Welcome to part 2 of our guide to financial instruments! In the first part, we examined dividends in closer detail. Many financial instruments pay dividends, so we thought we'd put that one first.
Chapters in this guide:
Part 1 - All About Dividends
Part 2 - All About Stocks & Shares
In this 2nd part, we will be examining stocks and shares. Some of them focus on growth, while others focus on paying out dividends. For most individual investors, equities will make up a large part of your portfolio, so let's see what they are all about!
What are stocks and shares?
A share indicates the ownership of a small part of a company's shareholder's equity. Therefore, buying a share essentially makes you a shareholder of the company proportional to the value of the shares you bought.
Similarly, stocks are simply a collection of shares. When you buy stocks from a stock exchange, you own shares in a corporation and are therefore entitled to that company's earnings and assets.
As the company's assets and earnings grow in value, you also gain those benefits, such as when your shares grow in market value (capital gain), or the company pays out part of its earnings to you (dividends).
When you buy shares, they sometimes also come with a right to vote on company decisions. After all, you're a shareholder of the company now! Buy enough shares and you can even control the company, but most companies have tactics to make sure this doesn't happen.
Where do shares come from?
When a company needs to raise money to fund a project or its operations, they can obtain it in two ways - taking on debt, or selling shares. With debt, the company is required to pay interest on the debt in addition to the original principal, which is a financial burden on the company.
With shares however, the company merely has to sell the share once, raising immediate money which requires no further paybacks or maintenance. Therefore, many companies choose to go public, selling shares to gain access to a larger pool of investors.
When a company goes public, they can choose a stock exchange to distribute shares from for investors to purchase. The proceeds from selling these shares then go back to finance the company.
At the IPO (initial public offering), the company is first legally allowed to issue a certain number of shares. This is the total amount of shares the company can legally sell to investors.
Although the company can sell the entirety of its authorized shares to investors, most companies do not do so. This is usually because they want to keep some shares leftover so that they can sell them if they need further financing in the future.
The number of shares that the company does release for sale is called issued shares. This is the number of shares issued by the company for investors to purchase, and will always be lower or equal to the number of authorized shares.
One step down from issued shares are the outstanding shares. Outstanding shares are shares currently owned (i.e. bought) by both internal and external shareholders, and will therefore always be less than or equal to the issued shares.
Outstanding shares include shares held by institutional investors as well as restricted shares held by company's insiders like the management and directors.
The number of outstanding shares changes dramatically as people buy and sell shares on the stock exchange. However, a rough estimate is given by the company in their reports for investors, and is an important number to take note of.
Several key metrics for checking company financials like earnings per share are calculated using this number (e.g. earnings/outstanding shares). Therefore, if the number of outstanding shares changes, the earnings per share of the company will change with it.
Finally, we have what is known as the treasury stock. If a company finds that their stock is undervalued and wish to resell it to get a better value, they can also buy back outstanding shares for resale. This is known as share repurchasing.
Treasury stocks are shares that have been bought back by the company, and includes all shares held in the company's treasury.
These shares now no longer belong to any shareholder, and are excluded from the outstanding shares, but are still under the issued shares (since they can be resold).
As they are no longer under outstanding shares, treasury stock are also not included in the number of shares eligible for dividend payouts and have no voting rights.
The more shares the company buys back, the lower the outstanding shares number. This increases the earnings per share (earnings/outstanding shares), making each outstanding share have more value.
As such, share buybacks increase shareholder value per share. When companies repurchase shares, you will often see the share price go up. This happens as investors think that the company finds their shares undervalued, in addition to the value of each outstanding share being increased.
What is shareholder's equity?
These days, shares and stocks are often synonymous with the term equity - but they are not quite the same.
If we think of the company as an entity which owns assets, the value of the company is derived from the assets that it owns.
In the event of a bankruptcy, the company has to first pay off its debts. These are lumped together as the company's liabilities. We use the company's assets to pay off its liabilities. Therefore, we subtract the liabilities of the company from the assets of the company.
Whatever remaining value leftover can then be paid out to the shareholders of the company. This portion is known as the shareholder's equity, or equity.
