Investing in shares 101: A beginner's guide

Many people feel investing in the share market is a complex and scary concept. This is often due to a lack of understanding.I have written a number of blogs about the advantages of index investing. However, I thought it might be useful to take a step back and take a look at the basics of share market investing.How does the stock market work?The share market is merely a place where people come to buy and sell shares. Some people will be buyers, and some will be sellers. They will each bid what price they are willing to buy or sell a particular stock. A deal will be done when they meet in the middle and agree on price. This is all done electronically (although, in Australia, prior to 1990, it was done on chalk boards).You can see an example of this in the screen-print below (for CBA). As you can see, there are 9 people that would like to buy 455 shares in CBA shares for a price of $79.77. There are also 16 people that are prepared to sell 519 shares for $79.79. Seconds after taking this screen shot, the shares traded or $79.78 (i.e. the mid-point). These transactions happen all the time and this is how shares are valued by the market.By the way, this is called market depth. That is, the number of buyers and sellers (and number of units) interested in trading a particular stock. It is important to invest in a stock with good depth to ensure your investment is liquid and fairly priced. More on this soon.What is a company worth?Obviously, the ‘market’ determines the value of a stock. As stated above, the market is made up of many buyers and sellers (most of them professionals).There is a concept in financial theory called the Efficient Market Hypothesis (EFH) which states that the price of a stock reflects all available information about that stock and therefore is an accurate indication of its intrinsic value. Whilst this theory has some merit, I believe that EFM is truer in the long run than it is in the short run. In the short run, popularity can drive stock prices, not fundamentals.Fundamentally, the value of a company is simply the present value of its future cash flows (i.e. profit). That is, what is the total value of say the next 10 years of profit after applying a discount rate (which is like an interest rate) to account for the businesses risk.So, the key factor that investors must focus on is cash flow (profitability). There are only two reason why someone might invest in a business that makes low to no profit. Firstly, they invest in the stock on the expectation that the company’s business model is so compelling that it will generate strong profits in the future. Or, secondly, they are speculating that the stock price will continue to rise (this approach is more like gambling).What are some of the key terms and when to use them?I have listed below some of the key financial measures and terminology that are important to be familiar with if you want to invest in shares. Of course, there are lots of measures to look at, and they might vary between industries, so this isn’t an exhaustive list.Earnings per share (EPS)This is the amount of profit after tax that a company makes divided by the number of shares on issue. It is good if a company’s EPS is consistent (low volatility) and exhibits a good historic growth rate.PE ratioPE ratio stands for price-earnings ratio. This is calculated by dividing a stock’s price by its EPS. This tells you whether the stock is valued conservatively or aggressively. The long-term average PE in the Australian market is circa 15. Most of the top 200 stocks have a PMy new book is available for pre-order now: Pre-ordering the book will help me get it into bookstores. So please do me a favour - please consider pre-ordering now - links and pre-order bonus are available here: https://prosolution.com.au/book-preorder-bonus Do you have a question for the podcast? Email us at [email protected]. If you're interested in working with our team and me, discover how we can work together here: https://prosolution.com.au/family-office-servicesIf this episode resonated with you, please leave a rating on your favourite podcast platform. Subscribe to my weekly blog: https://prosolution.com.au/stay-connected IMPORTANT: This podcast provides general information about finance, taxes, and credit. This means that the content does not consider your specific objectives, financial situation, or needs. It is crucial for you to assess whether the information is suitable for your circumstances before taking any actions based on it. If you find yourself uncertain about the relevance or your specific needs, it is advisable to seek advice from a licensed and trustworthy professional.