Last Updated on Feb 10, 2022 by Ayushi Mishra
The total share capital of a company is divided into many units of small denominations. Such units are called shares. Thus, a share is defined as the smallest fraction of the total capital of a corporation. Let’s discuss more about shares and their types at length.
This article covers:
- What are shares?
- Why do companies issue shares?
- Why do investors buy shares?
- Types of shares
- Features of shares
- How do shares work?
- How to make money by investing in shares?
- Limitations and risks of shares
Table of Contents
What are shares?
As defined in section 2 (46) of the Companies Act, 1956, shares represent a shareholder’s interest in a business; it is measured for liability.
Simply put, a public corporation/company issues shares to raise capital from the public. Each share is a percentage of ownership in the company representing an equal proportion of its capital. This ownership stake is tradeable in the stock market.
Besides possessing ownership rights, shares carry various entitlements like voting rights, priority right to receive dividends, or sharing a company’s surplus profits/net losses.
Why do companies issue shares?
Companies raise money by issuing shares to the public called ‘equity financing’ or public issue or IPO. They sell their ownership in parts in the form of shares. The fund raised from the public provides more freedom to use this capital as they need not pay interest on it, unlike debt financing from a bank. Companies do not need to pay back equity finance; thus, preferred over debt financing.
Mainly, a company issues an IPO to raise funds to finance the business for strengthening. Another reason can be repayment of some company’s borrowing. It may be raised to fund a new development or project that requires a significant amount of funds. It may also be issued to get startup capital. Or to overcome a particularly difficult period due to a downturn in the economy.
Why do investors buy shares?
- Investors buy shares in the hope of share appreciation with the company’s success in the future.
- By investing in shares, an individual gets the chance for long-term capital appreciation and earns profits through dividends paid by the company.
- Shares can be liquidated easily and quickly. Whenever you require funds, you can sell them.
- With share investing, you get an opportunity to participate in the growth process of a business. Significant shareholders of a company can participate in the strategic decisions of companies.
- Equity has the potential to deliver inflation-adjusted returns over a longer period.
Types of shares
Broadly, there are two types of share:
Common equity shares
These shares hold voting rights regarding policies or the election of directors. Shareholders can attend the concerning company’s general and annual meetings. A company can bind such rights to a specific number of shares.
Such shareholders are entitled to receive a part of the company’s net profits as a dividend. However, they can not secure any fixed amount of dividend and may have to bear the company’s losses also. Being a partial owner of the corporation, investors get exposure to the risk of business if unsuccessful. Dividend distribution depends on the earnings of the company.
Preference share offers the priority right to receive dividends. These shares carry preferential rights regarding capital reimbursement also when undergoing liquidation. In simple words, companies return the capital to such stakeholders before ordinary equity shareholders in case the company winds up. Preference shares do not possess voting rights.
Preference shareholders receive the guaranteed fixed dividend. Thus, low-risk profiles can include such shares. However, such shareholders cannot participate in the company’s profits beyond their fixed dividends. It means if a company raises its dividend rate when its net income increases, preference shareholders will not be befitted with this raise. Only ordinary shareholders can take advantage. Therefore, preference shares are generally not a popular choice among stock market participants.
Right shares (that carry the right to purchase shares before external investors) and bonus shares (in lieu of compensation for dividends) are popular equity shares offered by a company to its existing shareholders. If investors buy convertible preference shares, they can convert their shares into ordinary equity shares.
Features of shares
- Transferability: Company shares are freely transferable. Shareholders can easily trade them on the stock exchanges.
- Face value: Every share has a certain face value in monetary terms like Rs 10, Rs 20, Rs 125 or so.
- Market value: Shares are tradable; thus, every share possesses market value also. It may go up or decline than the face value.
- Issue value: Companies can issue shares at exact face value, that is, at par, for more than the face value, that is at a premium, or for less than the face value, that is, or at a discount.
- Distinctive number: Every share has a unique number that is used for trading them.
- Ownership: Shares essentially represent the shareholder’s ownership of a small portion of the company. The investor holding shares is called a shareholder or member of the company or owner of the company.
- Income generation: Shareholders earn income through share investment called the dividend. The dividend on preference shares is fixed and guaranteed, and that of equity shares is not fixed.
- Rights: Every share provides certain rights such as voting rights, the right to inspect financial books, and receiving a dividend among others.
How do shares work?
As mentioned, public corporations issue and sell shares to raise capital that can be used for different purposes to support their businesses, such as the expansion of business, and paying off its debt among others.
Companies issue shares through initial public offerings (IPO) in the primary market. Later these shares are available to buy and sell in the secondary market on stock exchanges. If a shareholder intends to sell their shares, the stock exchange will find a potential buyer who wants to buy those shares in the same quantity. It is the stock exchanges that handle the total trade of buying and selling shares with the help of stockbrokers intermediating each investor.
How to make money by investing in shares?
Shares are among the volatile asset class. Therefore, investors need to build a portfolio consisting of valuable shares that can generate a decent return consistently. There are two ways to make money in the stock market:
1. Through investing – the buy and hold strategy
Investors can buy and hold equities for capital appreciation in the long run. It is considered the most durable path to gain from shares and works for most individual investors who have a long term investment horizon to let their portfolios grow. This strategy is applied to less volatile shares.
2. Through trading – the buy low and sell high strategy
Another way to make profits is buying low and selling high. Investors buy shares in the hope that the price of stocks they have purchased will rise in the future. They make short term gains by selling their shares high. They need to learn about technical analysis, market trends to invest in the right shares.
Limitations and risks of shares
Limitations of shares include dividend uncertainty, fluctuation in stock prices, limited control, residual claim, and high risk.
Stock investing risks involve losing some or all of your invested money depending on the market conditions. If investors opt for the self-directed route, it increases the risk due to potential wrong choices of shares. Two main types of risks involved are volatility risk and absolute risk.
- Volatility risk: The stock market is highly risky due to volatility in the market. Volatility risk means sudden rises and falls in the price of a share. It is impossible to identify the fluctuations in the market. Changes in the economy as a whole can cause share prices to rise and fall. Some industries get affected more than others.
- Absolute risk: Absolute risk is the risk of losing invested money in case the company fails in its business and its shares become worthless.
Investors can spread risk in share investments, called diversification of risk, by investing across different industries and themes, or even countries.
Every investor has a different risk appetite. Investing in stocks is one of the great ways for an investor with a medium- to high-risk appetite to earn returns and accumulate wealth. But they need to understand the investing and trading techniques before participating in the market.
Investing in stocks can reward investors with impressive annual returns as historically, shares have appreciated over the long term. Diversification, discipline, market timing, patience are the keys to long term rewards. This blog has imparted all information on fundamental aspects of shares. To start investing or trading, it is vital to upgrade your knowledge and understanding of the stock market.