What is a share?
A share is a financial asset that represents part ownership of a company. Shares are a form of equity security that entitle holders to a stake in the financial benefits of company ownership.
Companies issue shares to investors in return for equity capital, which is invested into the business. Unlike debt, there is no requirement for a company to repay equity contributions.
Instead, shareholders receive returns on their investment via the distribution of company profits. Shareholders can also make capital gains if they sell their shares for more than what they purchased them for.
What are the rights of shareholders?
Shareholders are entitled to vote at the annual general meeting of the company and to elect its board of directors, who control the company. The board selects the managers who actually run the company. This means that ownership and management of the company are separated.
Shareholders have the right to vote on items that impact their shareholdings, for example, a merger or takeover, as well as executive compensation packages. Under the 2-strikes rule, if shareholders of companies listed on the ASX vote down a company’s executive remuneration package 2 years in a row, the board may be voted out of office.
Shares have ‘limited liability’ legal status, which means shareholders have no liability beyond the money paid for their shares. If the company fails, the most a shareholder can lose is the value of their shares.
But because shares are a form of equity ownership, shareholder claims on the assets and income of a corporation rank behind the claims of creditors. This means that shareholders may not receive any money in the event of insolvency.
Different types of shares
Companies can issue different types of shares, such as ordinary and preference shares.
Ordinary shares are the most common type of share traded on the ASX. Ordinary shares entitle shareholders to vote at the annual general meeting and to share in company profits in the form of dividends.
Preference shares are a kind of hybrid share, with features of both debt and equity. Preference shareholders are guaranteed a certain dividend return, but often do not have the right to vote.
Ordinary shares, by contrast, do not guarantee the payment of dividends. The company’s board will decide when to declare a dividend and the amount per share.
Ordinary shareholders have the right to the residual profits of the company, i.e., any profits that are left over after all creditors and preference shareholders are paid.
If a company is not profitable, it may not declare dividends. Equally, the board may decide to reinvest profits into the business rather than pay them to shareholders as dividends. For investors seeking passive income, however, ASX shares with a strong history of dividend payments are an attractive option, and many also offer the benefit of franking credits.
Ordinary shareholders are also entitled to any residual value if the company collapses, but they will be last in line. This means ordinary shares are higher risk than preferred shares or bonds.
With higher risk, however, comes the potential to reap higher rewards. Where a company makes a large profit, it is the ordinary shareholders who stand to benefit most from the windfall, rather than creditors or preference shareholders who are paid a fixed amount.
What is the difference between a share and a stock?
The terms ‘share’ and ‘stock’ are often used interchangeably to refer to securities that represent ownership of companies.
Of the 2 terms, ‘stock’ is considered broader, referring to ownership in companies generally. ‘Shares’ tends to refer to individual units of stock, that is, the actual amount of ownership of a specific company.
For example, if an investor says, “I own BHP stock”, you know they own a portion of BHP Group Ltd (ASX: BHP) equity. If the investor says, “I own 500 BHP shares”, you know their exact ownership. This means a reference to shares can indicate investment size, whereas a reference to stock does not, alone, provide information on the size of the investment.
Why are some shares cheaper than others?
Most companies have shares, but only those listed on a stock exchange such as the ASX can be publicly traded. There are more than 2,000 companies whose shares are traded on the ASX, with share prices that range from cents to hundreds of dollars.
Share prices are impacted by many factors, including the performance of the underlying business and broader economy, as well as the supply and demand for the shares themselves.
Fundamentally, the price of a share should reflect the current value of the future cash flows associated with that share. But the future is unknown, and investors have different opinions about what it will entail. Further, the intrinsic value of a share, as determined by its business fundamentals, may differ from its actual market price.
Active investors believe the intrinsic value of shares is separate from their market price. They seek to outperform the market by buying shares they consider undervalued. Passive investors, on the other hand, tend to believe in the efficient market hypothesis, which provides that the intrinsic value of a share should be equal to its market price.
For example, if the share price is $100 and the company’s EPS is $10, the PE ratio is 10x (i.e., the price is ten times earnings). The P/E ratio can be used to compare different shares both within and across industries. Whether an individual investor considers a particular P/E ratio to be good value will depend on that individual’s objectives and investment style.
Value investors tend to prefer lower P/E ratios, as this can indicate the market valuation of a share may be below its intrinsic value. Growth investors, on the other hand, are not averse to higher P/E ratios where they believe they are justified by the rate of earnings growth.
Are you interested in investing in shares?
If you’re interested in investing in shares, there is plenty you can do to educate yourself about the share market and inform your investment decisions. These should be guided by your financial goals. One common goal is to achieve financial independence through investment. Whether your aim is to build long-term wealth or secure passive income streams, investing in shares is a great way to pursue these goals.
Motley Fool contributor Katherine O'Brien has no position in any of the stocks mentioned. The Motley Fool Australia's parent company Motley Fool Holdings Inc. has no position in any of the stocks mentioned. The Motley Fool Australia has no position in any of the stocks mentioned. The Motley Fool has a disclosure policy. This article contains general investment advice only (under AFSL 400691). Authorised by Bruce Jackson.
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