How do we earn from the stock market? (Part 2) |

« How do we earn from the stock market? (Part 1)

How do we earn from the stock market? (Part 2)

May 23, 2011 by Rhyme and Reason Investing

In Part 1, we talked about how we could earn from our stock market investments through dividends. Among others, we said that:

The two (2) most common forms of dividends are cash and stock dividends
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We can probably understand more about cash dividends if we start with how similar it is with getting interest income from our bank time deposit
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The interest income we get from our bank time deposit is the bank’s way of paying us for borrowing our money, while the dividend we receive from a company represents our share in the company’s profit
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Interest income is taxed at 20%, i.e. if total interest is Php100, we only get Php80
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Cash dividend is taxed at 10%, i.e. if total cash dividends is Php100, we only receive Php90
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Payment of interest is promised (and assured) by the bank at the time we open our time deposit account, and our account is insured up to Php500,000
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Payment of cash dividends depends upon whether the company decides that distributing dividends is in the best interest of the company or whether the company has excess cash to pay dividends, thus there is no assurance as to when investors receive dividends and how much
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Investing in dividend-paying stocks can provide more profit compared to investing in a time deposit account
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We also noted that we sell stocks only for two reasons —- because we have already earned from it or because the reasons why we bought it no longer hold.

In this post, we will discuss how we earn through the increase in the stock’s market price.

How do I profit from the stock market?

BUYING STOCKS TO EARN WHEN PRICE MEETS VALUE

Personally, I think this is the tricky part, and yet most would-be investors have this as their main purpose as to why they join in the chaotic world of stock market investing.

Since buying a stock would make us part-owner of a company, the rule is:

…we buy a stock at its PRICE today, because we know that the VALUE of the company is higher than its current market price.

Given that, before we buy a stock, we need to know two things — the stock price today AND the value of the company.

It is quite easy to find out what is the stock price today of, say, PLDT (ticker: TEL). We just go to the Quotes page of our online broker’s website (as shown below), type in “TEL” and hit enter. Voila! The current market price of a share in PLDT is displayed.

stock price

Now that we know the stock price of TEL, should we buy it now? NO. At least not yet. We still need to know the value of PLDT and compare it to its current market price.

Is the market selling TEL more than its worth (i.e. overpriced/expensive)? Or is the market selling TEL at bargain price (i.e. cheap compared to the value of PLDT)?

If the VALUE of PLDT today is Php2,930 per share and the PRICE of TEL today is Php2,420 per share, then, we can own PLDT at a bargain! So, let us say we buy TEL today at Php2,420 per share.

example

After several weeks or months, other people realized that, indeed, PLDT is worth more than Php2,420 (maybe Php2,800, maybe Php2,900 or maybe Php3,200, etc.) and they start buying TEL and push its price higher.

Since at the time we bought TEL we thought that it was worth Php2,930, when the buying of others caused its price to reach Php3,000, without any change to what we assumed when we calculate its value before, we sell our TEL stocks at Php3,000 per share and pocket our +20% net profit.

LEARN THE BASICS, THEN BUILD FROM THERE

If at any given point in time we can answer the “What is the value of this company?” question, then not investing in the stock market is a huge mistake.

But more importantly, if we tremble on our knees when asked the “What is the value of this company?” question, then it may be prudent not to invest in the stock market, or at least not to invest in the stock market on our own.

In practice, as it could well be expected, it is very difficult to know the value of a company. Fortunately for individual investors like many of us, having a firm understanding of the basics can help, starting with Basics#1:

Understand the Business

Forget everything, but never Basics #1. Rule of thumb is to understand as much as we can about the business of the company. If we eat at Jollibee or we feel happy when we go to SM Mall of Asia, then we are on our way to knowing that Jollibee (ticker: JFC) and SM (ticker: SM/SMPH) are good candidates.

Next, it is crucial to understand that we invest today because we expect to get something more in the future. It’s always about the future. That is the spirit of Basics #2:

Value of the company

To explain Basics #2, perhaps we could use our time deposit example. In that case, our Php100 became Php104 after one year because the net interest rate is 4%. Note that our future cash flow is Php104 and the interest rate is 4%.

How much should I invest today to get Php104 in the future? Php104 ÷ (1+4%) = Php100.

It’s the same thing when we value stocks. However, since now we are dealing with a company that we expect would continue operating for many years, we do not only look at what the company can earn next year, or in the next two years. We need to know how much the company can sell (and collect, since sales are not important until they collected and result to cash inflows) as far forward in time as we expect the company to exist and operate.

“Really?? we need to know all that?” Yes, but we can still survive even if we do not have all those information. How? By using Basics #1 to know what increases/decreases future cash flows (the numerator) and what increases/decreases interest rate or the cost of doing business (the denominator).

If OFWs keep sending their money to their families here in the Philippines, then we can expect that people will eat more at Jollibee (ticker: JFC), that they will shop more at SM Hypermarket, or buy appliances from SM Appliance Center, and increase their Meralco (ticker: MER) bill as they use their appliances.

Also, if interest rates are expected to be kept at its current low level, it means the company can take out new cheap loans from banks to expand their operations. On the customer side, people may think that they can afford to get a home loan from a bank and buy a condo unit built by Megaworld (ticker: MEG) or Ayala Land (ticker: ALI).

Lastly, Basics #3:

Few reminders

Essentially, Basics #3 lists down the things that can keep us away from the vultures (sometimes, including ourselves) that always stand ready to tear us apart. It keeps our feet on the ground with our senses fully functioning and our guards activated.

As one author puts it, “If you have spent years working hard to build what you have, it only makes sense to take good care of it.”

The stock market can sometimes give us the high that makes us think that we can risk more of our hard-earned money. Basics #3 can help us put everything in perspective and allows us to check and re-check whether we are here for the game or we are here with a plan.

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