If you’ve ever wondered ‘What are shares’ or ‘why are shares so popular?’ – this ultimate guide to shares article is the right place. This article is the second in the Foundation learning series.
What are Shares?
You gain partial or full ownership of a company by owning shares, also known as ‘stocks’ in the US.
To delve deeper, we need to understand what companies are and why shares exist in the first place.
What is a company?
Although we often use the words interchangeably, ‘Company’ and ‘Business’ don’t actually mean the same thing. A ‘business’ is an enterprise carried out by individuals or a group of people, usually to create a profit. If they choose to, the business owners may decide to fill in paperwork with their local Company Authority (Companies House in England and Wales), and carry out the business behind a new identity – a company.
A company is like an artificial ‘person’ in the eyes of the law. A company has a name, an address. You could even argue it has parents, in the form of its original owners!
Why are Shares Necessary?
Shares establish who owns this new entity. It isn’t a real person after all. When a company is created, the paperwork will define how many ‘shares’ the company will have. For example, a company may be split into 1,000 shares. These shares are collectively known as the ‘share capital’.
Anyone who owns a share will be entitled to some of the company profits that are paid out each year (called dividends) and will be able to exercise some control over how the business is run. If two brothers created a company and contributed the same amount of money into the effort, you would expect that upon registration, each brother would own 500 shares.
In a simple setup, owning half the shares (e.g. 500 shares) means they own half the company each.
This brings us back to the question of – why do we have shares? Why couldn’t the company paperwork simply state that each brother owns half of the company? Isn’t that clear enough?
- Shares are an easy way to clearly define who owns what proportion of a company at any given moment. There can only be one registered owner of each share, and therefore there is zero ambiguity. In contrast, a wordy statement in the initial company documents could invite multiple interpretations.
- Shares make it easy to change the ownership of a company. Ownership can simply change hands by one person selling their share certificates to another. If this happened, there would be no need to re-write the company documentation as there are still 1,000 shares in existence. The company would update its register to show the purchaser as the new owner of all 1,000 shares after the transaction.
What is the difference between shares in a private company versus a public company?
There are two main types of companies in the UK; Private limited companies and Public limited companies.
Private limited companies end their company name with ‘Limited’, whereas Public limited companies end their name with PLC. For example such as Marks and Spencers PLC. or ‘Ltd’ for example; ‘Domino’s Pizza UK & Ireland Limited’.
So what is the difference between a PLC and a Ltd company? The main difference is that a shareholder in a PLC is free to sell their shares to whomever they like, whenever they like. In contrast, shareholders in a Ltd company must receive approval from other shareholders before selling their stake.
Is it possible to buy both private limited and public limited companies shares on a stock exchange?
The freedom to sell makes PLCs a perfect match for stock exchanges, where stockbrokers trade shares on behalf of their clients. The restrictions on the right to sell Ltd company shares would interfere with the speed and ease of trading and therefore private limited companies are never ‘listed’ on an exchange.
What is the reward for owning stocks and shares?
As a shareholder, you will receive a share of dividends paid out by the company, and also to gains (or losses) in the share price.
What are Dividends?
A dividend is a lawful distribution of profits earned in the past. Some companies pay dividends with rigid regularity. Companies either pay them on a quarterly basis, half-yearly basis, or annually.
However, not all companies pay dividends. Start-up companies still in a growth phase, need the cash for expansion plans, and therefore opt to pay no dividends. Instead, they reinvest the money internally to fuel faster growth in the value of the company. This will hopefully increase the future market value per share.
Let’s look at a real-life example of a company with a policy of paying dividends. The pharmaceutical company GlaxoSmithKline paid dividends of 80p per share in the 12 months to July 2019. The share price of GlaxoSmithKline is approximately £16. This means that the 80p of dividends is effectively like receiving 5% interest as a reward for owning the share for a year. We could also say the dividend yield is 5%.
If you buy shares through a stockbroker or investment company, dividends will appear in your account automatically after a distribution – you don’t need to take any action to physically ‘collect’ the dividends.
It is the job of management to propose the size of the dividend each year. Shareholders can vote for or against this motion at the Annual General Meeting (AGM) of the company.
How can you profit from an increase in the share price?
Dividends are only one part of the total return you can experience from owning shares – changes in the share price will also increase or decrease the value of the shares you hold.
When the market value of a share is higher than what you originally paid for it, you have made a profit ‘on paper’. The phrase ‘on paper’ recognises that this gain is only a live snapshot and will continue to move. At some point in the future, you will sell your shares and realise the gain or loss at that date. All stockbroker and investing accounts will continuously update the value of your shareholdings and show you the latest cumulative gain or loss.
