Shares, in the simplest way, are basic units of the company’s overall valuation. A Share, in the universe of online trading, is an entity that can be bought or sold at a specific monetary value.
Let’s try to simplify it even further.
When you buy a share(s), you basically own a percentage stake in the company that share belongs to. You also become a “shareholder” in the company as soon as you buy shares of the company.
It is similar to slicing a pizza into 8 parts where each part can be bought and sold for a specific price. Once that price is paid, you own the slice.
We will take more relevant examples in this review ahead.
Well, there are multiple instances in the history of the world when the set-up of a stock market or a trading space has been tried. Be it the french in the 1100s or the merchants of Venice in Italy in the 1300s, the similarity of those set-ups to the modern world’s stock market was minimal.
Factually, the first-ever stock market set-up happened in Antwerp, Belgium and was called Beurzen. Nonetheless, even the Antwerp set-up did not have stocks listed, which is the single most atomic unit of today’s stock market.
There is an interesting storyline behind the setting up of the first trading company in the world.
Ships, belonging to different businesses, sailed across the globe but at that point in time, there were risks such as pirate attacks, sea storms etc. This resulted in very few ships actually making to their respective shores.
This problem gave birth to a crucial element of trading – Risk!
Now, the businesses started using multiple ships segregating their load so that even if a few of those ships don’t end up making to the shore, they stand almost no chance of losing all of their load.
Similarly, investors started investing in multiple ships of these businesses while mitigating their investment risk at the same time.
And this is how the idea of the stock market, stocks, the risk factor was born, all of that later led to where we are today with the stock markets.
So, you see, there are various kinds of categorizations based on which shares can be analyzed.
Examples of Shares
Let’s try to understand the concept through an example.
For instance, you own a company named “RockFella Music“. You are the single owner of the company that records music albums of the singers in your state. Now, you want to try “Bollywood” and will need a capital of ₹10 Crore for that!
But, you got no money to materialize this expansion plan.
So, what do you do?
You hire an investment banking firm to help you out with your business’ valuation. After going through the financial statements of the company, they value “RockFella Music” at ₹50 Crore. They also help you in spreading this valuation over a total of 50 Lakh Shares, with each share valued at ₹100.
Now, you spread the word in order to sell 10 Lakh Shares out of the total (20% of your company’s stake) and let’s say, 100 investors, end up buying 10,000 shares each and investing ₹10 Lakh each in your company. Each of these “shareholders” ends up getting 0.2% of stake in “RockFella Music”.
Moving ahead, assuming your company was able to hit well in the tinsel town and company valuation in a matter of 2 years reached ₹200 Crore. When that happened, each of the investor’s initial investment of ₹10 Lakh each reaches ₹40 Lakh as well.
That is the whole concept of Share Market and how stocks actually drive a company’s performance and your investments in parallel.
Primarily, there are 3 ways by which shares are valued:
Cost Approach considers the tangible assets of the company including the manufacturing plants/real estate properties, pieces of equipment, physical machines etc. The company valuation is done based on the total valuation of all such assets.
The company’s book of net assets over net liabilities is calculated and then the net capital value is calculated. In order to find the share value using the cost approach, the net capital value is then divided by the total shares outstanding.
Although with this approach the share value is calculated, there is a certain limitation with this approach.
The cost approach does not consider any intangible assets linked to the company including the cost of the brand value itself.
Few businesses choose to use the market approach in order to calculate the valuation of the shares. This is a relatively complex approach and requires different parameters in order to reach a specific number. The price of the stock is divided by EPS or Earnings per share which gives the P/E ratio.
The higher the P/E ratio, the higher is the valuation of the company. It also depends on the industry type as the P/E ratio varies for companies coming from different business domains.
Thirdly, Income Approach is one of the straightforward ones when it comes to calculating shares valuation. In this method, the sum of the total potential income of the company from different revenue streams is calculated first. Now, either this cash flow can stay as is or it can decrease as well.
Depending on the way, it is kept – the resulting figure is divided by the number of outstanding shares of the company and the value of a share is calculated.
Shares and Dividends
When you own X number of shares in a company, there are chances that that company may decide to pay out a certain amount of dividend on a per-share basis.
Now, what exactly is a dividend?
Well, it is a monetary amount that a company decides to pay to its investors on a monthly, quarterly, half-yearly or yearly basis in order to retain their investors or for reasons including the fact that they are not looking to invest that money in the business either.
These dividend amounts are taken from the company’s profits and divided among the shareholders equally. The company may decide to distribute dividends in the form of a monetary amount or allocating additional shares to the investors.
At the same time, it does not mean that the company sharing dividends with the investors is a better company than the one not doing it and rather investing it back in the company’s further growth.
Shares and Debentures
So, as explained above, shares are something you pay for in order to get ownership in the company. Here the returns are in the form of an increase in share price and dividends (optional).
Debentures, however, are debt instrument products where you pay a company a form of a loan and you get interest amount on that principal you paid. In this format, you become one of the creditors of the company.
There are a lot of other differences between both these investment classes, such as:
You get paid for shares only when the company is profitable while you get interest payments in a debenture irrespective of the fact that the company is profitable or not.
Risk is high in stocks as compared to debentures but at the same time, returns are higher in shares too.
Payments for debenture holders get priority over shareholders for their dividend payments, if any.
Finally, this needs to be known that there are certain advantages of equity shares investment as compared to debentures and the other way around, the details of which however can be left outside the scope of this current discussion.
When a stock split happens by a listed company, then the number of issued shares increases and the corresponding face value of the share decreases.
For instance, if the face value of a stock ABC is ₹10 and the number of shares outstanding is 1,00,000, then with a stock split of 2:1, the number of outstanding shares will increase to 2,00,000 and the face value of the stock will decrease to ₹5.
In both cases, however, the market capitalization of the stock remains the same i.e. ₹10,00,000.
The generic reason for introducing a stock split is to increase the market stock value of a company.
Pledge of shares can be done by both the investor as well as the promotor of the listed company.
An investor when pledges his/her stocks from a demat account, the person gets margin (or a loan, in simple terms) from the broker at a specific interest rate. If the investor client fails to pay the amount, the broker can sell-off the pledged stocks from the demat account in order to recover the margin.
Pledge of Shares meaning is when a promotor when pledges his/her holding in the company in the form of shares held, he can get a loan from banks or any other financial institute for business or personal requirements. If the promotor fails to pay the loan, the bank can sell-off the pledged stocks in the open market to recover the loan.
Thus, pledging of shares is seen as a risky concept and should ideally be only used if you have a reasonable risk appetite.
Shares With Differential Voting Rights
Another shares-related concept is the shares with differential voting rights.
When these types of shares are issued, the investors get lower or no voting rights. The upside of such shares is that the investor may be looking at better dividends.
At the same time, the promotor of the business issuing such stocks does not see any form of dilution in his/her voting rights and chances of any potential takeovers are thrown out of the window.
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