Investing in Shares – understand the basics

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When you are investing, you are not just buying an asset randomly with the hope that you will incidentally make income. You need to properly understand what you are doing. If you are considering about investing in shares – understand the basics before you start. If you do not understand it, do not do it. Investing is like playing a game – if you do not know the rules, do not play.

On this article we will discuss the basic understanding you need to have before you invest in shares or any related financial asset. It is worthy noting that what we will discuss is just a tip of the iceberg.

We will discuss the following:

• Bid-Ask Spread
• Return on Investment (ROI)
• Earnings per Share (EPS)

Bid-Ask Spread

For first time investors, bid-ask spread can be very confusing. The bid price is the highest price that a buyer is willing to buy the shares for while the ask price (offer price) is the lowest price that a buyer is willing to sell the shares at.

When you are buying or selling shares, you are a price taker (that is you do not set the price). In this case for trade to happen, you will buy at the ask price or sell at the bid price.

Important notes:

1. A high price is attractive to the seller.
2. A lower price is a great deal for the buyer.
3. If an investor is rational (that is if 1 and 2 holds) then the ask price should always be greater than the bid price.

Due to the gap between the bid and the ask price, for a trade to happen, a middle man (market maker) has to facilitate the trade – the stock broker. Your broker will buy shares from the seller at the bid price (lowest price) and sell to you at the ask price (higher price). Therefore, their reward for facilitating a trade is the difference between the bid and ask price. This is the bid-ask spread.

Practical Example: Impala Platinum (IMP) Shares

Let us suppose you want to buy Impala Platinum Shares. The current price of the IMP shares is R 144.34.

A seller is willing to sell the shares for R 146.00 (ask price) and you are willing to buy for R 140.00 (bid price). Your broker will facilitate the trade gaining R 6.00 (that is R 146.00 – R 140.00) in the process (bid-ask spread). Therefore, you will buy shares for R 146.00 from the broker instead of the current price of R 144.34. This explains that dip in returns you will always see immediately after buying the shares.

Return on Investment (ROI)

It is very important to understand the returns you get from your investment in shares. ROI is used to measure the performance of your portfolio of assets.

This is a pretty simple calculation that calculates the returns you can get now if you are to sell your portfolio of assets after adjusting for the costs you paid. Let us define the formula as follows:

• • • Value of the portfolio – the proceeds from selling shares in your portfolio
    • Initial value of the portfolio – the amount of money you paid to acquire the shares in your portfolio.

Practical Example

Let us carry on with the earlier example of investing in Impala Platinum. Suppose you bought 100 shares 1 year ago for R 40.00 and decides to sell your shares today.

Since you will sell your shares at the bid price (that is R 140.00), your sale value will be R 14 000.

The costs of buying your shares (ignoring other costs like security transfer tax and VAT) was R 4 000.

Therefore,

In this case, you could have been earning 250% if you had invested in Impala Platinum shares last year.

Note:

• When you use ROI to compare the performances of different assets, you need to ensure that the time horizon of the investments is the same. Suppose you want to compare ROI for investment A (5 years) and B (2 years), then you can standardize the time period by calculating an average annual ROI for both A and B.
• If you invest in shares without paying anything, then your ROI is infinite.

Earnings per Share (EPS)

This measurement tells you about the profitability of the company whose shares you are buying. This may be a very important measurement to consider when you are investing in shares. EPS calculates the portion of the profit that a shareholder earns.

• • Net Profit  –  the income of the company after deducting expenses.
  • Preferred Dividends – dividends payable on preference shares. (Note that Preference Shareholders get paid before Ordinary Shareholders).
  • Outstanding Shares – these are the shares that are currently owned by investors.

Practical Example

For the sake of grasping the concept, we are going to use a simple example. Suppose the company realized a net profit of R 100 000 and declared R 20 000 Preferred Dividends. Let also assume that the total number of Outstanding shares are 1 000 000.

In this case, for each share you own, you earn R 0.08 of the net profit. Therefore, if you have 100 shares then you get R 8 as your portion of the net profit.

In conclusion, if you want to be successful on investing in shares, you need to understand the basics as a starting point. This should guide you as you select your portfolio. The more your increase your IQ on how to invest in shares, the more you can make good decisions. Our post about creating a portfolio of shares may be useful to you.