Stock market investing – IFB44: Back to the Basics Pt 2: Share Dilution on Wall Street

Stock market investing

stock-market-investing

Welcome to the Investing for Beginners podcast this is episode 44. Andrew and I are going to continue our discussion on back to the basics with the stock market and last week we talked a little bit about stocks and today we’re going to talk some more about stocks.  Because you know that’s our favorite thing to talk about besides that baseball and so without any further ado Andrew ahead something you wanted to say as we got started.

  • What is a stock
  • What are stock buybacks and how they affect us
  • What are share dilutions
  • What happens when we buy or sell a stock

Andrew: yeah so obviously last week I had a big thing about you know how shares kind of work and the whole premise behind the stock market. Behind why Wall Street’s there what the value is and how it provides value for really the whole world and how we can take part in that.


I think the next thing that we should really cover is how that applies to Wall Street today so obviously Wall Street’s very intimidating and it can seem like if you don’t have a double-double MBA and in finance that there’s no way that you can really have a shot at understanding it and making it work for you, and that’s so far from the truth and everything we try to do with this podcast is really to try to alleviate that and especially with this series that we’ve come up with here with going back to the basics.

We’re really hoping when you can go from just the average person who might not know anything and really start to put some of the pieces together and use that momentum and it can really take you in some far places and so it was really exciting to be kind of a part of that so with the whole discussion last week I talked about how company issues shares and how they can use those share you know they can essentially it’s called raise capital you hear this a lot in Silicon Valley and yeah you know on Shark Tank and with private equity it’s really a place for companies to incubate and get a jump start and go from either they’ll go from nothing to something with a great idea.

Or they’ll be a small business, and they’ll make that leap into in to getting capital and using that to have explosive growth right really and then there comes the point in time where the company transitions from being a private equity kind of corporation to becoming a public corporation which is really what we talked about, and that’s the kind of investment that is going to be available for 99% of us.

Because you know unless you have millions of dollars you’re an incredible investor, or you got Mark Cuban on the phone to give you these private equity deals. You’re going to have to have a lot of capital or and or a lot of connections to get into the sort of deals that aren’t on Wall Street.

So what we’re talking about are the companies are their own Wall Street the ones that have gone public they’ve when they go public, and anybody can buy them that’s called an IPO initial public offering.  And so the way that shares you know we talked last week its shares are always going to be part ownership that never changes but the way that a company will use shares once they have like an IPO. It’s going to be different depending on what stage of life the company’s in.

So last week I talked about how at the very beginning a company can issue shares and use that cash right in front to directly put it into the business and have explosive growth what happens on Wall Street is that these corporations are a lot more matured they won’t necessarily use cash from issuing shares towards the business they may or they may not, and so that’s some of the things that we want to describe today and it can really help you get a good sense of when you turn on CNBC, or you try to follow the things that are going on in the market give you a good sense of what this kind of verb’ kind of things that these companies are doing.

You start to hear about mergers acquisitions and what ‘s happening with the shares and what do those things mean and so I think really to start with that clarification we should talk about why basically how the market itself works and how these shares can be traded back and forth and how that’s going to affect what goes on with the corporation. Both for the shareholders and for the business itself so maybe Dave you can start on how it affects shareholders.

Dave: yeah exactly, so the easiest way to think about this is when you go online with your online broker. Whether it’s Ally Invest, whoever it is you’re using, and you want to buy a share of Apple, and you go on there, and you see what the price is listed at, and you buy it for $100.

Let’s say just to use an easy number when you buy that share you’re buying it from somebody else. Somebody else owns that share, and they have decided to sell it at $100  that’s the price that they feel is a fair price to sell it to you for. So when you buy that share at $100 now they may have bought it at $80 or they may have bought it at a hundred and twenty dollars, depending on which way the market is going in that particular time and what the market feels like the stock price is being valued at and so you may be getting it you know they may be making money on their trade or they may not.

