Understanding what you are really buying when you invest in a share will help you reduce the chance of being disappointed when market sentiment turns negative. In this post, we will look at what equity in a company really represents. We will also include examples to help you understand what you are really getting when you buy a share.
In most cases, investors buy shares expecting the share price to rise so that they can sell the shares for a profit. During a bull market, like the one we have experienced over the last decade, a lot of share prices do rise, regardless of the underlying fundamentals.
Decade-long bull markets are not the ‘norm,’ and most share prices don’t simply keep rising. As Warren Buffett says, “when the tide goes out, you discover who’s been swimming naked.” To put it another way, investors find out what they really own.
Where Does the Value of Shares Come From?
We can attribute the value of a share roughly to three factors. First, we have the legal rights that a share gives its owner. Second, we have the economic value that it represents. Finally, we have price momentum and the story that typically drives that momentum.
1. Legal Rights
A company’s shareholders have certain legal rights. These vary slightly according to the country and the type of share but typically include the following:
- The right to transfer ownership of the shares.
- The right to a pro-rated claim on the company’s assets if the company is liquidated, though bondholders and creditors are paid first.
- The right to receive a pro-rated share of dividends if they are paid.
- The right to a pro-rated vote on major company decisions
- The right to information, including financial statements, board meeting minutes, and company bylaws.
- The right to sue the company for wrongful acts.
There are, of course, certain exceptions to these rights, which depend on the type of share:
- Holders of preference shares have a claim on the company’s assets ahead of common stockholders.
- Non-voting shares are a class of common shares that do not give their holders the right to vote, though holders keep all the other rights.
- Super voting shares give their holders additional votes. These shares are sometimes issued to a company’s founders to give them control of the company when their ownership falls below 50%.
The actual value of these rights will vary according to the stability and financial condition of the company.
2. Economic Rights
The real value of a share comes from its economic value, which in turn depends on the company’s future cash flows and the value of its assets.
Sometimes shares are so out of favor that their market capitalization falls below the value of the company’s assets. If that’s the case, shareholders can theoretically vote to liquidate the company, sell the assets, and return the proceeds to shareholders.
If you buy a stock that’s trading below the net asset value per share, there are no guarantees on what upside you might realize, but the downside is theoretically limited.
More often, the economic value of a company comes from the value of expected future profits or cash flows. There are several ways to calculate the fair value of a share using expected cash flows, with the discounted cash flow (DCF) model being the most commonly used.
These calculations will only ever be as accurate as the estimates they are based on. Reliable estimates tend to be based on proven profit margins and conservative growth forecasts. Estimates are less reliable when they are simply based on a company’s potential: reality doesn’t always match up with potential.
3. Momentum and Narrative
During a bull market, the stocks that become popular amongst investors often come with a good story. When a convincing story is combined with a rising share price, a positive feedback loop develops. The price momentum is viewed as confirmation that the narrative is real, and the narrative backs up the rising price.
This is often what leads to bubbles which can occur for individual stocks, industries, and entire sectors. As stock prices rise, the narrative evolves until the expectations for companies and their valuations become detached from reality.
Bubbles almost always end with a major crash, and it isn’t unusual to see stock prices falling more than 90%. But bubbles can also last a lot longer than expected, and share prices sometimes double or triple after they enter bubble territory.
Three Types of Shares
The following three examples illustrate some of the different types of shares you may end up owning.
1. 3D Systems Corporation (NYSE: DDD)
Quite a few bubbles have burst since 2020, and the hypergrowth stocks that led the market during the first part of the pandemic have entered a serious bear market. But we don’t know how these stocks will play out over the long term.
To get a better idea of how a company and its stock can perform in the years that follow a bubble bursting, we can go back to 2014. Between 2012 and 2014, a bubble developed in the stocks of 3D printing companies. This bubble had many of the typical features, including a convincing narrative: 3D printing was about to revolutionize the world, and the growth would be astronomical.
This is the chart for 3D Systems Corp, which, along with Stratasys (SSYS), became the flagship stock for the industry.
We can see that the share price rose by 700% but then gave up all of those gains over the next two years. Since then, it’s traded between $5 and $50, with an average of around $15.
But how has the underlying business performed since 2013? In total, the company lost $6.63 per share between 2014 and the first quarter of 2022. Revenue increased from $513 million in 2013 to a peak of about $690 million in 2018, and now it’s running at around $580 million. In other words, sales growth decelerated quickly and has since declined.
Clearly, the company hasn’t delivered on investor expectations, which is reflected in the share price. This is the risk you take when you buy a stock trading on a high P/E ratio without knowing whether the growth will be sustainable. That said, it could have made a great momentum trade if you got out when the price turned.
2. International Business Machines Corporation (NYSE: IBM)
The next example is also a share that has disappointed long-term investors. IBM has been trying to reinvent itself for the last ten years and so far, hasn’t really succeeded. However, while IBM’s revenue has steadily declined, it’s still a very profitable company. That limits its risk, provided you don’t overpay.
If you bought IBM in 2013, you would have paid somewhere around $190. At the time, the company was earning about $15 a share, so it was trading at around 12 times EPS.
Since then, IBM’s annual revenues have fallen by more than 40%, but because the company has strong margins, it’s managed to push earnings to $77 a share. Furthermore, it’s paid out over $50 per share in dividends since 2013.
When you take dividends into account, the return since 2013 is around zero, and it was about -25% at the lowest point. This may be a disappointing result for an eight-year investment, but it’s much better than the 80% plus that 3D Systems has lost in value.
3. Alphabet (Nasdaq: GOOGL)
Finally, we can have a look at a share that delivered a more impressive return. At the end of 2013, Alphabet (then Google) was trading at a split-adjusted $28 (the stock was split 20 for 1 in July this year) The company earned $0.94 a share in 2013, so you would have paid 30 times EPS. However, unlike 3D Systems, Google already had a long track record of delivering growth.
Since 2013 Alphabet has earned $21 a share, and the share price has risen 300%. Alphabet has already earned 75% of the original share price and is now earning $5 a share for shareholders.
We can summarize these three shares as follows:
- 3D Systems Corporation was a speculative share driven by a convincing narrative and momentum. But there was no track record to back up the valuation and no margin of safety. As soon as investors realized there was no more upside, they all tried to exit, and the share price collapsed.
- IBM was reasonably valued and had good margins. Ultimately revenue declined, and investors are still waiting for a turnaround to gain traction. The share price has been disappointing, but the lower valuation, strong cash flows, and dividends have limited the downside for investors.
- Alphabet wasn’t cheap, but the company had a proven business model and a growing market. It managed to justify the price quite quickly and ultimately delivered amazing returns for shareholders.
Conclusion
There are many ways to make money in the stock market, but you have to know what you are actually getting yourself into when you buy a share. This article covers three of the more common types of opportunities, but of course, there are others.
Some shares, like DDD, are driven by momentum and narrative, and while large gains can be made, the price eventually retraces and seldom recovers. If you buy a stock like this, you need to be ready to exit when the price turns.
Value opportunities like IBM might not deliver the upside shareholders hope for, but the margin of safety means the downside is limited. If IBM’s turnaround had worked out, shareholders would have been rewarded. That could still happen. This means the payoff is asymmetrical, with less downside than upside potential.
Alphabet was always a promising story, but the valuation reflected that. The best companies usually trade on higher valuations. Your job as an investor is to decide whether they are really worth their cost and to take advantage of bear markets when they occur. These are also the shares that are worth holding for a long time, though not necessarily forever.
Before you buy a share, make sure you know what type of investment you are making and why you are making it. This will help you manage your expectations and plan the appropriate exit strategy.
