Category: Investing

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Investing

Investors Vs Traders In NZ (Tax Law)

You might have heard stock market investors talking about share traders and share investors. These are two different types of stock market investors in terms of strategy, but this also has a significant impact on an investors tax implications.

NZ Tax Law defines two types of investors in shares: Traders and Investors. As usual with tax, the difference is grey and separated by “intention” – though it’s the IRD who will ultimately decide what your intentions were, so you’re going to want your intentions to be crystal clear.

What Is An Investor?

An investor is someone who buys shares with the intention of keeping them long term. They are investing in a company to enjoy the growth of a company with a view to getting an income as an owner of the company or having a long term exit plan.

Being an investor is arguably less stressful because investors don’t sweat the daily ups and downs of the stock market caused by market sentiment, as much as Share Traders do.

Investors typically use Financial Analysis (FA) techniques to justify their purchase, and try to purchase quality well run companies with good growth prospects, or speculative stocks.

From a tax perspective, investors do not pay Capital Gains Tax (CGT) in NZ.

What Is A Share Trader?

Share Traders buy shares with the view of playing the share market. They buy the lows and sell the highs, with lots of trades. They use Technical Analysis (TA) techniques and spend a lot of time looking at graphs to determine where the share price of a stock might go. They may also do Short trades.

Share Traders tax on their earnings at the end of the year, but I assume can recover their costs if their investments make a loss (you’ll have to talk to an accountant to confirm this).

It’s possible to be an Investor and accidentally become a Share Trader, say if you buy shares with the intention of investing, but then have to sell because you need the money or market conditions become unfavorable and you decide to exit, or if you’re learning and make some incorrect purchases that you need to remove from your portfolio. Again, your accountant will be the best person to advice you on this.

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Investing

How To Calculate PE

PE, or Price to Earnings ratio is a measure of a company’s price, relative to it’s earnings. It can either be measured as a forward looking metric or a backwards looking metric.

To calculate the PE of a company, you divide it’s Market Capitalization (MC) by it’s earnings, or Net Income – Dividends. To calculate the forward PE, you use projected earnings (forecast by you or the company); to calculate the backwards PE, you use the earnings from the most recent financial report.

PE is a sort of valuation method to see if a company is worth investing in at it’s current price. You can think of the PE as the number of years you’d have to own a share in the company before the company earned enough money to cover the cost if your purchase (assuming earnings are the same each year).

For example, if a company’s MC is $100M and it’s earnings are $10M, the PE would be 10 (100 / 10 = 10). After 10 years of earning $10M, the company would have made $100M (excluding amortization & interest on the value of the money).

Assuming all this money is paid out in dividends, the investor would have made their money back. In this scenario, a PE of 10 might be considered as a 10% ROI.

Depending on several factors, such as risk, market sentiment, the growth rate of a company and expected return, an investor might be willing to buy a company at a higher or lower PE.

A fair PE for a company with zero annual growth might be 11, while a company growing at a fast rate might command a higher PE, such as 25 – 40. The PE that you are willing to accept is directly related to the amount of return you want to achieve on your investment – it is this factor that brings market sentiment into the equation.

It’s worth considering that this method of calculating value in a stock price doesn’t consider growth of a company sourced from investing profits back into the company before realizing them on a balance sheet, which is a tax efficient way to grow the company. PE is more suited to valuing mature companies, or growth companies with a significant profit margin. PE also doesn’t show value in a company that is not profitable.

This method is a provides a very real perspective of the Return On Investment (ROI) because it considers the part of the profits that are held by the company – though it’s important to ensure that if those profits which were held back are reinvested, that they do actually translate into growth. Otherwise they are just a poorly reported costs of doing business.

Finally, please feel free to check out my own proprietary method for calculating PE.

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Investing

A Glossary Of Investing Terms

Here’s a glossary of acronyms used by investors. I’ll add to the list as I go, and explain each term in more depth later on. In the meantime this should give you enough to go on, so you can do a proper Google search on the term.