So you buy it at $100, and you hold onto it for you know five years and then at the end of five years you decide you want to sell it for whatever reason and at that point you have to find somebody willing to buy it from you at whatever price it’s selling at that you think is going to be a fair price. So let’s say that it’s risen to $200 a share so now you’ve made $100 on that investment that you originally bought five years ago. So now you have to find somebody you know you don’t personally have to you don’t have to go on the internet and like start searching through all the of people in the world to find somebody to do it that’s your broker’s job.

But that means that there’s somebody else on the other side of that looking to buy that share from you, and they may think that $200 is a screaming deal and they’ll snap it up, or they may you know let’s say that the market is falling. Let ‘s say that the there’s been some bad news about Apple that’s come out that well recently Steve Jobs passed away and there was a lot of fear in in the market about what was going to happen to Apple because obviously, he was the brain trust behind the company.

So if that if you’re you know it’s risen to 200 hours, and then he passes away it could start falling like a rock and now you have to figure out am I going to be able to sell this above the hundred dollars that I bought and it at and you can’t always get out and that’s one of the things that we talked a little bit about last week and I wanted to elaborate a little bit more on that so you know there’s a finite amount of people out there that are going to be willing to buy it from you at any particular point in time and the trick you know with this is you know the we talked a lot about timing the market and buying at the top or buying at the bottom and selling at the top and those are all easy things to say it’s much harder to do because you never know exactly what is going to be the top you don’t have a crystal ball you can’t guess and you, in essence, you are guessing, and you can think that it’s the bottom or you can think that it’s the top.

But again you always have to find somebody else on the other side of that trade that is going to be willing to buy it now. Let ‘s say that you know I’m going to use Bitcoin, for example, everybody and her brother is talking about this. I even had some of my employees at my job that has never spoken to me about finance ever, and I’m sure I’ve never talked about it and they’re asking me about Bitcoin and what my thoughts are on it, so it’s obviously become a thing and let’s say that you know I’m not sure what the exact price is as of today.

But let’s say that it starts to it’ll say that starts to fall and you know the price starts to crater and it goes from I’ll just pick a number fifteen thousand to five thousand if you bought it a fifteen thousand it’s not just so easy like oh hey I see it’s down I’m going to get out of it and it doesn’t it’s not that easy because you have to find somebody on the other side that’s willing to buy it to you at whatever point it is as it’s falling and Andrew has talked about this before kind of like catching a falling knife that’s kind of what you’re looking at because if it goes from fifteen thousand to five thousand that’s a huge jump and you’re going to lose a lot of money because you thought oh yeah you know it starts to go down I can just sell it it’s not that easy because you have to find somebody that’s willing to buy it at twelve thousand because they think oh this is just you know this isn’t something drastic it’s just it’s you know it’s just going down a little bit but it could go down a whole lot and so that’s where you know getting into a bubble can be so dangerous and that’s why you know speculation when you’re talking about that I heard one of my favorite guys Meb Faber talking about Bitcoin a couple of days ago and he even used that word many times during his conversation about it.

He kept talking about it as a speculation because you know there’s so many other factors into it which we’re not going to go into today. But at the point that I want to make is that when you when you want to go buy something because you think it’s undervalued. Then you’re finding somebody that thinks oh my god this is you know I’ve lost money in this I got to get rid of it think of it as buying a car.

you think that the cars worth ten thousand dollars and you go to a car dealership and they’re selling it at seven thousand because they think that it’s a piece of junk but you think it’s the greatest thing ever so you spend a seven thousand dollars and in your mind you just made three thousand dollars and they’re thinking sweet they unloaded this thing and I didn’t lose that much money so that’s really kind of how the stock market works and as far as like buying and selling stocks you know there’s always got to be somebody else on the other side of that trade that is willing to take that price on whether it’s selling it or whether it’s buying it.

