The seven big drivers of share prices and when to buy

In the latest of a series of articles, former lawyer and City money man Peter Alcaraz discusses the biggest influences on bond and equity prices, and the other growth platforms that can make you big profits.

Peter Alcaraz read law and economics at Durham University and spent 24 years advising small and mid-sized companies on mergers, acquisitions, IPO's and fund raisings, first as a lawyer and for the last 20 years in corporate finance. At the age of 46 after reaching 'O' he left city life to write, study, travel and spend more time with his wife and two daughters. His first book, The Wealth Game - an ordinary person's companion was published in 2016 and has become a staple among wealth managers, business schools and private individuals wishing to develop their personal finance skills.

• How you can achieve financial freedom more quickly
• How to calculate your real net worth
• How to calculate your total future needs and retire early
• How to keep a firm grip on cash flow and preserve your wealth
• How you can generate more surplus cash flow
• Rules and strategy for achieving financial freedom quickly
• How being contrarian can help you win the wealth game
• Some basic laws of finance to help you spot a wealth opportunity 

Cash is a productive depreciator, eroded by inflation but capable of earning interest.

As a universal medium of exchange with no intrinsic worth, its utility value lies in what it can buy: interest from a bank, dividends on shares, returns on investments, goods and services, or other currencies.

The value of cash or its buying power is therefore relative, depending on the price or terms of what it can be swapped for and so changes daily.

You can influence the value of your own cash in the way you spend it.

Or put simply, your pound can be more valuable than someone else's….

The more value you are able to buy, the more your cash is worth; the same five-pound note can buy two take-away coffees or a large pack of fresh-filter coffee that makes 20 cups. Fifteen pounds buys a slightly worn winter coat in a charity shop, two packets of cigarettes, or a new pair of branded socks. One hundred pounds can deliver healthy family meals and household consumables for a week or a dinner for two. A thousand pounds can fund a long-haul backpacking holiday for a month or a weekend stay in a luxury hotel.

Even the same product can be bought for different prices; the price can be low near the source of production or from a discounter or second hand, and it can be high when it has been branded, packaged, advertised and passed through various middlemen. Overpaying represents a needless transfer of wealth from you to someone else.

On the savings and investment side, a player who can secure a better return on their pound than others has a more valuable pound. This argues for developing an understanding of different growth platforms and their value and price drivers.

Bonds

When you invest in a bond, you are lending money to the bond issuer, generally for a specified time period. In return, the issuer is legally obliged to pay interest, or coupon, at a pre-agreed rate and to repay the original amount borrowed, principal, face value, nominal value, or par value on the repayment date (maturity). Bonds are a financial instrument for funding government or corporate issuers. They are also known as fixed-income securities. As a bondholder, you are a creditor of the issuer.

A bond is a productive depreciator because its capital return is fixed and therefore erodes with inflation, but it generates an income.

Unlike company dividends that are not certain as to quantity and are not guaranteed, bond interest is certain but only as strong as the issuer, which may range from a well-funded country to a risky or near-bankrupt company.

You can hold a bond to maturity or sell it in the secondary market if there is one at the price on the day. This determines your capital repayment. People sometimes assume that the capital invested in bonds is safe but forget that the price of bonds falls when investors seek higher yields. Unless you hold a bond until maturity, the capital repayment is at risk, and only by holding an individual bond directly can you keep control of this. Bonds held in managed funds are bought and sold at the discretion of the manager.

Publicly traded bonds are evaluated, risk assessed, and rated by one or more specialist agencies, like Standard and Poor's, Fitch, or Moody's. The higher the rating, the less risky the bond is deemed to be and the lower the interest demanded by investors, so it's cheaper for the issuer.

In comparing bonds, investors look at 'redemption yield' or 'yield to maturity' (YTM). This takes into account any difference between the purchase price you pay and the par value of the bond.

If you spend £130 in the market to buy a £100 bond that pays £5 per annum with five years to run, you will receive income of £5 per annum but only £100 at redemption. Your capital loss of £30 works out as £6 per annum for each of the remaining five years. Take this as a percentage of the price you paid, so £6 / 130 × 100 = 4.6%. This figure is deducted from the 5% running yield to produce a YTM of only 0.4% per annum!

Bond prices tend to move in the opposite direction to interest rates. If interest rates rise, the fixed coupon attached to a bond becomes less attractive, and the price falls until it delivers an acceptable yield. When interest rates are low, and investors are chasing income, they will bid up the price of bonds, as they accept lower yields.

Inflation erodes the income and capital from bonds, making them less valuable. If inflation is 3% per annum, the real running yield on a 5% bond is 2% per annum. If inflation rises to 4% per annum, the real yield drops to 1% per annum. To compensate, the bond price falls, and its nominal yield rises. If investors want a 2% real return, but inflation is running at 4%, the nominal return needs to be 6%.

Falling and low inflation are associated with rising bond prices partly for this reason and also because low inflation usually means low interest rates. Rising or high inflation is consistent with falling bond prices, exacerbated by the interest rate rises that usually accompany it.