  • 10 Bagger – This is a term coined by famous fund manager Peter Lynch, and finds it’s roots in the game of marbles, in which a 10 bagger was a marble that had won 10 games (hence had been put back in the bag of marbles 10 times, and not lost as ante to the opponent. In investing terms, a 10 bagger is a stock that has increased in value by a multiple of 10.
  • ARR – Annual Recurring Revenue. This is company revenue derived from a repeating source. Typically a subscription from customers which is renewed at regular intervals.
  • ATH – All Time High: the highest price a stock has ever reached.
  • Black Swan – An unexpected thing or event that causes misfortune, such as COVID19, which caused an economic crash.
  • CAGR – Compound Annual Growth Rate.
  • Capitalized Cost – Instead of recording the total value of a purchased asset, the cost of it’s amortized value is recorded over a period of years instead.
  • CARR – Contracted Annual Recurring Revenue. This is company revenue derived from a repeating (contracted) source. Typically a subscription from customers contracted over X years.
  • COGS – Cost Of Goods Sold.
  • CR – Capital Raise.
  • DCA – Dollar Cost Averaging. Buying more shares at a different value to have an average cost per share instead of an absolute cost.
  • DCF – Discounted Cash Flow. A method used to value a business.
  • DPS – Dividend Per Share.
  • DRP – Dividend Reinvestment Plan.
  • Earnings Accreditive – An overall increase in profit, typically from an event or transaction (such as the purchase of a new business unit).
  • EBIT – Earnings Before Interest and Tax.
  • EBITDA – Earnings Before Interest, Tax, Depreciation and Amortization.
  • EPS – Earnings Per Share.
  • ETF – Exchange Traded Fund.
  • EV – Enterprise Value.
  • FMCG – Fast Moving Consumer Goods.
  • Helicopter Money – The idea of throwing money out of a helicopter (not literally) to stimulate an economy by increasing capacity for demand.
  • NPAT – Net Profit After Tax.
  • NPV – Net Present Value.
  • NTA – Net Tangible Assets.
  • PE – Price to Earnings ratio.
  • PEG – Price to Earnings Growth ratio.
  • PCP – Prior Comparable Period.
  • PIE – Portfolio Investment Entity.
  • QE – Quantitative Easing.
  • ROCE – Return On Capital Employed.
  • ROI – Return On Investment.
  • SP – Share Price.
  • SPP – Share Purchase Plan.
  • WACC – Weighted Average Cost of Capital.
Categories
Investing

How To Invest In The Stock Market (A Beginners Guide)

Investing in the stock market can be daunting, and is often an expensive learning curve. This article gives you an overview on how to invest in the stock market, what shares are, how to buy shares, how to research a company, etc. It won’t make you an expert, but it’ll give you the basic knowledge to get started.

How Do Shares Work?

When you buy shares (AKA stock), you’re actually buying a percentage of that company. There are different types of shares (that give different rights, such as shares with no voting power), but fortunately (as far as I’m aware) ordinary shares listed on the NZX and ASX all have the same rights.

Fun tip: If you’re buying shares in a non-listed company (in other words, a company not listed on the stock exchange), you’ll want to check the Company Constitution and shareholders agreement to see if you have the same rights as everyone else.

When a company is created (and registered with the Companies Office), that company decides how many shares it wants the company ownership structure to be split into. The owners are then recorded at the Companies Office and updated when shares are bought and sold.

When a company lists on a stock exchange, it’s no longer feasible to constantly update the Companies Office so the company hires a share registrar, such as Link Market Services or Computer Share. The share registrar will be connected to the stock exchange, and automatically update when shares are bought or sold.

Buying Shares On The Stock Market

Finding A Stock Broker

The first thing to do when buying shares is to find a broker. Brokers broadly fit into one of two categories: Those with value-add services and those that provide direct access.

If you want to buy shares in New Zealand and don’t want a value-add broker, your options are:

  • Sharesies – I understand that you don’t own the shares directly, instead they are held in a trust. This means that you can have a childs account, which I don’t think is otherwise possible in share ownership. See here for the cost of Sharesies.
  • ASB Securities – No annual fees, you own the shares outright, just pay for the trades you make.
  • ANZ – Same as ASB but with a slightly different fee structure.

If you want value-add services such as investment advice or drip feed automated selling for large volumes of shares, your options are:

Once you’ve signed up with a broker, you can then make a purchase through the broker. The next step is to choose a company to buy shares in.

Choosing A Company To Buy Shares In

The first step to choosing a company to invest in is to get a list of companies, which you can do from the ASX or NZX website. Once you’ve picked a company that you’re interested in, you’ll need to start researching that company.

How To Research A Company

To research a company, you’ll want to go to the respective stock market’s website (ASX or NZX) and search for the company. From here you’ll have access to all of the company’s announcements. Read through these, particularly the annual results and financial statements.

