Tri-County Technical College BUS 101 Introduction to Investing

1. Introduction to Investing
John Price

2. What is investing?
• If you invested $10 000
in the S&P 500 in 1950,
it would have grown
about 10%
compounded per year.
• The investment would
be worth about
$1 000 000 in 45 years.
Year Principle
1950 $10 000.00
1951 $11 000.00
1952 $12 100.00
1953 $13 310.00
1954 $14 641.00
1955 $16 105.10
1965 $41 772.48
1975 $108 347.10
1985 $281 024.40
1995 $728 904.80
2005 $1 173 908.47

3. What is investing?
$-
$500,000.00
$1,000,000.00
$1,500,000.00
$2,000,000.00
$2,500,000.00
$3,000,000.00
$3,500,000.00
9%
10%
11%

4. What is investing?
• Warren Buffet is the
wealthiest investor in
the world.
• His return has been
about 23.5%
compounded over 50
years.

5. What is investing?
• Buffett practices a
philosophy of investing
called value investing.
• The father of value
investing is Benjamin
Graham.

6. What is investing?
• Stock is partial
ownership of a
business.
• When you buy
stock, you become a
partial owner of the
business.

7. What is investing?
• If you're an
investor, you're looking on
what the business is
going to do, if you're a
speculator, you're
commonly focusing on
what the price of the
business’s stock is going
to do, and that's not our
game.
Warren Buffett, Berkshire
Hathaway Annual
Meeting 1997

8. What is a business?
• A business exists to
maximize profits for its
owners (stockholders).
• The managers of a
company are
responsible for this
goal.

9. What is a business?
Board of
Directors
Stockholders Management

10. What is a business?
• The board of directors
controls a company.
• The board may include:
1. Officers (President)
2. Officers of other
companies
3. Former government
officials
4. Academics

11. What is a business?
• Revenue is what a business makes.
Revenue is also called sales.
• Profit is what a business keeps.
Profit is also called income or earnings.

12. What is a business?
• All businesses own
assets which produce
revenue for the
business.

13. What is a business?
• An asset is anything
which has economic
value.
• Something has economic
value if people are willing
to pay you for it.
• Examples:
– Cash
– Inventory
– Property, Plant and
Equipment

14. What is a business?
• There are two ways a
business can raise
money to buy assets:
1. A business can take
debt.
2. A business can sell
ownership.

15. What is a business?
• Liabilities are debt.
• Equity is a contribution by the owner/owners.

16. What is a business?
Liabilities
• Raised by borrowing
• Have to be paid back
• Exist for a fixed time
• Do not give up control of the
business
• Create expenses
Equity
• Raised by selling ownership
• Does not have to be paid back
• Exists for an indefinite time
• Gives up some control of the
business
• Do not create expenses

17. Question
• Can a business have
more liabilities than
equity?

18. What is a business?
• There are two important
financial statements, the
balance sheet and the
income statement.
• The balance sheet shows
assets, liabilities and
equity.
• The income statement
shows revenue, expenses
and profit.

19. What is a business?
• The Value Line
Investment Survey is
the best source of
financial information for
the value investor.

20. What is a business?
• All profit belongs to the
owners (stockholders).
They can do one of two
things with it:
1. The owners could decide
that the business should
keep the profit. This is
called retained earnings.
2. The owners could decide
that they should keep the
profit. This is called a
dividend.

21. What is a business?
• The owners of most
companies usually only
take a very small piece
of the profits in
dividends.

22. What is a business?
• The business needs
money to expand. It can
use retained earnings
instead of taking debt or
selling more ownership.
• The business pays taxes
on its profits, and the
investor pays taxes on his
dividends.
• This is double taxation.

23. What is a business?
• A buyer pays $100 000
for a house.
• The buyer borrows
$80 000 from a bank.
• The buyer makes a
$20 000 down payment.
• The owner rents the
house for $1 000 per
month.
• The mortgage costs
$600 per month.
• The owner makes $400
per month.

24. What is a business?
Balance Sheet Income Statement
Revenues
Rent $12 000
Expenses
Interest $7 200
Income
$4 800
Assets
House $100 000
Liabilities
Mortgage $80 000
Equity
$20 000

25. What is a business?
Balance Sheet Income Statement
Revenues
Rent $12 000
Expenses
Interest $7 200
Income
$4 800
Assets
Cash
House
$4 800
$100 000
Liabilities
Mortgage $80 000
Equity
$24 800

26. What is a business?
Balance Sheet Income Statement
Revenues
Rent $12 000
Expenses
Interest $7 200
Income
$4 800
Assets
House $104 800
Liabilities
Mortgage $80 000
Equity
$24 800

27. What is a business?
Balance Sheet Income Statement
Revenues
Rent $12 000
Expenses
Interest $7 200
Income
$4 800
Assets
House $100 000
Liabilities
Mortgage $75 200
Equity
$24 800

28. Question
• What is then the effect
of profit on equity?

29. What is rate of return?
• Investors seek to
maximize their rate of
return.
investmenttotal
profittotal
r

30. What is rate of return?
%101.0
1000$
100$
r
%101.0
10000$
100$
r
%1001
100$
100$
r

31. What is rate of return?
• Knowing the rate of
return allows investors
to compare two
investments.
• Which is better?
– Stock A’s rate of return =
10%
– Stock B’s rate of return =
20%

32. What is rate of return?
• Since you cannot
control the profit an
investment makes, the
price you pay
determines the rate of
return.