Shares

A share or equity is a unit of ownership in an enterprise, usually a company, entitling the holder to participate in any distributions of profit and returns of capital. Unlike a bond, neither is guaranteed, which makes this a riskier product. A share is a productive appreciator because it offers uncapped income and capital returns.

Investors value companies by using discounted cash-flow analysis or applying multiples to trading metrics, such as revenues, profits, and net assets. These tools work only as well as the information fed to them, and because companies are complex and dynamic, many judgements are required, which makes the valuation process more of an art than a science.

The most common practice is to value a business before taking account of its debt financing and any cash balances and to adjust for these after. The earnings available to all finance providers (i.e., debt providers and shareholders) are known as EBITDA (profits or earnings before interest, tax, and non-cash accounting items like depreciation of assets and amortization of intangibles like goodwill). EBITDA is projected for the current and upcoming year, and a multiplier is applied to give total enterprise value (TEV). From this, the company’s net debt is deducted, or net cash is added to produce the equity value available to shareholders.

For publicly listed companies, multipliers are often applied to the profits available only to shareholders, known as profit after tax, or PAT (profits after debt financing costs, tax, and accounting items have been deducted). The resulting equity value, also known as market value, is commonly used for comparing listed companies.

Companies that make no profit, such as start-ups or early-stage internet or high-tech businesses, are sometimes valued on a multiple of current or projected revenues/sales. This can quickly become fantasy, as many never become profitable.

These multiples are known respectively as TEV (enterprise value)/EBITDA, price/earnings (PE), and revenue or sales multiple.

Multipliers are derived in two ways, often blended:

1.    The reciprocal of an investor's required rate of return—If an investor's required rate of return for a share is 12%, the multiplier is 1/12 = 8.3×. Required returns of 10% and 15% deliver multiples of 10× and 6.7×, respectively. EBITDA is pre-tax, so the comparable return requirement should also be pre-tax. Earnings are post tax, so you would use your after-tax return requirement. For this and other reasons, EBITDA multiples tend to be lower than PE multiples for tax-paying companies. 

2.    An average of the multiples at which comparable quoted companies trade or an average of the multiples at which similar companies have recently been bought and sold—the latter approach is commonly used to value residential property.

Remember that this type of multiple-based valuation doesn’t take account of capital employed by the business or the returns earned on it. A company can destroy shareholder value by earning a lower return on its assets than its cost of capital, even as it increases earnings.

What drives share prices?

Supply versus demand and the availability of money drive prices. Supply into an otherwise finite pool is set by the aggregate number of new shares issued less shares cancelled following buybacks or take-overs. Demand is the variable to watch, and being a human sentiment coloured by fear and greed, it has many influences:

A.    The relative attractiveness of equities versus other asset classes—in other words, how much do investors want to hold equities now versus cash, debt securities, real property, or other assets?

Given the vast amounts of money circulating the globe, if a greater proportion of this suddenly starts to funnel into shares, the price ‘tide’ for all shares rises. If there is a mass exodus, and investor money drains out of shares, the price of the entire asset class falls. This rising or falling tide lifts or lowers all ‘boats’ on the water. The financial performance and underlying value of a company may not change an iota, but its price will.

This great rotation typically involves a move from less risky assets, like cash and bonds, into more risky assets, like shares and property, or vice versa. It explains why many financial academics and investors believe that the asset allocation between classes of risk assets is more important for returns than your choice of specific assets within a class.

B.    Interest rates

Interest rates are the base for investor return expectations. When they rise, return requirements (cost of capital) also rise, and share prices fall. At the same time, the higher financing costs for companies deplete their profits, creating a doubly negative effect. A drop in interest rates has the opposite effect.
C.    Inflation

Equities offer inflation proofing. If companies can pass on rising costs to customers while maintaining sales, the nominal value of their sales and profits rise, as do their share prices and enterprise values. Company borrowings that are fixed in value depreciate in times of inflation compared with its assets that rise in value, reducing gearing levels and strengthening balance sheets. Growing or high inflation carry the risk that central banks will raise interest rates, depressing share prices.

Low or stable inflation enables companies and funders to invest confidently; businesses grow, and investors lower their risk premia to the benefit of share prices.

D.    Availability of money

Easy bank credit at low cost fuels share price growth. Both companies and their investors have more to spend. The same applies when central banks expand the money supply by printing money or pursuing quantitative easing, as demonstrated by share prices between 2009-2016.

E.    Fear and greed

Discussed earlier, nowhere is this better seen than in stock markets. Fear and greed drive herd-like behaviour one way or another, with dramatic effects on share prices.

F.    Currency exchange rates

A weak local currency makes domestic shares cheaper for foreign buyers. If, at the same time, a company is exporting products or services to stronger currency areas, its products are cheaper, and it will sell more. In addition, the foreign currency proceeds of these sales, when converted back to local currency for accounting and reporting purposes, will boost profits further. A strong local currency has the opposite effects.