You should be looking to see if the director’s historic forecasts matched the following years results, to get a clue about how much credence should be put in this current year’s forecast. You should also be checking the finances to try to understand what’s going on.

Next take a look at the Companies Register to see who the major shareholders are and do a bit of research on them. Check up on the directors while you’re there too. Take a look into their other (including past) endeavors.

Next, have a look at some forums to see what others think or know that you might not. A great resource for the NZX is ShareTrader (There is one poster named “Beagle” who I particularly like, though there are many other wise folk there). A good resource for the ASX is HotCopper, though HotCopper seems to be comprised of a higher percentage of people who are blindly fanatical about particular stocks, so the conversation is less balanced.

Beware of any up-ramping or down-ramping of shares on stock market forums, as some posters may have their own agenda. Also be aware that not everyone on these forums is an expert.

I will also provide my own commentary and valuations for stocks on this website (see the ASX and NZX pages for details) and also news that I feel is relevant.

Finally, throughout all this, you should keep abreast of the news, and try to predict what might happen to the future of these companies. Factors like government policy, interest rates, foreign exchange rates, and property values play a significant part to influence the value of large companies on the stock market. Stats NZ is also another good source of broader economic data.

Valuing Shares

Once you’ve found a company that you think you might like to buy shares in, you’ll need to decide how much they’re worth – because if you think that they’re selling for more than you think they’re worth, the only way to make money on those shares is if there’s a Greater Fool.

I won’t go into how to value shares in this article because it’s a very big subject, but valuing shares is a vital part of investing and I highly recommend you do some research into this. Check out this article on how to value shares to start you off, and remember that there are two ways to invest, as either an Investor in shares (who holds for a long time) or a Share Trader (who does lots of trades [including stock shorting] to make money over a shorter period of time). The later type of investor pays capital gains, but has the opportunity to make a lot more money. Share Traders typically use Technical Analysis (TA), while Investors typically use Financial Analysis (FA).

Making Your First Share Purchase

Once you’ve decided what shares you want to buy and how much you want to pay, you’ll probably want to check the Market Depth before putting a bid in. The Market Depth tells you how many buyers and sellers there are, and what they are offering to pay / receive for their shares. This gives you a clue but beware that more often than not, there’s some manipulation going on there.

Once you’ve made a bid and you have waited until the bid has been accepted, you should receive something from the registrar in the mail (the registrar gets your details from your broker). Once you receive this, it will have your unique ID on it, which you can then use to register on the registrars website. This lets you update your details so you can receive company information through email, update your bank and tax details for dividend payments, sign up for Dividend Reinvestment Programmes (DRP), etc.

Final Words

Once you’ve learned how it all fits together, the next thing to do (which is really the first thing to do, but you probably won’t know how until you have some experience) is to decide what your investment goals are and make an investment strategy. For example, do you want to buy some shares so you can save up some money for a house; are you looking for long term investment income; or are you looking to exit your growth shares in X years so you can buy shares in stable dividend paying shares for retirement; or perhaps you’re rich and looking to use the stock market to spread your risk? Whatever your investment goals are should be defined first, because these will affect your purchasing decisions.

I hope this article helps start a few people off on their journey to becoming richer with shares. Remember that this article is just a quick outline, and you’ll have to do a lot of your own research.

Good luck.

Categories
Investing

A Checklist For Angel Investors

This article provides a checklist for Angel Investors prior to investing in a company. It’s a list of documents you’ll need and things you’ll need to check before buying shares in a private company.

