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This is quite a short module, but it is a very important module. In this module, we will explain an underlying principle of the share market assessment and how it works. We will give you a framework onto which you can hang everything which you learn about the share market. The concepts which we will explain are simple and yet subtle and elusive. You may find that you need to read this module through several times and at intervals to get a good understanding.

 We begin with a question:

“What do you get when you buy a share?”

You get a tiny piece of a listed company which is recorded electronically in the company’s share register. And that tiny piece of the company entitles you to get your share of the company’s dividends (if any are paid) and to get your share of any liquidation dividend (if the company is ever liquidated).

However, the simple fact of the matter is that most shares listed on the JSE are not liquidated – they can be acquired by other companies and occasionally they are de-listed, but you will probably never get to share in the proceeds of a JSE company’s liquidation.

So, what is left? Only the dividend. When you buy a share, what you are essentially buying is a right to the future flow of dividends from that company in perpetuity – and nothing else. This means you are paying a lump sum now - in order to get the right to a flow of future incomes (the dividends).

But,  you might say, “What about a capital gain?”

A capital gain arises because you sell your shares to someone else for more than you paid for them. For that to happen the person who buys them from you must have a higher opinion of the future dividends of that company than you had when you bought the shares. In other words, a capital gain merely reflects a change in the perception of that company’s future dividend flow. A capital gain is thus just the dividend in a different form.

If you can accept that idea, it makes sense to make a forecast of the future dividends of the company whose shares you are going to buy. After all, it is that future flow of dividends that you are buying. 

The best way to illustrate this is by way of an example,

Suppose that you are looking at a share, ABC Ltd, that is trading on the JSE and, as a result of your analysis, you believe that this company will pay a dividend of 100c next year. You have spent some time studying the company’s financials and its past performance. You have read everything in the press and on the Stock Exchange News Service (SENS) about this company and its immediate history. From all that you have made your forecast of next year’s dividend.

Let us also suppose that at the same time you predict that the next dividend after that will be 120c – in two years from now. In fact, let us suppose that you make the following prediction of the company’s dividends for the next 5 years:

Year	1	2	3	4	5
Forecast	100c	120c	140c	150c	180c

But, of course, you would not want to pay 100c now for a dividend of 100c which you are only going to get in a year’s time. There is the opportunity cost of the money and inflation to consider. You might, however, be prepared to pay 70c now to get that 100c dividend next year.

The next dividend is 120c, but you will only get that in two years’ time – so let us say that you are only willing to pay 60c for that now. Then 45c for the third dividend, 30c for the fourth and 20c for the fifth. And then let us say that for all the dividends that come after year 5, you are prepared to pay now a further 75c. So, what you are prepared to pay for the share looks like this:

Year	1	2	3	4	5	Later
Forecast	100c	120c	140c	150c	180c
Value Now	70c	60c	45c	30c	20c	75c

If we add this up, we come to 300c (70c + 60c + 45c + 30c + 20c + 75c) – and that is what this share is worth to you now in today’s money.

If the share is trading in the market for 350c, you will regard it as expensive – and if it is trading for 250c you will see it as cheap and you might well buy it.

The process of reducing your dividend forecast to its value in today’s money is called “discounting”. And that is probably the single most important word in the share market. You will often read that a particular event which impacts on the profitability and future dividends of a company has been “fully discounted”, “partly discounted", or “not discounted at all”. What is meant by this is that investors have or have not taken that event into account and adjusted their perceptions of the company’s likely future flow of dividends – to arrive at a lower or higher value for the share.

But, of course, what we sketched out above is just your forecast of the future flow of dividends.

The next investor who is interested in this share might say that he thinks that next year’s dividend will be 105c or 110c or 90c.

In fact, if we did a survey of all the investors interested in this share, we might find that their opinions of the current value of the share vary from a high of 400c to a low of 200c.

And the market price of the share could be anywhere in between those two extremes – depending on whether there were more pessimists than optimists or vice versa.

The market price of a share is, in fact, determined by:

 

The average of all interested investors discounted
cash flows of the company’s future dividends.

 

Now let us suppose that you have a time machine and you can travel into the future.

Using your time machine, you are able to establish that your forecast of the future dividends of the company is 100% correct.

That means that you now know the real value of the share. You know what the share is really worth in today’s money.

Then you come back to today and you see all these other investors desperately trying to predict the company’s future dividends and discount their predictions into today’s money.

But you now know the truth. You know what the share is actually worth.

With that idea in your mind:

• Fundamental Analysis is the search for the share’s real value,

 and

• Technical Analysis is the study of investors’ perceptions of the share’s real value as it is reflected in the share’s price and volume patterns.

In other words, there are two types of investors out there. There are conservative people who search for a share’s real value (like stockbrokers and institutional fund managers – the fundamentalists) and then are there are those people who say that the real value does not matter – it’s what people think the real value is that matters. And that can be seen in the share’s price and volume pattern (the technicians).

So, there is the reality, and the perception of the reality – and they are obviously linked together. The reality constantly impacts on investors’ perceptions. They interpret company announcements and other information that they get into what they are prepared to pay for the share or what think it is worth.

Think about and study these two definitions of fundamental and technical analysis, because they will impact on everything you learn about and understand about the share market.

Institutional fund managers spend a lot of their time trying to forecast the future flow of dividends from blue chip shares. They get the company’s financials and study them in detail before meeting the directors of the company and questioning them closely about the company’s prospects. Private investors should also take the time to study the company’s latest financials and SENS messages because they might reveal potential dangers in the share.

You may argue, however, that you do not have the time to make forecasts of the future dividends of company – and we do not expect you to. We would suggest, however, that you are actually doing a discounted cash flow of the shares that you buy intuitively or subconsciously.

For example, if you are interested in a particular gold mining share which is trading in the market for 1000c on Friday afternoon and then suddenly over the weekend the gold price drops by $25 an ounce – you will obviously adjust what you are prepared to pay for that share downwards on Monday – and so will every other investor who is interested in it. In effect, you are changing your expectation of the company’s future dividend flow and then discounting that back into what you are now prepared to pay for it now.

So, what we are showing you is what is actually going on – consciously or subconsciously when share prices go up and down in the market. Investors are changing their perceptions of the expected future flow of dividends and then discounting that into a price which they are prepared to pay now. If you understand that, you can begin to understand the underlying mechanics of the market and how fundamental and technical analysis are linked together.

Obviously, changes to a company’s fundamentals – such as its expected headline earnings per share (as, for example, revealed in a trading statement) will have a direct impact on its share prices as investors quickly adjust their perceptions of its future profitability and dividend flow.

There is often information, which is not made available to the public, but which nonetheless impacts on the share’s price and volume through the insider trading of an inner circle who are privy to it. This type of activity can be discerned from the daily market action of the share’s price and volume, but the fundamentalist will not know about it until it is too late.

So, there is merit to both fundamental and technical analysis of shares and you should aim to become an expert in both.

GLOSSARY TERMS:

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