Let me set my stall out here. This blog is, hopefully, going to be the first of a set of three that covers the basics of stocks and shares. It’s gonna cover what a share is, how to measure the size of a company and what I reckon are the two most important ratios investors use to pick shares: EPS and P/E. Now I know that some of you guys who regularly read my blog will find this topic a bit too simple. But if you are new to that great big bowl of custard called the financial markets, read on!

So what is a share? In simple terms it is a small portion of a company, a slice of the pizza if you like. Bit too simple huh? Ok. In concept it is similar to, say, if you were to start up a gardening business with your brother-in-law. If you and he were equal partners there gardening business would have just two shares – one owned by you and one owned by him. The business would be run by the two of you, in the way that you want and in order to fill your pockets (hopefully with notes rather than hedge clippings).

COMMON IDENTIFYING FEATURES OF A SHARE
However there are a few features that distinguish an share (or a stock if you are from North America) issued by a Public Limited Company. The really important ones are:

• They are freely and publicly traded which, translated into English, means that almost anyone can buy or sell shares, and they can do that fairly quickly at a stock exchange (via a stockbroker).
• Because shares are freely and publicly traded, the value of the shares can change on a second-by second basis.
• They have ownership rights which means that them what bought the shares (otherwise known as shareholders) get to vote on important stuff to do with the company (like who runs it and how much they get paid)
• They sometimes, but not always, pay a dividend. More on that in the next post.

When investors buy a share, or spread bettors go long, they are hoping the share price will rise. For that to happen someone out there needs to look at the share and think “OK, that share currently has a price of €2 but I’m willing to pay anything up to €2.10 for it.” And to do that they need to have a rationale or a methodology for working out what they think a share price is worth.

People have written whole books on how to value shares. And whatever sins I have committed in a past life, I must have paid for them now ‘cos I’ve been obliged at various times to read several of these tomes. However I’ll try to be both as brief and as un-boring as possible here.

The most common method of picking stocks is simply to compare lots of shares against each other and choose the best one. Now the sharp-eyed amongst you will spot that, if you start off with 20 shares and every one of them is a dog then no matter how much time you spend analysing you are still gonna end up with a dog. And that is one of the central problems with fundamental analysis. But even so, that’s the way the industry works.

SIZE AND MARKET CAP
So if we have 20 shares, how do we filter out the one we want? The first thing we might do is try to find a big company, based on the idea that big companies are more stable than smaller ones. It ain’t always true; neither WorldCom nor Enron were tiddlers. But typically there’s more demand for shares of IBM or Microsoft than for an equivalent slice of a small company.

Measuring the size of a company is tricky, but the way it’s done is by Market Capitalisation. Let’s go back to our ‘a share is a slice of pizza’ analogy. If we have slices of pizza being sold for €2 per slice, and there are ten slices, the whole pizza is worth €20. Market Capitalisation, or “Market Cap” to its friends, is a measure of the ‘worth’ of a company and is calculated by multiplying the price of a share by the number of shares issued (no of slices). Market Cap is also quite a good proxy for the size of a company – so when people talk about General Electric being the biggest company in the world they are probably talking about it having the largest market cap.

THE DAFT BIT
Now, to get any further with this post I’m going to have to stretch my Pizza analogy to near-breaking, and it’ll help if you get misty for a few moments and do a little dreaming. So imagine, if you will, you are on holiday in Italy. Naples perhaps, or Florence. It’s evening, you can hear water tinkling in a nearby fountain and the smell of the lilac trees is mingling with that of Vespas and hair oil. Are you there yet? Good, so now you are walking down a small street filled with loads of stalls and each one is selling Pizza slices. The smell is making you hungry, but which one should you choose?

EARNINGS PER SHARE
When deciding you might think about what toppings it has – and the financial equivalent of that is how much profit a company is making. But profit is such a vulgar term darling, so the financial markets call it earnings instead. A company that has a lot of earnings (i.e. is making a lot of profits) is obviously going to be pretty tempting – it’ll be the Mighty Meaty with extra Mozarella, and will be more sought-after than plain old Margherita PLC which only has average earnings.

Knowing what is on your pizza slice helps us choose, but that’s not the end of the story – oh no. Next we want to find out how much topping we get on our pizza slice. It’s all very well ordering the Mighty Meaty but if that actually means lots of tomato paste and only one skimpy slice of pepperoni per slice we ain’t gonna be happy. In financial markets the term is Earnings Per Share (EPS). Quite simply it divides how much money a company earned last year by how many shares that company has. 40 slices of peperoni on a pizza that gets cut into 10 means 4 pieces of pepperoni per serving. Earnings of 100 million divided by 10 million shares gives an EPS of 10. You get the picture.

PRICE TO EARNINGS
So are we done inspecting pizza stalls. Can we finally eat now? Uh uh, not yet. There is one more element to consider – price. How much does the pizza slice cost? Pizza A might have 4 slices of pepperoni and cost €2, but if Pizza B has 8 slices of pepperoni and costs €3 it is clearly better value.

The really easy and simple way to analyse shares would be to divide the earnings by the price – that would give you how much money a company generates per euro or £ you invest in it. Wouldn’t that be nice and simple? Yep, too simple by half. Instead the financial markets turn the ratio on its head and work out price divided by earnings or P/E. In Pizza terms that gives you how much money you are paying per slice of pepperoni (for Pizza A it is 50 cents and for Pizza B it is 37 cents). While in the land of stocks and shares what you get is how much money you need to stick into shares in order to ‘buy’ €1 of earnings.

So if two shares are being considered and one has a P/E of 10 (you need to invest €10 of your money to buy shares that generated €1 of earnings last year) and the other has a P/E of 20 (you need to invest €20 of your money to buy shares that generated €1 of earnings last year) you could say the first one is ‘cheaper’. Of course there are probably reasons why it is cheaper … the most common being the second company is growing faster than the first one.

USING THE RATIOS
Earnings Per Share (EPS) and Price To Earnings (P/E) are the absolute bedrock of investing. Most spread bettors don’t use them that much – but as share prices are largely driven by what the investors are doing it’s as well to be aware of them.

Now, a quick couple of points about these ratios. Firstly, lots of newspapers and websites publish these ratios but many of them have their own way of working out the figures. So, if you use are ever comparing two companies, I suggest using figures from one source only. That way you know you are comparing apples with apples.

Secondly, there are a few variations of P/E and EPS (for example see the Reuters’ ratios page for Google). One of the most common is to use Sales revenue in place of Earnings figures. Sales per share and Price / Sales are particularly good, for example, for valuing new start-up companies that might be selling quite a bit but are ploughing all the cash generated back into growing the company (so have fairly small profits). Other people prefer to look at Cash Flow Per Share or Price / Cash Flow as, although Cash Flow is not dissimilar to Earnings, it offers less scope for ‘creative accounting’.

EPS and P/E are probably the first two ratios that most big investors would look at, but there is a third member of the trinity: dividends per share. So the next post will be dedicated to dividends.

‘til then I hope the markets are with you.