  • Business Plan – This should include a SWOT analysis, Risk Analysis with mitigation if possible, forecast (with solid justification for the numbers), information about any planned future capital raises, and a plan for how they’re going to spend the money. There are some good Business Plan templates on the internet for this.
  • Exit plan – which should be a conversation about each directors intentions.
  • Evidence of the things in the Information Memorandum (IM) or business plan, such as a copy of contracts to prove ongoing sales.
  • Financials for the past few years (which you’ll need for the valuation).
  • Financial Models – I like to see that a company has done some financial modelling to show that they’ve can justify their decision to seek funding from an investor. They should have modelled the projection of the business without investment, with other types of investment, etc. It should be obvious to you why they’re willing to give up part of their precious business rather than just take a bank loan.
  • A Company Constitution – You’ll want to have a commercial lawyer check this after you’ve checked it. Getting a good lawyer is very important. All lawyers say that they do commercial law, but the fact is most are only good at family law. It’s very important that you get a lawyer that specializes in commercial law – which usually means hiring a big law firm.
  • A Shareholders Agreement – Again, you’ll want to have a commercial lawyer check this after you’ve checked it.
  • Valuation – The company will likely have their own idea of the value of the company. You’ll need to do your own valuation to ensure that you can see value (and the right ROI) of your investment in the company. You’ll need to be able to justify this to the entrepreneur if you want to negotiate on the price.
  • Check the Companies Register for existing ownership structure, company history, and search each director and shareholder to ensure that they don’t have a conflict of interest.
  • Check the Insolvency and DRO Register to see if any of the directors have a history there. You may wish to give the director a change to talk about the reason they are listed on the register before walking away from the investment.
  • Check the LINZ database to ensure that the addresses of the directors matches that of the NZ companies database and also get clues about their financial position from dates of mortgages registered against the property title. I recommend using Prover for this, as property data in NZ is complicated, and I believe that this company does the best job of assembling this data into a useful tool.
  • Check the ID (Drivers License / Passport) of the person that you are dealing with to ensure that they are who they say they are, and are listed on the Companies Register as a director.
  • View the Directors Resolution.
  • Search for the directors, shareholders and company on Google and social media websites and read up as much as you can.
  • Ensure that the Shareholders Agreement or other legal document ensures that IP is owned by the company, and new IP that is relevant to the business, which is created by the directors of the company is owned by the company. This stuff should all be in the Shareholders Agreement.
  • Get a list of assets owned by the company.

Get the following Warrants from the company, if they are relevant:

  • There is no outstanding debt, shareholder loans, GST & PAYE is all paid.
  • There are no undeclared convertible notes or other unlisted shareholdings, etc.
  • There is no contractual restraint of trade to another company (such as a former employer) and have no such arrangement pending would also be good (they might be selling a large business that has a restraint of trade term which makes them unable to work in the business in which you are buying shares).

Your lawyer can help with a list here, as they are likely to have a boiler plate template with a list of warranties – though it’s your responsibility to check these off before the contract stage.

Categories
Business Investing

How To Do A Business Valuation

There are a number of different ways to value a business, and although there are a few recognized methods, business valuations are as much of an art than a science.

This article discusses the types of valuation available, when to use each type and links to other articles showing how to do each respective type of business valuation. By the end of this article you still won’t know how to do a business valuation because there are many significant subtleties that are unique to the business you are valuing, but you’ll have a good start from which to grow your knowledge.

Choosing The Right Type Of Valuation

The outcome of a valuation will depend on the type of valuation chosen, the values used in the valuation and the reason for the valuation. That’s why the first step in valuing a business is to choose an appropriate method of valuation.

The Football Field Approach

The Football Field approach isn’t really a type of valuation, more of a method of helping to choose a valuation type. Ironically, given that choosing the type of valuation is the first thing to do, a Football Field can only be done once you’ve done every other type of valuation available.

This isn’t my favorite way to choose what type of valuation to use, but it’s something that I do because it helps get your head around the valuation and give some sense of how the chosen valuation method fits in with alternative ways to value the business.

When I do a Football Field, I perform each type of valuation that can be done on the business thrice; once with a pessimistic view, once with an optimistic view, and once with a view of what the most likely outcome is. Then I place them all in a graph so I can see how each type of valuation compares.

You can then use this to see any commonalities between the different types of valuations and where the upper and lower values are.

Valuation Methods

Here follows a synopsis of various valuation methods, their appropriateness to different types of business and a link to a more in depth description of how to value a business using the respective method.

Discounted Cash Flow (DCF) Analysis

A DCF Analysis is primarily used by accountants to calculate the value of a business in terms of its total worth across a 5 year period. This valuation method is typically used when determining the monetary value of a business for the purpose of arbitration or contractual value. For example, it may be used to calculate the equivalent cash value of a shareholders stake in a company if that shareholder were to be subject to a Call or Put Option.

A DCF Analysis is less frequently used as a method to calculate the market value of a business because (while it may factor opportunity cost or depreciation of the value of money invested in the return in the business – AKA the “Discount”) it typically doesn’t consider a margin of profit for the buyer to entice a purchase.

That said, a DCF Valuation does provide the benefit of factoring in future growth of a company and therefore may be argued as a suitable way to value high growth companies; hence I use my own version of a DCF Analysis when valuing growth companies, which includes a margin of profit – a model that alters based on the exit strategy for the investment.

