What are Shares?

Don’t get confused by language

Shares close upWhen an investor talks about stocks and shares, the words are most commonly interchangeable: they are typically taken to mean the same thing. In America it is more usual for people to discuss investing in stock, while in the UK it’s more natural that investing in shares is considered.

In brief, a share is a part ownership of a company that gives the investor rights to a portion of the profits or growth of the company in proportion to his investment. In other words, a shareholder shares in the fortunes of that company.

Why do companies issue shares?

When a company wants to raise cash it will often issue shares.

One reason for raising such cash is when the management/ founders of a private company want to realise the value of that company without selling it entirely. This may, of course, be a private sale of shares, but is often made by selling shares to the public. This first issue of shares is called an Initial Public Offering (IPO).

Consider a private company that is valued at, say, £1 billion. By offering for sale 50% of the company, the founder will receive £500 million. After the sale he will hold 50% of the company, meaning he will only receive 50% of any future profit or worth. The remaining profits will be divided amongst the new shareholders.

In reality, when the company makes profits it will decide how much to retain or use for growth (perhaps by acquiring other companies or expanding into new markets) and how much of that profit to pay out to its shareholders by way of dividends.

Another reason for a company to sell shares and raise cash is to give it the money to fund growth. When it does this it creates and issues new shares which it then offers to existing shareholders before others. Such an issue of shares is called a Rights Issue.

Types of Shares

Companies issue two types of shares.

Ordinary shares, giving the holder full voting rights at shareholder meetings, will pay dividends to the shareholder. These dividends will be flexible and depend upon the profits made by the company – just like the price of a share, dividends can go up and down.

Preference Shares offer holders the certainty of a fixed amount of dividend, and the knowledge that these dividends will be paid before the dividends applied to ordinary shares. Though holders of preference shares hold no voting rights, in the event of the company being wound up they will be paid out before ordinary shareholders (hence the term preference).

Why buy shares?

Investors buy shares to achieve either income through the payment of dividends, or capital growth through the rise in share prices. There are many factors that affect a company’s share price, and these range from company specific (the success or failure of a new product, for example) to the wider economy (perhaps the imposition of a windfall tax on corporate profits).

Dividend income is taxable along with other income, while profits made buying and selling shares is subject to capital gains tax. However, every investor is allowed to make a tax free capital gain each year (in the tax year 2013/ 14 this allowance is £10,900).

Buying and selling shares

The shares of public companies are traded on stock exchanges, and companies have to meet certain requirements before being allowed to list their shares on an exchange. These requirements may include trading history, principles on executive pay, and the need to provide full and frank company information in a prospectus before an IPO. The company also has to adhere to rules with regards to offering new shares and the release of company results and other price sensitive information.

In summary

Shares are one of the four main asset classes available to savers and investors (the others being cash, bonds, and property). They offer the flexibility to produce the time of return an individual investor requires – whether income or capital gain – and can be used as part of a tax efficient investment portfolio (particularly is invested via a stocks and shares ISA).

The level of risk associated with shares investment is generally considered higher than most other investment assets, though the shares of large well established companies carry less risk than new-to-market small and growing companies.

The prices of shares can go down as well as up, and may be volatile over shorter time frames. However, this said, historically shares have given a better long term investment return than any of the other main asset classes.

Adam

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Adam is an experienced financial trader who writes about Forex trading, binary options, technical analysis and more.

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