posted in: Building Wealth
An introductory guide to investing in the share market
An introductory guide to investing in the share market
To many, the ups and downs of the share market can be quite confusing. Why is it that some shares perform well and others not so well? What influences whether shares will grow or drop in value? How do you know which shares you should invest in?
If you’re interested in investing in shares, it’s important to understand the drivers which can influence a share price. Here’s our back to basics guide on what you need to know.
What is a share?
Publicly listed companies operate using a model where they distribute all or some of their ownership via shares to the public. They generally do so in order to raise money for future growth or the owners of the business wish to cash in on some or all of the value they have created. Therefore a publicly listed share represents a portion of ownership in a listed company where the shareholder owns a percentage of that company.
As part owners, shareholders have some say in the direction of the company through voting on board resolutions or attending Annual General Meetings (AGM), although most shareholders in publicly listed companies only own a small fraction and their voting rights are minimal.
What is the share market?
The share market (or stock exchange) is a marketplace in which shares in publicly listed companies are bought and sold. In Australia, our national share market is the Australian Securities Exchange (ASX) which represents thousands of public companies across many industries. There are several share markets all over the world. Thanks to the internet, buying and selling shares in a share market can occur virtually and easily.
How can you make money through shares?
There are two main ways owning shares can make a shareholder money; dividends and capital growth. If the company makes a profit it can choose to pay a portion of the profit as a dividend to shareholders, the amount of which will be influenced by the number of shares you own. If the share price increases in value then you also make money through capital growth. Should you sell your shares at a higher price than you paid for them, you will make a capital gain. One of the benefits of shares is that they can be liquidated within a matter of days giving you faster access to your money than other asset classes such as property.
What are franking credits?
Investing in shares can be a tax efficient choice due to franking credits. Franking credits are tax credits associated with dividends where the company has already paid tax on their profits before they pay out the dividend. Shareholders receive a tax credit for frank dividends, that can be then used to offset their personal tax. Another tax advantage is that if you hold shares for over a year, you may qualify for up to fifty percent discount on any capital gains tax that you incur when selling shares for profit.
What’s the difference between a passive or active approach to investing in the share market?
There are various approaches to investing in the share market but an important high level distinction is the difference between passive and active investing.
A passive strategy is often undertaken through the use of low cost index funds which track a specific index, for example the ASX200 which is Australia’s largest 200 companies by their total value. This approach is extremely transparent and cost effective.
The contrasting approach is active management, often undertaken via a Managed Fund where the fund manager is given a specific mandate to invest the funds under their control in certain assets. This approach is more expensive but you have the experience of a fund manager who is seeking to beat the corresponding index’s performance. Investing via a stock broker is also another example of an active investment strategy, as the stock broker buys and sells specific shares in an attempt to outperform the market average.
How do I invest in the share market?
There are numerous structures that can get you into the share market including exchange traded funds (ETFs), direct stocks/shares, managed funds and listed income companies among others. Furthermore, you can own many of these directly through the provider, a broker investment platform or your superannuation account. Every investor’s needs and risk profiles differ, so it is important to seek advice and develop an investment strategy tailored to your specific objectives.
What determines share price?
Now that we understand what a stock/share is and how it’s traded on the share market, what determines a share’s value?
While it may seem that share price would simply reflect the financial performance of the particular company, the reality is quite different. While strong financial results will usually have a favourable impact on share price, ultimately share price is determined by market forces. This means that when the demand for a share is higher and more people buy the share, the price will go up. If supply outstrips demand, then the value of the share will fall. This can lead to some unusual scenarios where the share price can be completely separate from the performance of the company. Here are some examples.
Tesla – growth stock
In the last year, Tesla’s share price has grown six times over to around $670 a share. In February 2021 it was reported that the price of the stock was trading at 200 times next year’s anticipated profits. So, what’s driving this growth? It’s not just the company’s performance. In fact, 2020 was the first year that Tesla was actually profitable. While Tesla is leading the pack when it comes to making electric vehicles available to the mass market, it’s not the only car manufacturer offering electric cars. Tesla currently has about 23 per cent global market share, but it’s very likely its market share will decline over time. Instead it appears that the buzz around Tesla is driving demand for the share, pushing up the share price. Therefore, many commentators suggest the share is overvalued.
GameStop – the power of the masses!
In some cases, share price rises can be the result of investors joining forces to artificially push up the share price. This is what occurred with video game, consumer electronics and gaming merchandise retailer GameStop in January 2021. Users of subreddit r/wallstreetbets called for other users to buy into GameStop in an effort to push up the share price. Many hedge funds held a short position with the share, which essentially means they were betting on the share price falling and would financially benefit from a fall. Any rise in the share price would cause them to lose a substantial amount of money. The redditors knew this and deliberately created this course of action. GameStop’s share price rose a whopping 30 times in less than a month to over $500 a share.
These examples demonstrate how share prices rely heavily on market forces – not just company performance – which can distort values.
What’s the P/E Ratio?
Given the fluctuating nature of the share market, there are many different ratios and equations that we use to put the share price into perspective. An example of this is the price to earnings ratio (P/E Ratio). This ratio is the share price divided by the earnings per share of the company, which has historically been a measure of whether a company is under or overvalued. This would typically be used in conjunction with other tools to get an accurate reading of a company’s present value comparative to the rest of the market.
Growth companies have high P/E ratios because they often price in the prospective growth of the company’s revenue and can look relatively overvalued to their value counterparts. For example, a growth company like Tesla had a P/E ratio of 1085 whereas the Commonwealth Bank, a well known blue chip stock, has a P/E ratio of 20.36.
Elaborating on what we discussed above, Tesla’s reported future growth is priced in because investors are prepared to pay for a stock which is presently highly valued but overtime may produce high levels of capital growth. Whereas the Commonwealth Bank is a more stable blue chip stock which has an established business, therefore investors will not price in such a high level of exponential growth.
What’s the best way to invest in shares?
There are many different ways to invest in shares and it’s important to be informed about how share investing works before taking the leap. Investing in shares can be a great way to build wealth and in some cases the returns can well and truly outstrip the returns of other asset classes. Shares are also easily liquidated if you need access to your money.
However, it’s important to also be aware of the risks. Given the share market is speculative, share markets can be very volatile and theoretically a shares value could fall to zero.
Talk to your financial advisor to determine whether investing in shares is the right course of action for you. A good investment strategy should be in line with your goals and long term financial objectives.
Want to find out more about whether investing in shares is right for you? Get in touch with us for a free consultation on your financial goals and how to achieve them.