so from my understanding it’s like a supply and demand thing right so if there are more sellers than buyers you’re going to push the price down if there’s more buyers and sellers then that’s why you see the price go up exactly and that’s any perfect illustration and that is Bitcoin. you know that you know as we’re speaking it’s just you know it’s skyrocketing because everybody want does they don’t want to miss out it’s you know the FOMO the fear of missing out and that’s what’s driving the price up because there’s so much demand for it cool so now we kind of know how price moves and how these shares basically the exchanges are a place where people are buying and selling the shares and trading them and so the prices are moving because of this activity now let me kind of bring that into the corporation side because on one side where the corporation may issue shares and it’s a great way for them to again grow the business from a very beginning stage.

what you’ll actually see on Wall Street most of the time after the initial public offering the IPO is you’ll tend to see a lot of companies just keep those same shares outstanding meaning they’re not going to add or subtract shares and I’m just talking in a very general sense and then let me talk about the two different actions they take on top of that.

So basically if you have this pool of let’s say 2 million shares and they did the IPO and so 10% went to fund manage Henry you know fund manager Jerry over here bought bond up 5% shares a couple of Joe schmo’s maybe bought like 0.2% of all the shares and so all the shares kind of get distributed. And on the IPO is where this price is set and then from there once all the shares are distributed then we start to see the price go up and down depending on how the supply and demand are for those shares.

As time goes on and so the business will kind of run and though more organically or naturally have these business these expenses they’ll have revenues and stuff coming in and they’ll have earnings and they’ll be trying to grow in with the goal of being able to post high-performance numbers in order to create more demand for their once the demand for their stock goes up the stock price goes up once the stock price goes up. Then everybody’s bonuses at the company management the CEO all their stock options become more valuable they can it’s just a revolving thing, and so good business results equal good share price and on and on and on.

Now there are some things to keep in mind that businesses might do that affects how you hold your shares and there’s this concept called dilution. So there are two things a company can do with their shares.

The reason why we care for investors is that our share says we own one share that represents part ownership of the business. Now if they’re going to issue out more shares that means that the company’s being broken into more and more pieces and you own less and less of the company that’s not good unless you get equal value to come out of that.

So an example I’ll give for that is Disney, and this is something that’s very recent just as of two days ago. One more recording this so as a full disclaimer I own Disney it is one of the dividend fortress positions in the Sather research letter, the only reason I’m sharing that information is that it’s already appreciated in price to the point where it’s too expensive to be a buy option at these prices.

So it was a good thing for myself, and the subscribers were able to get in at a low price and have seen that price go up. So basically what’s happened is that Disney is going to be buying Fox now when you buy a company it’s obviously you have what’s called a merger or an acquisition and that’s why you’ll hear the things like M&A; is talking about mergers and acquisitions and it generally means the same thing like they might call something a merger but there’s always one company buying the other there’s always going to be one company in control.

They might you know take on somebody else’s name so it sounds like a merger right like the bigger company might take the smaller company’s name because their name is more well-known.

But at the end of the day one company’s buying the other and so there are two ways a company can buy another company, and you’ll really see this near the end of bull markets, and you’ll start to see this one industry start to consolidate and mature and it’s kind of you to know as much as I love to talk about how fair and how much opportunity there is in the stock market.

There is also the dark side where the rich get richer, and the poor kind of gets swallowed up and then you do see that happen in industries especially as they mature not to say that the poor ones all necessarily die. They could get bought out, and there’s a lot of different situations, and it’s not all negative.

But when one bigger company buys out a smaller company they’re going to either pay with it in cash or with stock. So the way Disney’s buying Fox is they’re going to buy with stock what that means is that they’re issuing new shares and so the shares for Disney’s owners now are all being diluted because you have this pool.

I think they had like 1.5billion shares and it’s going up to two billion shares something like that so basically your one share that might have let’s say all the Disney shares all the shareholders originally owned 100% of the business now because they’re diluting 25% whatever the Disney shareholder had that was 100 percent to now 75 percent of the company.

