What is a share of stock?
[One of O.A.'s goals is to help readers with the vocabulary of investing and economics. This is the first in a regular series of posts I'll call "tutorials." We'll collect these and post them under a tab at the top of the page....With that, I present Part 1 of our first tutorial]
I got a little riled up when I read this in in the Journal a couple weeks back:
Is Yahoo’s standalone potential so great that it should command a 48 times price-to-earnings ratio for next year’s earnings…?
The point was that Yahoo should “strike while the iron is hot.” YHOO’s shareholders should count themselves lucky with MSFT’s offer valuing their shares at a whopping 48 times earnings.
Mish made a similar comment earlier this year:
Yahoo!Finance…shows the P/E of Yahoo to be 55. That is hugely overpaying even in a good environment, and is preposterous heading into a recession that figures to be both long and nasty.
The reason I’m bothered by such comments is that the P/E ratio is an incomplete and, in this case, totally misleading way to measure a company’s value.
Forthwith, a brief tutorial on P/E: what it means, why investors use it, why it’s incomplete and a better, more accurate alternative.
And as we go through these questions I also promise to give you a better understanding of what a share of stock actually is and why people buy stock to begin with. In fact, that’s where we’ll start…
What is a share of stock?
Just to be safe, let’s start at the very beginning. Exactly what is a share of stock? It’s a fractional share of ownership in a business.
The best way to explain is probably by way of a simple example….
Say, for instance, Jen and Jane are fired up about clothes and decide to open a store together, J&J’s. To get their store up and running, J&J’s need to rent space, stock their shelves with inventory, pay lawyers to set up the papers, etc. Let’s say all of this costs $100,000.
But Jen and Jane don’t have $100,000. Each has $20,000. To open their store, they need $60,000 more. Let’s say their wealthy friend Gayle invests $10,000. To represent these equity investments in the new business, Jen and Jane decide to issue a “share of stock” for every $10 investment made in the company. Since $50,000 has been invested, they issue 5000 shares of stock. Jen and Jane each own 2000 of the shares outstanding, Gayle the other 1000.
For the remaining $50,000 needed to open the store they get a loan from the bank.
Summarizing all of that gives us “J&J’s capital structure” (i.e. the capital raised to fund the new business)
- $50,000 of Equity…represented by 5000 shares of stock outstanding.
- $20,000–Jen, for which she receives 2000 shares of stock
- $20,000–Jane, receives 2000 shares
- $10,000–Gayle, receives 1000 shares
- $50,000 of Debt (the loan from the bank)
Question: who owns the store? Answer: All of the above. Between them Jen, Jane and Gayle own the store’s profits, but before the store can earn a profit, it has to pay interest on the $50,000 loan to the bank. And what if the investors decide to sell the store before they’ve paid off the loan? In that case, any proceeds from the sale would go to pay off the loan first. Anything left over would then be split among the three investors. So you can think of the bank as “owning” the business until it’s debt is repaid. [All of this will be crucial in later parts of this series; for now, we'll stick to the question we started with: what is a share of stock...]
We defined stock at the start: it’s a fractional share of ownership in a business. In the example we’ve set up, there are 5000 total shares outstanding. Each individual share represents .02% ownership in the company. 1/5000 = .0002 or .02%. Jen and Jayne own 2000 shares (or 40%) each. Gayle owns the other 1000 shares, 20%. But just what is it these three own a percentage of?
Let’s add some more numbers to the example. These will also help us understand more difficult concepts in later parts of this series.
First, let’s add details about the money owed the bank. Let’s say the bank gives J&J a $50,000 10-year loan at a fixed interest rate of 10%. The store must pay interest and principal on that debt until the $50,000 loan is totally paid off at the end of year 10. With an example like this you have to calculate what’s called an “amortization schedule” to determine the total payment to the bank.
I won’t throw the details of amortization at you. We’ll save that for a tutorial on mortgage loans! For our example, all we need to know is how much the store has to pay the bank each year. The answer is $8,137. Don’t ask why.
Second, fast forward a year so we can kick around the store’s financial results:
So after paying all the expenses of the business, including the interest/principal on the bank loan, there is $7,711 in profit left to split among the stockholders. 40% of the profits go to Jen, 40% go to Jane and the remaining 20% goes to Gayle.
YHOO has a lot more than 50 shares of stock outstanding. Closer to 1.4 billion actually. But the principles above apply: when you buy 1000 shares of YHOO stock, you’re buying an ownership stake that entitles you to approximately .000071% of the company’s earnings. (Divide 1000 into 1.4 billion to get that %)
–In Part 2 we’ll define the P/E ratio itself. And Part 3 will discuss why P/E is actually an incomplete way to measure company valuation. There’s a better way…