McDonald Story Continued
This post is a continuation from Episode 1 and Episode 2 of “Can we invest in McDonald’s business in India?” which involves a conversation between a teenager Guna ‘G’ (who is interested in the stock market) and her dad ‘D’.
G: Dad, I was at McDonald’s today with my friends. I was explaining the difference between gambling and investing in them, and one of my friends asked me how is buying Shares different from purchasing lottery tickets. I explained the difference but I guess, I wasn’t convincing enough. How do you suggest that I explain the difference between Shares and lottery tickets? I want to be brief and would want to explain it in not more than 3 points.
D: When you buy a share, it represents part ownership of the company. Shareholders (of common stock) have voting rights and can vote ‘for’ or ‘against’ some of the corporate matters related to the company. For example, refer paragraph ‘Ordinary Business’ on page 116 in Annual Report 2014-15 of Westlife Development Limited (WDL) to know what shareholders of WDL could have voted on during September 2015. Shareholders may also vote on other important matters like proposed merger or acquisition. Another difference between Shares and lottery tickets is that shareholders receive dividends when they are declared. Dividends could be considered as the cash bonus that is received by the shareholders. When you hold a share for many years, there is a possibility of receiving dividends multiple times, unlike a lottery ticket.
G: Okay. I have noted down three terms – ‘part ownership’, ‘voting rights’ and ‘dividends’. I feel I’ll be able to explain the difference between Shares and lottery tickets to my friends convincingly. By the way, I will have to prepare a presentation on ‘basics of finance and investing’. I’m planning to present this topic to my friends. I don’t want the presentation to be long and boring. Suggest something that I can refer to. Honestly speaking, I had a difficult time interpreting financial statements of Westlife Development Ltd in the Annual Report.
Bill Ackman’s video on Finance and Investing
D: I highly recommend Bill Ackman’s video for this purpose. Let me find it for you on youtube. Here you go.. After your friends go through this presentation, they will clearly understand the difference between gambling with lottery tickets and investing in shares.
Guna goes through the video and talks to her dad the next day.
G: Dad, the video was awesome! I could interpret the financial statements in WDL Annual Report better. I have a question on stock valuation. How do I analyze if a stock is overvalued, fairly valued or undervalued?
D: There are many methods to do such an analysis. You could use the concept of PEG ratio popularized by Peter Lynch. If the estimated growth in earnings is greater than Price to Earning (PE), the stock could be termed as undervalued. In other words, if the ratio of PE to estimated earnings Growth (PEG ratio) is less than 1, the stock could be termed as undervalued. If PEG ratio is greater than 1, the stock could be termed as overvalued. Remember, performing such an analysis is more an art than science because you have to forecast future growth of the company. Also, note that high-growth stocks will usually demand a PEG ratio greater than one and you may have to compare PEG ratios of stocks in the same sector. You could also explore Discounted Cash Flow method to analyze if a particular stock is a good buy at the current market price.