33. What is rate of return?
• How much would you
pay me to get $1 100
one year from now?
• If you paid $1 000, your
profit would be $100.
What is the rate of
return?
%101.0
1000$
100$
r

34. What is rate of return?
If you paid $950… If you $1 050…
%8.15158.0
950$
150$
r %8.4048.0
1050$
50$
r

35. What is rate of return?
• This is how a bond
works; you pay me X
today, and I pay you Y in
future.
• The rate of return is
easy to calculate.

36. What is rate of return?
• There are two ways to
get a return from
investing in stocks:
1. Capital gains
2. Dividends

37. What is rate of return?
• Warren Buffett’s first business
was a pinball machine which
he purchased for $35.
• He asked Sarge, the owner of a
local barber shop for
permission to put the pinball
machine in the shop.
• Sarge agreed for 20% of the
revenue (sales).
• After the first day, Warren
finds $10 in the machine.

38. What is rate of return?
Balance Sheet
Assets $43
Cash $8
Pinball Machine $35
Liabilities
$0
Equity
Paid-in capital* $35
Retained earnings $8
Income Statement
Revenue
$10
Expenses
$2
Profit
$8
*money
contributed
by investors

39. Question
• Would you sell this
business for $43?
• If not, how much?

40. What is rate of return?
• The market value depends on
the expectations for future
earnings.
• If the business earns $8 per
day for a year, retains 100% of
earnings and never borrows
money, it would add $2 920 in
equity.
• In ten years, it would add
$29 200 in equity.
• How predictable is the
business?

41. What is rate of return?
• If a business uses profits to
buy more assets, it should
make more profits the next
year.
• This means equity in the
business should grow, if the
company is growing
earnings.
• Equity of a company tends
to grow at a compounded
rate.

42. What is rate of return?
$8 per day
$8 per day
$8 per day
$8 per day
$8 per day
$8 per day
$8 per day

43. What is rate of return?
If profit is positive…
Profit
Assets
and
Equity
Revenue
If profit is negative…
Loss
Assets
and
Equity
Revenue
decreasedecrease
decrease
increaseincrease
increase

44. What is rate of return?
• If the price you pay
determines the rate of
return you get, what are
some indicators of rate
of return?
1. Earnings per share
2. P/E ratio
3. Equity (Book value) per
share

45. What is rate of return?
goutstandinsharestotal
earningstotal
shareperearnings
• Earnings per share is
the most important
measure of
performance.

46. What is rate of return?
• The price-to-earnings
ratio is a measure of
investors future
expectations for a
company.
shareperearnings
priceshare
P/E

47. What is rate of return?
Bull market Bear market
• Investors are optimistic
about future earnings.
• Stock prices are inflated
• High P/E ratios
• Investors are pessimistic
about future earnings.
• Stock prices are depressed
• Low P/E ratios

48. What is rate of return?
• The book value per
share is equity per
share.
• It says what a stock is
worth in the accounting
sense.
shareofnumber
equitytotal
shareperBook value

49. Question
• Why is book value per
share usually lower
than the share price?

50. What makes a good investment?
1. Does the business have a competitive advantage?
2. Are earnings per share strong and going up?
3. Does the company earn a high rate of
return on equity?
4. Does the company have
too much debt?
5. Does the
business have to
spend much on
operations?

51. What makes a good investment?
• A competitive
advantage is like a
moat.
• It acts as a barrier to
entry into a market.
• It’s what one business
does better than it’s
competitors.

52. What makes a good investment?
Some sources of
competitive advantage:
1. Cost advantage
– Produce goods at a
lower cost
2. Differentiation
– Brand name
– Technology
– Switching costs

53. What makes a good investment?
• You will see that we favor businesses and
industries unlikely to experience major change.
The reason for that is simple: We are searching
for operations that we believe are virtually certain
to possess enormous competitive strength 10
or 20 years from now. A fast-changing industry
environment may offer the chance for huge
wins, but it precludes the certainty we seek.
Warren Buffet, Berkshire Hathaway letter to
shareholders 1996

54. What makes a good investment?
• The key to investing is not assessing how much
an industry is going to affect society, or how
much it will grow, but rather determining the
competitive advantage of any given company
and, above all, the durability of that
advantage. The products or services that have
wide, sustainable moats around them are the
ones that deliver rewards to investors.
Warren Buffett, Fortune Magazine December
1999

55. What makes a good investment?
• If no firm has a
competitive advantage,
the industry will be very
competitive.
• Prices will be driven as
low as possible.
• Firms can enter and exit
easily and profit margins
will be low.