You can think of shareholder's equity as the amount that shareholders have remaining to split among themselves in the event that the company sells all its assets at market value and pays off all its liabilities.
Total Assets = Total Liabilities + Shareholder's Equity
When you buy shares in a company, you are eligible to a portion of the company's shareholder equity as you become a shareholder of the company. Therefore, shares and stocks are often termed as equity these days.
Breaking down shareholder's equity
Shareholder's equity is actually made up of 4 primary components:
- Additional paid-in capital
- Outstanding shares
- Treasury stocks
- Retained earnings
Additional paid-in capital
During the initial public offering (IPO) stage, the company issues new shares at a set value known as the par value. If an investor were to buy these new shares at a share price above the par value, the excess is known as the additional paid-in capital.
This additional paid-in capital is only for the IPO since the company still owns these shares before the IPO and hence will receive all money from shares sold. Shares traded after the IPO will be between investors, and any excess will be the seller's capital gains, not the company's.
Other than retained earnings, shareholder's equity also include outstanding shares. Recall that outstanding shares are shares that have been sold by the company and are currently held by shareholders.
Shares owned or bought back by the company are also regarded as part of the shareholder's equity.
Finally, retained earnings are earnings that a company keeps for itself instead of paying it out to shareholders in the form of dividends.
These retained earnings can be positive or negative. A positive retained earning means that the company still has earnings leftover after paying off its liabilities and handing out dividends, which shows sustainable profits and growth.
Conversely, a negative retained earning shows that the company has dipped into its reserves from past earnings on even took on debt to cover its payments. This means that the company has more debt than it has earnings, resulting in possible financial instability.
We use the term possible because there may be reasons for this negative retained earnings, such as taking on debt to fund an important project, for example. Do read the company's shareholder letters to find out.
If you've read our first article in this series, you'll know that it is important that the dividends paid out are sustainable in the long run because a high dividend yield is useless if the dividends are not unsustainable.
Types of stock issued
A company can issue more than one type of shares. Different types of shares can come with different privileges, such as voting rights. Let's explore some of them.
Preference vs common stock
Most shares that we buy on the stock exchange are common shares which come with the voting rights (e.g. one vote per share).
However, there is also another class of shares known as preference shares. Preference shares have no voting rights, unlike common shares. However, as its name suggests, they come with preferential treatments in terms of payouts.
Shareholders of preference shares will receive a stated fixed dividend amount. Meanwhile, common shares do not have any guaranteed dividends. Instead, dividends are subject to reduction or removal.
If a company chooses to pay dividends, then preferred shareholders will have a higher right of claim to them before the common shareholders. Depending on the type of preferred share, the company may even have to pay off previously owed dividends to preferred shareholders first.
Only after that will any leftovers be divided among the common shareholders based on the total number of common shares.
Should the company go bankrupt, preferential shareholders are also given the priority in getting any payouts from the sale of company assets before common shareholders.
Due to the fixed dividend rates, preferred shares are generally safer than common shares, but this comes with a trade off.
If the company did well that year and the total amount of dividends that the company is willing to pay out is high, common shareholders earn more dividends since preferred shares have fixed dividends.
All in all, preferred shares are low-risk and hence provide low returns while common shares are higher risk and give higher returns.
Under normal circumstances, common shareholders gain significantly more dividends than preferred shareholders. And if you have done your due diligence, liquidation should be very unlikely to occur.
Class A, Class B & Class C stock
You might have seen various tickers on a stock exchange before, such as BRK-A and BRK-B. At first glance, they seem like the same company, so why are there different tickers?
When a company issues new shares, they can decide the type of share that gets issued. They can also create new types of shares to issue.
Each type of share may have different rights and benefits, so it's up to you as the investor to do the proper research before buying anything.
For example, Google has three types of shares: Class A, Class B and Class C (as of June 2020).
Their Class A shares are the normal common stock, with a typical one vote per share right.
Their Class B shares are reserved for the founders and insiders only (privately traded), and have 10 votes per share, to preserve ownership and voting rights within the company itself.
