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Wednesday, 12 December 2012

Basics of Reading the Economy and Shares: Lesson 1



After reading the examples and lessons below 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:

Lesson 1 - Business Evolution
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 South Africa. He charges R1400 to arrange telephonic interviews, type out a professional CV, follows up on references, and puts people in contact with the overseas employment agency after thorough screening. They benefit from receiving high quality candidates, and he benefits R1400 for each candidate he screens. The candidates benefit from Pete’s reliability, good contacts, and thorough screening as it lands them more jobs more often. By word of mouth about 3 people hear of Pete’s service, and pays him to find them jobs.

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 UK. He used his fax machine to send faxes about his service to 1000 UK employment agencies.

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.

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