G.    Rotation within equity classes

Investor tastes are fickle, and money often flows strongly to one type of company or another—for example, blue-chip dividend payers, small growth stocks, or mid-sized value players. At present there is much debate about a possible switch from growth to value stocks, the latter of which have been out of favour in recent years. Individual countries and regions go in and out of fashion, as do industry sectors. Learn to watch and anticipate these trends.

Buy equities for inflation-proof income and capital growth, but only for the medium or long term, so with a minimum hold period of at least three years and preferably more.

Buy shares in times of economic recovery or stability or when fear stalks markets and prices have fallen due to panic selling. Avoid buying when markets are frothy. If you have enough spare cash, hold in tough times, and avoid what traders call “trying to catch the falling knife,” selling and crystallizing real losses. Stock markets have always bounced back.

Residential property

Residential property differs from cash, bonds, and shares in that its primary utility value is not financial but as a dwelling, yet it also offers uncapped, inflation-proof rental income potential and capital growth. Cash income is generally paid monthly and without tax deductions at the source. 

The attractiveness of residential property is further enhanced by the owner's scope to influence and negotiate prices, improve or develop the property, gear up with cheap mortgage debt, and utilise tax breaks. 

These unique benefits make it a productive appreciator and growth platform par excellence.

A residential property's status in the wealth game, however, depends on how you use it. It can be used as anything from a luxury to a pure investment.

If you use the property as your home, you forego the rental income opportunity but save yourself the cost of paying rent to live there or in a similar house. The benefit and the cost cancel each other out. If you could rent out your house for £25,000 per annum but choose to live there instead, your potential income of £25,000 per annum is offset by its £25,000 per annum effective cost.

In order to gain, you need to reduce your accommodation cost to less than £25,000 per annum. You might let out a room and, by reducing your usage of the house, capture some of the available rental income. Alternatively, you can move out completely, let the house, and rent a home that costs less—the difference between the rent you pay and the rent you earn is upside.

As a property owner, the income cost of your accommodation is foregone rent.

The capital return on your property is captured whether you live in it or not, but there is a rub: it helps you reach O only if you release some or all of it into your pot. By living in the same home until you die, your accommodation need cancels out any gain.

To release gain, you could borrow cash against your equity in the property, sell it and buy somewhere cheaper, or rent. It follows that the capital cost of your accommodation is unreleased gain.

The associated 'on costs' of insuring, maintaining, and running a home and the lifestyle that goes with it grow in proportion to its size, gardens, age, and style, as well as the value of its location. Large old grand country houses with elaborate gardens attract the highest on costs. Outgoings for all homes are magnified in a wealthy area. The range of on costs for a family house can easily range between £5,000 and £150,000 per annum. What are yours?

It gets worse because on costs are value straight out. They have no corresponding financial benefit like rental income potential or capital gain to offset them. They directly erode your surplus cash and wealth. An owner who treats their property purely as an investment will only incur essential on costs related to insurance and maintenance but not those related to lifestyle.

Foregone rent and on costs are cash that you could have invested in growth platforms to generate extra wealth.

Putting all this together, the true cost of your accommodation is foregone rent + on costs + potential returns given up on these + unreleased capital.

By identifying the true or opportunity cost of your living arrangements, you can consider this separately against your needs and decide whether it is a luxury or subsistence cost. Do you need to spend this much on your accommodation, or is it an indulgence, a reward to be enjoyed as such? How does this choice affect your path to O?

Buy residential property first for its investment potential, and second for its use as a home. In the beginner and central phases of the game, it should be the cornerstone of your portfolio, and its unique advantages over cash, shares, and bonds make it a must-have asset.

It's easier to predict a sustained price rise for residential property than for shares, bonds, or other assets with more complex or less clear price drivers. The clues are economic growth (particularly after a slowdown or recession), stable or rising employment, improving consumer confidence, low or stable interest rates, and competition amongst mortgage lenders.

Also look for times when people have been unable to buy or sell for a few years and get on with their lives. This generates pent-up demand for change, which is released like the cork from a champagne bottle when the funding tap is switched on and confidence returns. Buyers waiting on the sidelines for signs of market improvement are quick to jump in, so as not to miss the boat, accelerating the upturn.

Predicting house price falls within a twelve-to twenty-four-month period is harder, because credit doors shut suddenly and consumer confidence turns to pessimism without as much advanced warning, and economic statistics lag rather than lead. The danger in selling early and sitting on cash or holding back from entering the market in the hope of a property crash is that you can miss years of growth.

Residential property offers a natural hedge against economic downturn, because we all need somewhere to live. When buyer demand and prices are weak, more people rent and income yields improve; when buyers return prices rise, but the availability of rental stock reduces to match lower demand, thereby maintaining rent levels.

How do debt and compounding help you reach O? Read next time to find out...

Peter Alcaraz is a freelance contributor and not a direct employee of interactive investor.