What causes a share price to increase or decrease?
The price of a share is ultimately based upon the expected value of all the dividends that the share will generate in the future.
‘Is it really that simple?’ I hear you ask. ‘Isn’t a share price linked to news about the company, such as whether they’ve met sales targets, where they have a good pipeline of new products, and whether the company is profitable?’
The answer is that all of those factors do move the share price. However, they only do so because they influence expectations of future profitability, and hence what dividends can be paid.
An example of why share prices move
Earlier, we calculated that GlaxoSmithKline’s annual dividends were worth 5% of the share price. Meaning that new investors are buying in at a price which gives a dividend yield of 5%. We can assume that this 5% return is satisfactory, given that it is the market price.
Imagine an extreme scenario in which news emerges that a cancer drug being trialled by GSK has been a runaway success and will lead to a new drug on sale which will double the profits of GSK. If we assume that the company distributes all profits in the form of dividends, we would expect the dividend to also double; from 80p to £1.60 per share. Said another way, the dividend yield is set rocket from 5% to 10% if the share price remained the same.
We have already established that the market feels a 5% dividend yield is a perfectly acceptable level of return for a company of this size and risk. Therefore the new 10% yield, has made the shares an irresistible bargain. No other shares on the market are offering such a high return for this level of risk. Investors will rush in to buy the shares, whilst sellers will either withdraw their shares from sale or increase their prices. Given that the market feels that a 5% dividend yield is a fair return, bargain hunters will continue to buy and push the price of the share up until they hit £32. At this exact price point, the new £1.60 dividend is again only a 5% yield for new investors, and therefore the share price settles at this level, and the trading frenzy is over.
This was a dramatic example, which explains the shock to expectations and the market forces which are in play each time a share price moves.
Why are shares popular investments?
- Shares are popular because they generate superior returns. The FTSE100 has gained 375% in the last 25 years (source). Property, bonds and savings accounts all take a back seat to the enviable returns that shares have generated.
- Shares are convenient because they are more liquid than investments in property. ‘Liquid’ means that they can be sold and converted into cash quickly and reliably. In the UK stock market, an investor can expect to sell shares within a minute of clicking ‘sell’ and will see the cash within 5 working days. Tradings continue even during tough trading conditions such as during market crashes. This compares favourably to property (such as housing or offices) which are difficult to sell quickly, and may not find a seller at all in a difficult climate.
- Participating in the stock market is undeniably exciting. While the number of choices can be a barrier to starting your investing journey, it increases the sense of accomplishment.
Why do shares generate higher returns than bonds or other investments?
Shares receive a higher return because shareholders need a higher return to compensate them for the risks they take. If shares only provided a return similar to bonds or savings accounts, it would be illogical to put money in shares – their market values are more volatile and their returns are less certain in the short term.
Debtholders have a relatively sweet deal – they may have the right to repossess assets of the borrower and will have priority over shareholders if the company collapses. These rights reduce the risk for the lender or bondholder and therefore they demand a lower return than shareholders.
The relationship between risk and return is interesting, and in our article about the science of diversification we explain why investors choose to combine shares with lower-yielding investments to produce steadier returns.
What are Shares and Why do People Invest in Shares?
Shares grant their owner partial or full ownership of a company.
Both private and public companies issue shares. However, members of the public can only invest in Public Limited Companies (PLCs) through their stockbroker. PLC shares are traded on Stock Exchanges.
Shareholders receive a share of any dividends, which is shareholder income funded by the profits of the business.
Not all companies pay dividends. Start-ups or cash-starved businesses may choose to retain cash to spend on expansion which will improve their ability to pay dividends in the future.
The annual dividend divided by the price of a share calculates the dividend yield. The dividend yields sometimes exceed the interest rate paid by bonds and savings accounts.
Shareholders also experience any gains or losses arising from changes in the market value of their shares. News and events which change market expectations of future dividend payments cause a change in the valuation.
Shares are the highest returning mainstream investment. This is because they carry the most risk.
If you're curious how something as complex as the stock market ever formed, I recommend you visit the Wikipedia article for the London Stock Exchange. The timeline tracks the development of the sophisticated platform, from its humbe coffee house origins.
Next article: What is your Attitude to Risk (Questionnaire)
Foundation level is a free course about mastering the principles of investing and building a portfolio from scratch. Designed for target returns of 6% per year.
Begin your own journey in this course or upgrade to a more advanced level.
Choose a Free Investing Course