Chapter 2- Company, Shares, Dividend & Types of Shares
Since the book assumes no prior knowledge in investment in Shares, let us briefly touch upon what Shares are, and the type of Shares. If you are aware of all the terms already you might want to skip this chapter and the next and join us again on Chapter 4. A quick brush through the Chapters 2 & 3, is advised, though. It might just trigger off a new thought and might cover some basic in greater detail than you might have picked up till now.
What is a Company?
The word company was formed from the Latin words ‘Com’ (together) and ‘Pains’ (bread). Originally the word company referred to a group of people having their meal together. Now it is used to describe a group of people who have contributed money or other infrastructure (capital) with the aim of getting labour to work on it to generate profit. Such a group needs to get itself incorporated as a legal entity in the form of a “Company”.
A company could be a Private Company (with privately held shares) or it could be a Public Company (with publicly traded shares). We will limit the discussion in this book to Public Companies since this book is all about investing in the publicly traded Share Market.
What are Shares/Stocks?
A company ownership is divided into small and equal portions, each of which is called a Share (also referred to as a Stock). Each company will have different number of shares at different prices (based on a number of factors) and these Shares or Stocks are what we (as Individual Share Market investors) purchase and sell to make our profit. We can become a shareholder in a company by purchasing shares of that company and we can transfer our ownership rights by selling our shares to others. Since the company is an independent legal entity, it is not affected by any changes in its owners.
Face Value and Market Value
The Face Value of a share (also called the Nominal Value or Par Value) is the term used to describe the value of the share when the company was formed. These shares are taken against the initial capital that goes into the company to make it a profitable business. The price at which the Share is trading currently is called the Market Value of the Share. Another term used to describe Market Value is CMP (Current Market Price).
When companies pay part of their profits to the Shareholders, this amount paid out is called Dividend. This amount is decided by the Company’s Board based on performance and future plans of the company and the amount paid is proportional to the no of shares one owns. These can be paid on a Quarterly, Half Yearly or Annual Basis. Also, there is no compulsion to pay Dividends even if the Company is making Profits if the Board decides that using the money for some other purpose would be more beneficial in the long run. This amount can be paid in the form of Money, Shares and in some rare cases in the form of Company Products or even Property.
Dividend is calculated on the Face Value or Nominal Value. Which means if the Company declares 30% dividend, and the Face value of the shares is Rs. 10, then the company will be paying all Shareholders Rs. 3/- per share.
Equity Shares and Preference Shares
The shares that we described above can also be referred to as Equity Shares (hence the term Equity Market). It just specifies that the shares don’t carry a fixed rate of dividend. The company has the freedom to decide on the rate of dividend from time to time to provide returns to it shareholders. For the rest of the book, a mention of shares would be used to refer to Equity Shares.
Preference Shares of Preferential Shares give a fixed rate of dividend. In case the company runs in loss for a year and is not able to pay dividends even to the Preference Shareholders, then the unpaid dividends CAN be carried over till the company is able to clear all arrears on Dividend payment. Such preference shares would be called Cumulative Preference Shares. A company is not allowed (in most countries) to pay any dividends to its Equity Shareholders till all pending dividend has been paid to the Preference Shareholders.
If a company wants to raise additional money to fund its expansion or diversification plan, or if it generally needs more working capital, it can do so by selling additional Equity Shares in the market. Sometimes these shares are sold on a “Rights Basis” to existing shareholders, which means the shareholders have the first right to buy these shares by virtue of their existing shareholding. Such shares are called “Rights Shares” and could be sold at par (at the Nominal Value) or at a Premium (above the Nominal Value).
Companies, when they get profitable start building up reserve cash. This cash is sometimes used to expand or diversify business. However, part of it may be used to reward existing shareholders. This can in the form of dividend or in the form of Bonus Shares. When companies find that their Equity Capital is too small relative to their growth, they capitalise a part of their reserve cash by issuing out Bonus Shares. Bonus Shares are issued out FREE to the existing shareholders in the ratio of their shareholding. In the company’s Books of Accounts this reserve cash makes it way from Reserves to Equity Capital.
Bonus shares increase the number of shares each shareholder holds, but does not dilute any shareholder’s proportionate ownership of the company. A Bonus Shares issue would typically be followed by a drop in the Share Prices, but usually not in the same proportion in which the Bonus Shares are issued. Hence a Bonus Shares issue would usually always affect all Shareholders positively.
A Stock Split, as it is usually called, results from a decision by the company to distribute additional shares to the existing shareholders while reducing the Nominal Value or Face Value of the Shares in the same proportion, so as not to change the Equity Capital of the company. The Market Price of the share immediately adjusts to reflect the split, since buyers and sellers of the Share are all aware of the Stock Split.
Companies usually declare a Split if the Price of the share rises significantly and is perceived to be too expensive for small investors to afford.
Buyback of Shares
In certain situations, a company might decide to buy back its own Shares with its own Capital. The Company’s Act debars the company from re-issuing these shares, and hence after a Buyback of Shares, the shares bought back cease to exist. This effectively reduces the Equity Capital of the company and the no of shares available in the market for trading. However, since the no of shares are reduced while the company’s earnings and profit remain the same, it leads to an increase in the CMP (Current Market Price) of the remaining shares.
Let us now move on to some other instruments of investment – Debentures, Securities and also take a look at what Mutual Funds are, how they operate, IPOs and more