Stocks
Definition
Equity Shares, commonly known as stocks are small parts of a company
(corporation). Stocks represent ownership of the issuing company and typically
entitle the holder to voting rights when major corporate decisions of the
issuing company are put to vote.
Rights of the shareholder
Shareholders collectively also appoint the board of directors of the issuing
company and typically approve/reject major decisions taken by the board such as
the issue of new shares, mergers and acquisitions etc. In case of bankruptcy of
the issuing company, shareholders also have a claim on the assets of the
company, though their claim is subordinate to that of bondholders.
Trading of Shares
Shares are most often traded on stock exchanges. In order for a company to
enable its shares to be traded on an exchange, it has to list its shares on the
exchange. The issuance of shares by a company and their subsequent listing on a
stock exchange for the very first time is termed an Initial Public Offering
(IPO).
Dividends
Investors expect to be compensated for investing in the shares of a company. To
compensate investors, companies typically pay their shareholders a part of their
income every year. This payment is known as a dividend payment.
It is not legally binding on a company to pay dividends. In fact, several
companies do not pay dividends for several years together, preferring to
re-invest their earnings in the company’s operations.
Capital Gains
Increases in the price of shares result in capital gains. If the market value of
a share is greater than its purchase price, the difference between the market
value and the purchase price is the unrealized capital gain. If a stock is sold at a price greater than its
purchase price, the profit is known as the
realized capital gain.
Total Return
The total return to the shareholder consists of the dividend income and the
capital gain on the share.
Total Return = Total Dividends received + Capital Gains
Types
There are two main types of stocks – Common stock and Preferred stock.
Common stocks give their holders ownership in a company and claim on the assets
of the company in case of bankruptcy. In addition, they also give holders voting
rights when important corporate decisions are put to vote at shareholder
meetings. Common stockholders typically receive a dividend from the issuing
company at its discretion.
Preferred stocks are hybrids between debt and equity instruments that give their
holders a higher priority claim over the assets of the company than common
stocks. Preferred stock holders receive fairly certain fixed dividend payments
every year but typically do not have voting rights. The scope for capital gains
on preferred stock is rather limited.
Valuation of shares
Shares can be valued in several different ways. Analysts use complex models to
value shares of different companies. These models fall into two categories:
- Discounted
cashflow models
- Multiple
models
Discounted cashflow models discount the cashflow that is expected to be received
from the stock, typically in the form of dividends, using a discount rate that
is reflective of the risk associated with the investment.
Multiple models use a market-based multiple of a fundamental parameter of the
company to value the stock of that company. For example, the earnings multiple
model values a stock as a given multiple of its earnings per share. Therefore,
if the appropriate earnings multiplier is 15 and the earnings per share of a
company are $1 per share, the value of each share of that company is $15.
We will cover different valuation methods in detail in another article.
Next: Mutual Funds