Investment Basics II: Shares

This post is designed to sort out some terminology that can be a bit confusing in the investment arena. Starting to invest can seem like a really scary thing. I know that when I first started I was almost too scared to actually start because there just seemed so much to know. It turns out that, yes, there is a lot to know, but not that much that you really need to know before you start. The important thing is actually to dive in and start once you've got the Basic Theory and Good Investing Principles down. Don't wait until you know everything before you start - remember that time in the market is one of your biggest friends when it comes to compound growth.

Shares / Stocks

What does it mean to invest in the stock market or to buy shares? A share is a very small part of a company that has chosen to list on a stock exchange. When you buy a share you actually own a small piece of that company. Let's do this by way of example.

Bob and Mike start a pizza company. They're extremely creative in the kitchen, but not so much when it comes to names. So they decide to call their company Bob & Mike's Pizza Company. Bob has R600 to invest in the company and Mike has R400 to invest. So to be fair, they agree that Bob will have 60% of the company and Mike will own 40% of the company. The initial total investment in the company was R1 000 and this was the value of the company. Several years pass [pages fly off a calendar, a clock spins really fast and a sun rises and sets several times through a window] and before they know it, their pizza company is worth R10 000. How did it get there? They've been working hard for years and any profits that they have made they've put back into the company (after taking modest salaries for themselves to fund their frugal lifestyles).

At this stage Bob and Mike decide that it's time to expand. They don't have any more of their own money to put in so they list on the Johannesburg Stock Exchange so that the public can invest in their company. Sure, they'll have to start sharing their earnings with the members of the public who are brave enough to invest, but the profits will be bigger too. Without access to additional capital from the public their growth will be severely limited (and you thought crowdsourcing was something new?). Bob and Mike decide to slice their company up into 10 shares. Bob keeps three slices of the company and Mike keeps two slices (in keeping with their original 3:2 ratio of capital injection into the company). The remaining five shares they make available for sale. I'm a huge fan of pizza and I've been wanting to diversify into the industry for a while so I decide to buy one of the shares on their first day of trading which leaves four slices still available on the market for other potential investors.

Bob & Mike's Pizza Co.
Photo of original pizza: Food Recipes (CC-BY 2.0)

So how much does this one share cost me? Well in principle each share should be sold for the total value of the company (R10 000 on the day of listing on the JSE) divided by the number of shares issued (in this case ten shares). A simple way to calculate the price of a share would look like this:

Using this simple model my single slice of Bob & Mike's Pizza Co will cost me R1 000. Okay, fine. I now own 10% of a pizza company (1 share out of the 10 issued). 

What does owning a share do for me?

1. The company pays me a share of the profits.

As the company earns money, I get my fair share of the profits. Now a company will not always pay out all of the profit to its shareholders. Some profit is retained by the company to aid future growth. Whatever profit is left over is paid out to the shareholders per share so the shareholders who own more shares get more of the profits. When a company pays outs profits to shareholders these are called dividends.

If Mike & Bob's Pizza Co. makes R2 000 profit in the year following my share purchase they may decide to keep R1000 in the company to keep it growing. The remaining R1 000 of profit gets paid out to the shareholders. Because there were 10 shares the divident payout will be R100 per share and I will receive R100 because I own one share. Bob owns three shares so he will get R300 and Mike owns two shares so he will get R200. If the remaining four shares haven't been bought yet, then they are still owned by the company and those dividends are retained.

2. My share increases in value as the company grows. 

My investment has helped the company to grow (they can buy a bigger and faster pizza oven, hire more delivery staff start a new branch in a nearby suburb etc.). As the company's value increases the value of my share increases (and here's the important bit) without me needed to put in any additional money or work. If after a few years [more pages fly off a calendar] the company is worth R20 000 (according to the company's books) then my share (being 10% of the company) will be worth R2 000. 

This might be the actual value of the share, but this can be very different from the market value (what you pay for to buy a share and what you get you you sell a share). A more realistic share price calculation looks like this:

The market value  of a share depends on how the company is seen by the public (prospective investors as well as customers), how many shares are actually available for sale and how the company is expected to perform in the future. This is where most of the volatility of investing in the stock market comes in. The market share price goes up and down throughout the day and from day to day without the actual share value necessarily changing. The actual share value does change, but not from one second to the next. The actual share value changes as the company earns profits (and puts them back into company so that it keeps growing) or as the company makes losses. In the long run the the market share price can't help but mirror the actual share price. Public perception (and all the other complicating factors) can skew the share price in either direction at any one moment or even for several months or years at a time, but over a long period of time the actual value of the company can't help but be the real basis for the market value of the share. The market value of a share tends to bob up and down around the true value - the graph below might make this clearer. 

Imagine a company that experiences fairly steady growth year on year - sometimes it may grow a bit faster, and sometimes it may grow a bit slower. The growth of this company is represented by the smoothly increasing blue graph. The green graph shows what the share price might be on the stock market at any moment. In the long run it tracks the blue graph fairly well. This means that when you come right down to it in the long run, the market does actually care about the actual value of the company - otherwise there would be no correlation between the actual share price and the market share price. I've annotated the same graph below.

Now, I need to come clean. What I've told you so far isn't strictly accurate for a single company. It's much better if we think of the above scenario and graphs as representative of the stock market as a whole (the set of all publicly listed companies). So why is the above a little naive as far a single company goes? Well, although in the long run the market value might care about the true value of the company in the short term the market might not yet know the true value of the company. For example (Graph A below) hype could drive up the market value of the company in the short term. Meanwhile, the company itself may be in turmoil (the CEO is resigning, the storehouse burned down and the insurance hadn't been paid...). Sometimes the market just can't catch on fast enough until it's too late. The share's true value might hit zero in an extreme case and the market value will hit zero too. It is definitely possible to lose everything when investing in a single company. 

As another illustration, Graph B shows how volatile the market value for a single company (or even a single sector of the economy) can be. Graph C shows volatility, but over a large number of companies across different sectors of the economy the volatility is lower and the ride less bumpy. This is the reason why it is good to be diversified. Overall risk is lowered and the ride is smoother as well. 

So we don't ever invest in a single company. We want to invest in lots of companies. But there are costs involved in buying and selling individual shares. Plus how many of each company should we buy?

In the next post we'll look at Mutual Funds (aka Unit Trusts) as well as Index Funds to see how we can achieve this diversification easily. These investments products are ultimately invested in shares (lots of shares in lots of companies) so it's important that you're comfortable with what a share actually is. Hopefully this post has helped give you sufficient detail as well as the bigger picture.


Yours frugally
Mr Cent(ri)Frugal Force