Finally, their Class C shares have no voting rights.
As you can see, companies may come up with various types of shares for various purposes, one of which is to preserve voting rights within the company itself to prevent takeovers from outsiders.
Note that these different classifications of shares are not the same as preferred vs common shares. Preferred shares can be considered as an asset class of their own, kind of like a bond since they pay fixed dividends, while these classes are primarily common shares with different rights.
Other stock types
Sometimes, other than the official stock types mentioned above that have different trading rights and regulations, investors also classify stocks by their nature.
For example, investors may classify stock by their market capitalization (the value of the company). Large cap stocks are shares from companies that are worth 10 billion or more, mid cap stocks from 2-10 billion, and small cap stocks with a market value of 300 million to 2 billion.
These terms are coined by investors, and are useful if you want to diversify your portfolio with various kinds of stocks.
How are share prices determined?
Earlier, we discussed how shareholder's equity is equal to the company's assets less the company's liabilities, and is the value owned by shareholders.
As a result, outstanding shares have a book value which depend on a company's total assets and liabilities. The book value of a share is the value of shareholder's equity divided by the number of outstanding shares.
Share price (book value) = Shareholder's equity / Outstanding shares
The book value of a share is simply the intrinsic value of a share as determined by actual assets owned by the company, but reality is not so simple - there are a multitude of factors which causes the share price to differ from the book value of the share.
The main driving force of share prices is supply and demand. In economics, when demand increases, prices will be driven upwards as investors "compete" for the stock. In contrast, when supply increases, prices will be driven downwards as there is less "competition" for the stock.
Supply is normally affected by a company's decision while demand is affected by investors' sentiments about the market.
The supply of shares can be increased when a company decides to issue more shares to fund their business. However, the supply of shares can also be decreased when a company decides to engage in a share buyback, as we've explored earlier when talking about treasury stocks.
While changes in supply are more predictable and results in a relatively expected change in share prices, the same cannot be said for changes in demand. Investors' sentiments can cause the demand for a stock and hence share price of the stock to vary wildly.
Investors' sentiments are affected by many things, some of which include economic outlook, interest rates, and most significantly, the financials of the company.
If the company's future is bleak, investors will want to drop the stock, causing demand to fall. As a result, the share price will plummet as well. In the previous part of this guide, we have also examined how a reduction or payout of dividends can cause the stock price to drop.
Conversely, if a share is performing well or investors expect good growth, then demand will surge, increasing the share price.
Is a share overvalued or undervalued?
As the share price of a share fluctuates based on investors' sentiments, it often differs from the book value of the share. How do we know if a share is undervalued or overvalued?
This information is important as it helps you to determine what is a good price to buy or sell. For example, you could sell if you think the share is overvalued, and buy when it is undervalued, allowing you to gain higher profits.
In general, undervalued stocks are called "value stocks" by investors, since they provide great value at a low price.
There are several ratios to take into account when you want to determine the value of a stock, such as the price to book ratio (P/B ratio) and the price to earnings (P/E ratio).
You can read more about them here. Of course, just blindly trusting the ratios won't help much since share price is highly volatile and unpredictable.
Analysts often use mathematical models to predict the expected share price of a company, with methods such as finding the present value of all predicted future earnings, and so on.
Honestly, there is no 100% accurate way of determining a "fair" share price, so you'll have to make the final decision yourself. Often, a good understanding of the business and confidence in its continued growth is more precious than a guess about its share price.
If you find a price unfair either by comparing against analyst prices or from your own judgment, remember that you can always find another company to invest in! Don't tunnel too hard into one particular stock.
One thing to note is that an overvalued stock is not always a poor buy and an undervalued stock is not always a good buy. This is because stocks may be overvalued or undervalued for a variety of reasons.
A stock may be overvalued because investors believe that the company has strong growth potential and hence choose to invest in it, pushing the share price up. Conversely, a stock may be undervalued because its financials and growth prospects are poor, not because it is an undiscovered gem.