So the company’s swallowing the smaller company, it’s becoming. You want it to become 25% larger because your share your ownership stakes becoming 25% smaller and so I sent an email out today to everybody on the daily list, and it talked about that more in depth.

But the general concept is that if a company uses shares to dilute basically to make an acquisition make themselves bigger you want the value how much of their growing your current business it needs to be more than the value that your shareholders are losing.

So if they diluted 25% you’d want to see revenue you’d want to see earnings and you would want to see either cash or assets being 25% or more because you lost 25% in dilution and so what we’ve seen what you’ll tend to see with these acquisitions a lot of times is the share price might kind of stay flat as things kind of sort themselves out and so the market capitalization grows and balloons because there are now more shares but the share price kind of stays constant because essentially it could have been more of a lateral move and that’s kind of what a lot of these things are and so at least when you’re talking about buying a company with using an all-stock transaction that’s kind of what you that’s what you’re talking about, and that’s what you tend to see, and that’s what we’ve seen here with Disney now why is it all matter you know I talk about market capitalization.

That sounds like maybe a more advanced term to kind of break that down that’s just going to talk about what the market is valuing a stock at.

So there’s a couple different metrics we talked last week about earnings we talked about Book value we talked about cash right now let’s break it down a little bit further I’ve spent this whole episode talking about shares so let’s talk about how shares lead into the different things and how as investors you can use share data and combine it with some of the other metrics to make some basically.  You want you to want to make some evaluation on how the stock is doing how the company the underlying company behind the stock and how it is doing.

So the first one that I want to talk about is market capitalization, and so you look at the stock ticker it’s going to say you know go back to Dave’s example of Apple if it says $100 is what Apple trading that now that’s the price for one share now Apple could have 500 million shares they could have 2 billion shares they could have 7 billion shares.

The number of shares of the company has doesn’t matter what does matter is that you are is that you know how many shares there are and then from there you can calculate maybe what percentage of shares what percent ownership you have or what you’re going to want to know is how a company’s market price is relating to their other metrics.

So for example market capitalization, the way to calculate that would be you would take the shares how many shares that they have total and you multiply it by what the what the share price is trading at the time. And so you know if it’s Apple I think it’s around 700 billion dollars what that means is the market price for Apple is 700 billion dollars.

It’s what it’s priced at now, and so now once you have that market capitalization number, you can combine that with the earnings number that we were talking about last week.

So let’s take another example say apple market cap is 700 billion okay let’s say earnings are at I don’t know a hundred billion just to make it simple, so that means for that’s seven billion dollars per one billion dollars of earnings. Right to think of it this way if you have a stock that is at 700 billion and they’re earning a hundred billion dollars versus I’m sorry it’s hard to it’s hard to keep up with this when I don’t have a written down and we’re trying to go audio.

So I’m trying to use very simple numbers here okay let’s say let’s say they’re earning billion right, so you have a company earning 7 billion a company earning 10 billion if they’re both tradings at 700 billion then obviously you’re going to want the company that has 10 billion in earnings right because it’s earning more relative to what you’re paying.

You’re paying to get a seven hundred billion dollar company you’re paying 700 billion to own this company, and they’re earning 10 billion that’s better than a little say like Microsoft I don’t know what their numbers are but let’s say if they’re at 7 billion then Apples earning more and it’s all in relation to what the market price is.

So we call that a price to earnings ratio and we’ve actually done the whole episode on that which you can look in the archives the basic most simple breakdown of that any way that you can maybe conceptualize and logically think about it is that these companies are going to have different sizes of how much earnings are they are they’re going to have different sizes of how many shares they’re putting out. And they’re going to be at different market prices and different market capitalizations.

What’s important to compare is not to look at a company like Apple who’s making let’s say ten billion in earnings and compare it with a company a little small company like you know AMD or something who’s maybe making a billion dollars in earnings.

