08:38 AM, 02 Mar 2024 (AUS EST)   The market is currently closed       

Understanding the Share Language & Jargon

OK, so you're excited about investing in shares and raring to go, but before you begin it is important you understand the language and jargon of shares. You will find that these terms are regularly used, in this guide, on the media and in stock market publications. It is important that you understand the lingo, as your evaluation of a company may be dependent on one vital piece of information.

Market Capitalisation

The market capitalisation or market cap is the total value of a company. The value is derived by multiplying the current share price by the total number of shares.

For example:

Market Cap of ANZ: Current share price x total number of shares
: $14.39 x 2.04 billion (ANZ share price on 13/11/08)
: $29.4 Billion

So why is the market capitalisation important and how can it help you?

The market cap represents how much the company can be bought for, if someone was going to buy all the shares on the stock market. Although not all the owners of the shares would be willing to sell (as some may believe they are worth more) – it is a good indication of what the market is willing to pay for a company of that particular size, in a certain industry and market position.

Generally, if a company has a low market cap, any one person has greater influence over the share price, therefore the price will exhibit more volatility. For example, if you sell 100,000 shares worth $1 each, in a company that has 1,000,000 shares, your trade will mean that 10% of all traded share will be exchanged (if you are willing to sell at the market price, this will cause the share price to fall and therefore the market cap).

Market Capitalisation Categorisation

Micro Stocks: less than $10milion
Small Stocks: $10 million to $100 million
Medium Stocks: $100 million to $1 billion
Large Stocks: $1 billion to $10 billion
Major Stocks: more than $10 billion

Earnings Per Share (EPS)

Earnings Per Share is one of the most important "bottom line" measurements. A companies’ earning is usually expressed in earnings per share. This is a ratio illustrating the level of earnings generated per share. Ie. If there are 1,000,000 shares and the company earnings was $1,000,000, then EPS is $1. This one dollar represents what the company has done with the money invested. This value is after taxes and debts but before dividends.

EPS allows you to measure the growth of a particular company. The higher the earnings per share year on year end the earnings, the higher the growth and thus, higher the share price. Changes in forecast EPS can have a dramatic effect on the share price of a stock.

Price/Earning Ratio (or "PE Multiple")

This is the king of value measurements. The price/earning ratios is derived by the current Share Price divide by Earnings Per Share. Think of PE as the amount of years required to pay off an investment. For example, if a stock has a PE of 10, this means that it will take 10 years for you to make before you get back your capital invested.

This number is generally between 10-20, although newer companies, especially in technology sector, can have much higher PE ratios.

So what is a good PE? Is 10 better than 20? You'd think that taking 10 years to get a return on investment is better than 20 years, however this isn't the whole story. Shares are all about the "future", future earnings, future projections and so a stock that has a high PE usually means it has better growth prospects that ones than ones that have lower PEs.

A stocks future P/E is called its forward P/E.

For example:

A stock is selling for $20 a share and earned $2 last year. Because the earning was last year we say that this stock has a trailing PE of 10. If the projected earnings for next year is $4, then the stock has forward PE of 5.

Return On Equity (ROE):

The return on equity tells you what a company has done with the money you've invested. This value is derived by dividing net income by total shareholders' equity. Bigger is always better with this number as it means bigger profit. This is also one of Warren Buffets' fundamental rules.

A good ROE is generally regarded as 3-5% above the current fixed interest rate or bond yields. A stock that can sustain a 15% ROE is considered very good and a ROE of anything above 20% is considered excellent.

Earnings Yield

The Earnings Yield of a stock is the inverse of the Price/Earning ratio and turning it into a percentage.

For example if ANZ has a PE of 12, then the Earnings Yield of ANZ is:

1/12 = 8.33%

So what does this mean? This means that for every dollar invested you will get a return of 8.33%, assuming earnings remain flat. By converting the PE into a percentage we can now more easily compare it to returns from other investment types such as bonds or saving accounts. However, earnings yield does not take into account other payments you will receive as a shareholder, such as dividends.

We can even compare the earnings yield on the entire S&P 500 and compare it to Australian government bonds (10 year Treasury bonds). As of 27/2/09 the 10 year Treasury bond rate is 4.4% whilst the S&P 200 index had a combined earnings yield of 10.6%.

Return On Equity (ROE)

ROE = (Net Profit/Shareholder’s equity) x 100%

*Net profit after tax, for full fiscal year

Shareholders equity does not include preferred shares

Return on equity (ROE) measures the companies’ ability to generate profit from the equity they have to work with. Return on equity is expressed as a percentage, for example;

Company XYZ net profit after tax = $4,000

Shareholders’ equity = $10,000

ROE = 4000/10000 = 40%

Return on equity is important because as a shareholder, equity represents your money and so it make sense to understand how well your money is being put to use. Obviously the higher this number the better.

Return on equity is a measurement the great investor Warren Buffet looks out for. Buffet implied that a return on equity of at least 14% was desirable. Coca Cola which Buffet held for 10 years (since 2002) had a return on equity of 45%.

Return On Capital (ROC) or (ROIC)

The return on capital is essentially the same as return on equity (ROE) except that it also factors in companies debts, including loans & bonds. The ROC or ROIC (Return on Invested Capital) measures how efficient a company uses its resource to generate profits.

ROC = (Net Profit/Total Capital) x 100%

*Capital includes long-term debt, and common and preferred shares

For example if we look at the example for return on equity

Company XYZ net profit after tax = $4,000

In the above example the capital was $10,000. Now let’s assume that company XYZ owed $5,000 in debt.

Total Capital = $10,000 + $5,000 = $15,000

ROC = ($4,000/$15,000) x 100%

= 26.7%

If a company had no debt then the ROE and ROC will be the same.

Dividend Yield

The dividend yield is the ratio of how much a company pays out, usually as dividends, relative to it's share price. The formula is as follows:

Annual Dividends Per Share / Price Per Share

For example: Lets say SGB pays out $1.66 in dividends per year and the Price Per Share is $21. The dividend yield is calculated as follows;

Dividend Yield: 1.66/21 = 7.9%, You can use this number to compare to what savings accounts pay (around 0.5%, or high interest accounts, around 5%).

Let's say two companies ABC and XYZ both gave out $5 annual dividends per share. Company ABC is trading at $100 while company XYZ is trading at $50. The dividend yield for company ABC is 5% while XYZ is 10%. Consider all things equal, it is clear that company XYZ offers better value – solely looking at dividend yield.