Crash
- 1997 Asian Crisis
- 2000 Tech Wreck
- 2001 Sep 11
So what does this mean? I'm not suggesting that you should all take out your life savings and starting buying shares but rather be prepared for it. For example, have you found yourself a broker yet? Are you CHESS sponsored? Have you researched the stock you want to buy?
How you can you make money owning shares
This is really the bottom line for investors, making money, because at the end of the day it’s all about profits. You hear about people becoming millionaires investing in the share market but have you ever wondered how owning shares can make you money?
If you are a shareholder there are two ways in which you can benefit from owning shares: capital appreciation or/and dividends.
Let's consider a fictitious company that sells Ugg boots; we shall call this company Betsy's Uggs. Betsy's Uggs sell quality Ugg boots via eBay. The company's major clients are from the USA. When Betsy's Uggs gets an order via eBay, the Uggs are packaged and sent off to the customers.
Let's consider the following:
Uggs cost: $100 per ugg boot
Uggs sold per year: 100
Revenue per year: $100 X 100 = $10,000
Profit per uggs sold: $70
Profit per year: $70 X 100 = $7,000
Betsy's Uggs Share Price: $35 per share
Amount of shares available: 1000
Capital appreciation, sometimes called capital gains, is the profit you keep after you buy and sell a stock. The mantra "buy low, sell high" works well here. Just as effective is "buy high and sell higher". So why do share prices move? What makes them go up?
It all comes down to earnings or potential earnings. When a company grows and expands and profit increases the value of the company increases and so does the stock and thus the share price.
For example: Let's look at Betsy's Uggs
The following below can affect Betsy's Uggs share price
- Raising the price. If each Uggs were raised from $100 to $120
- Getting more market share. Instead of just the USA Betsy's Uggs might start shipping to the UK as well
- Different product line. Instead of just Ugg boots the company can branch out and start selling sandals & slippers
- Do combination of all the above
Let's say you bought 10 shares of Betsy's Uggs at $35. 2 years later you sold the shares at $70, your return is 100%.
As a shareholder of a company you are entitled to a share of the company's earnings in the form of dividends. Every half companies will report on earnings and will determine whether to pay a dividend. When business is good and earnings are high companies are more likely to payout a dividend, however if earnings are low, dividends may be affected.
* While dividends are a good way to entice investors, not all companies pay out a dividend, especially new companies starting out.
For example, Betsy's Uggs earns a net profit of $70 per Ugg boot sold. The company sells 100 Uggs per year, so the total net profit for year is $7,000. The company directors get together and decide that Betsy's Uggs is doing well and decide to give out dividends to their shareholders. They decide to keep $5000 to use it on running and growing the company. The remaining $2000 will be split amongst its 1000 shareholders. One week later each shareholder gets a cheque for $2 per share ($2000/1000) owned, this is called the dividends.
If a shareholder bought the shares at $35 then the dividend yield is 5.71% ($2/$35)
Let's assume you bought Betsy's Uggs shares at $35. You then sold those shares 5 years later for $105 and during that time the total dividends was $15. So what is the total return?
The total return is:
||= (Rise in stock price + total dividends) / stock's purchase price
||= ($70 + $15) / $35
Capital appreciation or dividends?
So what is more important, capital appreciation or dividends? Should you look for a company with big dividends or one that has potential for great capital gains? Well, this depends on you investment strategy. Companies that pay out big dividends are usually blue chip shares, such as banks ANZ, Commonwealth Bank CBA, or Telstra TLS. Great capital gains are usually associated with startups (IT) or resource (mining) so therefore quite risky.
So assuming that you are a conservative investor, stocks such as ANZ or Woolsworth might be more suitable.
Do remember, you are investing in a business and businesses can fail, even big ones such as HIH Insurance or One Tel, remember them? When they do fail you may lose everything. Shares can be a very risky investment!