You can’t just say well Apples are making 10 billion and AMD’s making 1 billion so Apples better. That’s not necessarily the case you have to compare what the price of that company is in the market, and so that’s how you’re going to determine whether you’re getting a good deal or not and that’s when we talk about margin of safety there’s a lot of different valuations you can use to make these comparisons to say okay well this price for how much earnings are companies giving me this price is really good or like an Amazon type deal this price is you know really expensive as a shareholder.

I’m going to be paying a lot and I’m not getting much in earnings compared to the rest of the market and the other opportunities that are out there so you can use that you can use these shares to make determinations and kind of take the next step into going away from the stock price and learning about market capitalization. There’s metrics called earnings per share, and that’s a very widely used one especially on Wall Street and with analysts and things like that and there’s like book value per share there’s just a ton of different metrics that you can make that relate to a share and the reason why those metrics are important is because you are essentially going to be able to look at okay this is the comparison of so here’s the if I look at the ticker this is how much I’m going to pay and then if I compare that to for example earnings per share this is how many earnings a company is making per shareholder per share, and you can use that to gauge if a company is growing or if a company is declining.

So for example, if a company is again keeping the same amount of shares forget about the Disney thing if they’re keeping the same amount of shares and their earnings are growing. Then you’re going to see the earnings per share growth and then as these sort of manipulations happen where stocks maybe make a secondary offering, or they dilute the shares like what Disney is doing.

They’re diluting the shares to acquire if they’re doing all stock all stock acquisitions or if they’re doing a stock buyback which is the reverse of that which I’m going to cover at the very end here. So basically all those different things might be like a whirlwind it’s like oh I can’t decipher whether this company is growing or not that’s where metrics like earnings per share come in book value per share comes in and you can look at those trends and you’ll see not only if the company is growing as far as like a total earnings number perspective.

But also if it’s growing in relation to how much of a stake and how much part ownership you have and some maybe a little more advanced than just simple earnings or even like price-earnings or price to book is but it’s definitely something that you’ll hear about enough the longer you’re in the market, and it’s something to consider because at the most basic level you have to remember what a share is what it means for you and how you can use that to navigate through Wall Street.

So that encapsulates what shares are and how they relate to what goes on on Wall Street today. What goes on with the stock exchanges and how when you’re buying a share that’s what’s happening like what they’ve said this is how you’re able to buy a share the brokers doing that for you and this is kind of how it relates to the big picture and the grand scheme of things when it comes to these public corporations. And I talked about the Disney thing and how a company can dilute shares in that way and so I’d be remiss if I didn’t talk about the opposite side of that is share repurchases.

So what a company can do, and you’ll see this happen a lot where a company makes a profit right now the company can do several things with that profit a company can either keep the profit as cash and just grow their cash reserves that help them in tough times and it just keeps a nice healthy buffer. Right, a company can reinvest it, and they’ll call that on the financial statements they’ll call it things like capital expenditures.

Think of you know spending on research and development things like that or even just buying new equipment buying more assets and growing the business organically in that way the LAT you know the couple other things a company will do with profits is they’ll pay a dividend, and so I love dividends you just listen to a couple of episodes you’ll figure that out pretty quick. It’s a great way to attract shareholders and push the stock price in that way because it’s essentially rewarding the shareholders for taking on this risk and a company can also buy back shares.

So we’re a company diluting their shares are adding to the shares outstanding and your ownership is shrinking stock buybacks are the exact opposite they are buying back shares and essentially removing them from the shares an outstanding pool and your ownership of the business is growing and getting bigger. So that’s a good thing, and the thing is it how you determine if it’s good or bad depends on the situation. But in general it’s it sounds like a good thing right you’re  getting more ownership and it’s better than nothing like you would prefer a company to have profits rather than not obviously.

