New investors can easily be dazzled by flashing screens, crazy price swings and financial jargon. But people have been investing in companies through the financial markets for centuries and while some of the processes may have changed, the basics have not.
In this article we will seek to explain exactly what shares (also known as stocks or equities) are and what you should be think about when it comes to trading them.
PART OWNERSHIP
In the most basic terms shares are securities which represent part ownership of a businesses. Public companies, those listed on the stock exchange, usually have many millions of shares which can be bought and sold via intermediaries, typically stockbrokers.
The company’s ‘market value’ is calculated by multiplying the total number of shares by the value of each individual share.
Listed businesses tend to prefer a large number of shares in issue. This is because typically there are many shareholders who only want to trade in small ownership increments.
Large asset management companies may own a few percent of a listed company up to very high percentages, stakes often valued in the billions of pounds but retail investors - pensioners, savers and others - will often have smaller shareholdings.
More shares in issue mean the shares have a lower price and tend to be more liquid. This balances the requirements of both large and small shareholders.
Investors in the stock market are not always investing directly in the real economy. Buyers of shares on the stock market are transacting with other investors - sellers of the same stock - through an intermediary, usually a stockbroker. The availability of both buyers and sellers on an exchange - as well as intermediaries - is what provides liquidity, which is the ability to buy and sell shares at any time within trading hours.
Shareholders in public companies can buy and sell at almost any time and transaction costs tend to be comparatively low. Trading of shares on a public market creates liquidity and tends to mean they trade at a fair price, which benefits both buyers and sellers.
WHY SHARES MOVE UP AND DOWN
Once listed, a company’s board of directors provides regular updates to the stock market on their progress. Earnings updates are usually the most important of these because investors are informed about the performance of the business and its management’s plans for the future.
Profit after tax (sometimes called attributable profit) is the amount the company has made on behalf of its shareholders. Dividing attributable profit by the number of shares in issue gives earnings per share (EPS), which is usually the number followed most closely by analysts and investors.
EPS is a reference point which can be compared against the current share price and other companies across a sector to give an indication of the price of the security relative to its peer group.
Markets attempt to distil all of a company’s expected future earnings (EPS) and related uncertainties into its share price.
In theory a stock trading at 100p a share is expected to generate cumulative EPS of 100p over an undefined period of time after adjusting for the cost of money and risk.
The cost of money is usually taken as a long-term government bond yield, which means share prices also respond to interest rate changes. Risk relates to the level of certainty or uncertainty associated with the earnings of the company in question.
Changes to future profit expectations are usually the main announcements which move share prices up and down. Speculation regarding a business being taken over or making an acquisition itself are also factors. Sometimes regulatory fines or legal disputes play a part in moving the share price.
Finally, share prices can occasionally move for reasons not related to a company’s underlying financial performance or prospects. For example, when asset management companies face investor withdrawals, they may be forced to sell shares in companies, regardless of those companies’ investment merits.
Occasionally, large shareholders sell blocks of stock into the market which can depress the share price for a period of time. These changes primarily affect the supply and demand balance of shares on the exchange, rather than underlying financial performance of the business. In this case, illiquidity in the security may cause the market valuation of the business to move below its underlying value.
INCOME FOCUS
Dividends are another important part of investing. These are announced alongside earnings announcement. Dividends are paid out of earnings, so should usually be well covered. Dividend cover is calculated as EPS divided by dividend per share (DPS).
A well covered dividend is usually considered safer than an uncovered dividend - where a company pays out more in dividends than it has made in profit. The yield of a share is the expected or previous year’s dividend payout divided by the current price of the security.