56. What makes a good investment?
• Profit margin is profit as
a percent of sales.
revenuetotal
profittotal
marginprofit

57. What makes a good investment?
• Is price the most
important factor in the
customer’s decision to
buy?
• If so, the business may
not have a competitive
advantage.

58. Question
• What business can you
think of which have a
durable competitive
advantage? Start with
businesses which you
understand.

59. What makes a good investment?
1. Does the business have a competitive advantage?
2. Are earnings per share strong and going up?
3. Does the company earn a high rate of
return on equity?
4. Does the company have
too much debt?
5. Does the
business have to
spend much on
operations?

60. What makes a good investment?
Weak Earnings per Share
Year Earnings per Share
2000 $3.22
2001 ($3.02)
2002 $0.15
2003 $0.50
2004 $2.13
2005 $1.25
2006 ($1.50)
2007 ($0.19)
2008 ($3.13)
2009 $0.00
Strong Earnings per Share
Year Earnings per Share
2000 $1.48
2001 $1.60
2002 $1.65
2003 $1.95
2004 $2.06
2005 $2.17
2006 $2.37
2007 $2.57
2008 $3.02
2009 $2.93

61. What makes a good investment?
• Average growth in
earnings has been
about 7% since 1970.

62. What makes a good investment?
1. Does the business have a competitive advantage?
2. Are earnings per share strong and going up?
3. Does the company earn a high rate of
return on equity?
4. Does the company have
too much debt?
5. Does the
business have to
spend much on
operations?

63. What makes a good investment?
equity
incomenet
ROE
• Return on equity is a
measure of how
efficient a firm is with
the owner’s investment.
• The average return on
equity has been about
12% since 1950.

64. What makes a good investment?
1. Does the business have a competitive advantage?
2. Are earnings per share strong and going up?
3. Does the company earn a high rate of
return on equity?
4. Does the company have
too much debt?
5. Does the
business have to
spend much on
operations?

65. What makes a good investment?
• Look at total earnings
compared to total long-
term debt.
earningstotal
debtterm-long
yearsofnumber

66. What makes a good investment?
Coca-Cola Debt
years8.1
000,000,800,4
000,000,625,8
Ford Debt
years11
000,000,470,7
000,000,000,80

67. What makes a good investment?
1. Does the business have a competitive advantage?
2. Are earnings per share strong and going up?
3. Does the company earn a high rate of
return on equity?
4. Does the company have
too much debt?
5. Does the
business have to
spend much on
operations?

68. What makes a good investment?
• If a business makes
$1 000 000 every year,
but has to spend
$2 000 000 every two
years to replace its
assets in order to stay
competitive, what
happens to its equity?

69. What makes a good investment?
Balance Sheet Income Statement
Revenues
Rent $12 000
Expenses
Interest $7 200
Depreciation $2 000
Income
$2 800
Assets
Cash $2 800
House $100 000
Accumulated
Depreciation
($2 000)
Liabilities
Mortgage $80 000
Equity
$20 800

70. What makes a good investment?
• Depreciation represents
how much a business
must spend to replace
their assets in order to
remain competitive.
• If the ratio of
depreciation to net profit
less than one, the
business doesn’t have to
spend that much in order
to remain competitive.

71. How to calculate rate of return?
• To calculate the rate of
return of an
investment, we need
two things:
1. Current stock price
2. Prediction of future
stock price

72. How to calculate rate of return?
• To predict the future
stock price we need:
1. Current stock price
2. Earnings growth rate
3. Historical average P/E
ratio

73. How to calculate rate of return?
• If earnings per share are
$5.00 this year, what
will they be ten years
from now?
Year Earnings per Share
2011 $5.00
2012 $5.50
2013 $6.05
2014 $6.66
2015 $7.32
2016 $8.05
2017 $8.86
2018 $9.74
2019 $10.72
2020 $11.79
2021 $12.97

74. How to calculate rate of return?
• Multiply future earnings
per share by average
P/E ratio.
• The result is a
prediction of the future
stock price.
Year Earnings
per
Share
Average
P/E
Ratio
Future
Stock
Price
2011 $5.00 15 $75.00
2012 $5.50 15 $82.50
2013 $6.05 15 $90.75
2014 $6.66 15 $99.90
2015 $7.32 15 $109.80
2016 $8.05 15 $120.75
2017 $8.86 15 $132.90
2018 $9.74 15 $146.10
2019 $10.72 15 $160.80
2020 $11.79 15 $176.85
2021 $12.97 15 $194.54
PriceshareperEarnings*/ EP

75. How to calculate rate of return?
1
ValueBeginning
ValueEnding
RateGrowthCompounded
periodsofnumber
1

76. How to calculate rate of return?
If you paid $100… If you paid $50…
1
$100.00
$194.54 10
1
19454.1 1.0
10688.1
%88.60688.0
1
$50.00
$194.54 10
1
19808.3 1.0
11481.1
%81.141481.0

77. How to calculate rate of return?
• The average rate of
return on common
stocks since 1950 is
about 10%
compounded annually.

78. What is rate of return?
• Since earnings and
equity grows at a
compounded rate, the
price of stocks tends to
do the same.