But so what’s what that what that’s going to do is it’s going to push earnings per share and the other per share metrics up without any of the earnings or the book value or anything like that having to grow because you’re shrinking the per share, and it’s going to push that up, and it’s going to make a company look better on Wall Street it’s going to push up the price a bit too because not only does it kind of positive reinforces the not only doesn’t give this positive perception on Wall Street, and it creates some good momentum to go behind it, but they are they’re essentially acting as if a bunch of investors was to buy the company itself.

So basically the market caps going to stay the same it’s just going to move in the inverse – how many shares are being bought, so that’s going to push your share price up right then. And there it’s like a free return in a sense obviously a lot of good things.

There are some downsides to all of this and what I would say with that is when their company dilutes shares like taking the case of Disney you have to evaluate if they’re getting enough value back if you know if you’re going to dilute your shares but you’re going to buy a company that only grows you like 3% that doesn’t make sense right you’re just wasting shareholder, and you’re doing it the service to your shareholders because you are diluting their shares and not give enough back in return.

On the flipside as an investor as a company if they are buying back shares but their stock is already expensive that’s also doing a disservice to the shareholders because what they’re essentially doing is taking their cash and lighting it on fire whereas maybe the company would have been better just giving that as straight-up a cash dividend to shareholders or they might have been better putting it back in the business. But what you don’t want is a company buying their shares when their shares are already super expensive because it’s wasteful if you were an investor and I have a ton of positions like this where I bought the stock when it was cheap it’s not cheap anymore.

So if I were to put the new money, I probably wouldn’t put it in the stock. It’s a good problem to have because it means your stocks went up in price and you’ve seen some nice gains from it but you know if as an investor I wouldn’t be putting money into those stocks. If I were to put new money somewhere well then what the company is doing by doing that and buying their shares when they’re already expensive is they’re wasting money that should have either been growing their business or should have been given back to me so I can use it in a different opportunity.

So that’s kind of the ups and downs and some of the things that you’ll see with how the shares work on Wall Street how they work on the exchanges and how that kind of all this crazy storm that kind of all puts this connect interconnects everything and puts investor money to work and creates prosperity and creates a strong economy and all of these different things. Those are kind of like the moving pieces and the little details here and there that you probably won’t hear from 95% of the different resources that you have out there.

So hopefully this was helpful hopefully you understand a little bit more about the pros and cons of the different ways that companies manipulate shares, and you have some tools that can equip you towards feeling like you can you can buy some shares and be comfortable with that and understand what do what do these shares me. I mean they used to be little pieces of paper right nowadays it’s just numbered on the computer screen so now you can maybe understand that it’s not just numbers. But it actually represents ownership of a business and it’s something you’re taking part of whether you’re cognizant of it or not and so it’s understood it’s important to understand that if you’re a part of thisthen this is what they’re doing withthose shares and doing with the earnings and the profits and the capital, and that’s what makes this thing move, and that’s the oil, and that’s the fuel that really puts everything in place, and it’s why that there’s so much potential that you can make money in the market.

So I know it’s a bit confusing, but hopefully, this is kind of like a blueprint to show you like this is how it works.

Dave: very well put and I think those were all great points and you know this continuing series that we’re going to be doing I think will help illuminate some of these confusions that people might thave about some of these basics of the stock market – often in our lives we just kind of jump right into the quote-unquote good stuff without learning the basics that can help really advance what you’re doing. You know the basics are always the foundation of where you go you don’t want to relearn how to you know hit a baseball or throw a baseball or dribble a basketball.

You have to start with just the basics of how to do it, and then as you get better than eventually, you become Michael Jordan or LeBron James. Maybe not all of us but some of us you know can rise to that occasion but you know I think that’s going to wrap it up for us tonight.

I hope you guys enjoyed our conversation on back to the basics and next week we’ll continue with some more back to the basics, and we’ve got some great things planned for next week’s episode as well. So without any further ado you guys go out and find some great intrinsic value, invest with a margin of safety emphasis on the safety and have a great week, and we will talk to you guys next week.

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