A DCF is probably the most complex method of performing a business valuation and is not relevant when profit is low compared to revenue (or if profit is negative), as there is value in such a company that is not apparent through the profit (such as goodwill, IP, etc.).

Here’s a Wikipedia article on how a DCF Valuation works.

Comparable Market Analysis

The Comparable Market Analysis (AKA Comparables Market / CM Valuation) involves finding historic sales prices of comparable businesses and using these to deduce what the business might be worth.

The Comparable method is typically used where there is a lot of sales data available in an open market – such as in a stock market or business broker.

The Comparable Market Analysis is heavily influenced by market sentiment and can result in wildly different valuations depending on when it’s done. This can lead to a Greater Fool scenario and also be subject to market manipulation. In the absence of these issues and a short investment time-frame, this is arguably one of the best valuation methods because it tells you what the business is worth at that time.

The problem I have with this type of analysis is that it doesn’t consider the return an investment can give you relative to the performance of the company in the absence of a sale or change in the market conditions, and it relies of the analysis of others.

Therefore, I posit that this type of valuation is most appropriate for stock market traders (but not stock market investors) and business brokers who have access to historic sales data and have some control over the market.

Discounted Dividend Model (DDM)

This is basically a DCF valuation based on dividend return instead of NPAT, which gives the perspective of value of a business based on the return to the investor in the absence of a sale. Truthfully I don’t use this method and don’t know much about it. There’s a really nice Wikipedia article on DDM if you’re interested to learn more.

I suppose this method could be useful for a retiree who wants to calculate Return On Investment (ROI).

Price-to-Earnings (PE) Ratio

The PE value of a company is calculated by dividing the Market Capitalization (MC) of the company by its earnings (Net Income – dividends). This can be done as a backward PE (where the last reported annual figures are used to calculate earnings) or a forward PE (in which the forecast earnings are used in the calculation).

More information on Price-to-Earnings ratios is available here.

Also, check out my own proprietary method for calculating PE.

Multiples Of Revenue

This is a common method of valuing businesses for sale by business brokers. It’s sort of a lazy method because it doesn’t attempt to calculate the value of a company in any depth. It doesn’t consider the effort required of the company to be profitable or the value of the assets that the company holds (though often business brokers will add the value of stock to this number). There are other methods of valuing a business that business brokers use, many of which consider a salary component for the owner, though these methods are beyond the scope of the type of investing I do; hence will not be discussed here.

The benefit of using multiples of revenue is that it does place some value on the company that is relative to its capacity to become profitable if that is not currently the case. Also the value of the goodwill, IP and other aspects could (lazily) be considered to be relative to the revenue of the company, which otherwise may not be recorded in the company’s profit.

This type of valuation is also often used when valuing companies whose customer base is on an Annual Recurring Revenue (ARR) pricing scheme.

I like this valuation method when based on multiples of ARR, but prefer to derive my own valuation method based on the component of a company’s ARR that has the capacity to be profitable (I blend elements of DCF in this method).

This is because I only want to invest in companies that are capable of being profitable so they can offer multiple exit opportunities (sale, Put Option, dividend return, etc.). Also, while theoretically a company could give a positive return on investment if the valuation is based on multiples of ARR, while the cost of growth is less than the multiple of ARR growth, this could lead to a Greater Fool scenario with no other exit than a sale.

Summary

There are a lot of methods to value a business, and I’m sure there are more than I have listed here, and after reading this you can probably appreciate why it’s important to chose a type of valuation that’s relevant to the purpose of your valuation.

Whether you’re valuing your business for sale, looking for investment or trying to decide what the business is worth so you can buy out a business partner at a fair price for all parties involved, there are many valuation methods to chose from. Though given the number of scenarios of requiring a business valuation and the variable nature of finding value in different businesses, there’s no single method for every case.

This is why I suggest that if you are an investor, you should come to your own conclusion about the method of valuations that you use, or make your own valuation methods as I have.

Addendum: An investor should also consider soft aspects of value in a business (such as IP or value in directors). An investor should also watch out for creative accounting and consider the reliability of forecast profit projections. There are a number of things to consider when valuing a business that are not discussed here, and they are learned with experience; hopefully this article sets you up with the basics to get started and my analysis of stocks on this website will help fill in the gaps and grow your knowledge on the subject of valuing businesses.