A stock's beta is a measure of how closely related the movement of the share price is to the general market trend. For example, a stock with a beta of 1 will have its share price move exactly like the market, and a stock with a beta higher than 1 will have its share price move like the market, but with a higher amplitude.
|1||Exactly follows the market|
|0||Independent of market movement|
|-1||Moves oppositely to market|
|> 1||More volatile than market|
|< -1||Moves oppositely with more volatility|
When comparing betas, it is important to remember that you cannot directly compare betas of companies in different industries. This is because some industries are more strongly affected by market movement than others.
On the surface, it may seem as though a beta value below 1 would be ideal since in an economic downturn, losses would be minimal because the stock is not volatile.
However, it is vital to remember that the converse is also true. When the economy is doing well, companies which are less volatile do not benefit much from the strong economy.
Similar to how the share price of less volatile stocks do not drop steeply during an economic downturn, share price of less volatile stocks also do not increase sharply during an economic boom.
That said, the share price of companies may not always follow the market. Sometimes, certain news may cause the share price to move in an unexpected direction. Other times, measures may be taken by the government to boost the economy.
It is good to have a mix of companies with different betas, some high and some low, in our portfolio. This is because while companies with high betas can help our portfolio to grow rapidly in an economic boom, companies with low betas act as a hedge during an economic downturn to reduce losses.
Stocks splits & buybacks
When a stock is undervalued or the price gets too high, the company may take some action to adjust the price.
An action that a company may take when its share price gets too high is a stock split. In the example above where we examined Google's stocks, their Class A and Class C shares were actually the result of a stock split.
As its names suggests, a stock split occurs when the company decides to split each share into multiple shares.
A 2-for-1 stock split, for example, will result in each share owned splitting into two, and a 10-for-1 stock split will result in each share owned becoming 10 shares.
Note that since the overall shareholder's equity remains the same, but the number of outstanding shares increases, each share price will be divided by the number of shares it is split into, causing share price to decrease.
For example, a 10-for-1 split will see a stock that was originally worth $10 per share become $1 per share, since its value is now divided into 10 new shares.
Your overall investment value doesn't change - if you have $10,000 invested before the split, your new stocks will still be worth $10,000 after the split. The only difference is that you own more shares.
Since the share price drops, the equity becomes more accessible for small time investors who may otherwise not be able to buy much stocks due to the high prices. This opens up the company's stock to a larger pool of investors, allowing the company to raise more money through equity funding.
As the investor pool opens up, this may increase demand for the stock, leading to the share price rising further.
Reverse stock splits
Often, stock exchanges mandate a minimum share price to be able to trade on the stock market. For example, for the New York Stock Exchange (NYSE), all shares must maintain a minimum share price of $1 per share to be listed.
As such, if a company finds that their share price is falling below the minimum limit, but they wish to remain listed to continue getting funding from investors, they can choose to do a reverse stock split.
Unlike stock splits, this combines stocks together. For example, a 1-for-10 reverse split would combine 10 owned stocks into 1 stock.
Similarly, since the equity stays the same, the share price will be multiplied by split ratio. In the above example, each new share owned will be 10x the original share price, since 10 shares have been combined together.
As we've examined before in treasury stocks, a company may choose to buyback outstanding shares. This reduces the number of outstanding shares, resulting in an increase in share price since the equity remains unchanged.
Stock buybacks also increase the price to earnings ratio of each share since the number of outstanding shares decreases, making stocks more attractive to investors.
A company buying back their own stock could also signal that they find their own shares undervalued, showing confidence of future growth. Therefore, investors usually watch out for stock buybacks.
A company may also declare that they will seek to buy back at least a certain amount of stocks in this financial year, as a promise to investors that they have confidence in their own situation.
Alternatively, the company may use stock buybacks as a way to hold stock in their own treasury for other means, whether it is for resale at a later time when stock prices go up, or to give stock options to employees as a form of salary to attract talents at preferential rates.
Growth, value & dividend equities
By now, we have covered how stocks are given out, the types of stocks as well as several ways stocks are used by companies for growth.
As mentioned earlier, investors themselves have coined various terms for different stocks, which serve different purposes in an investor's portfolio.
Let us first examine the differences between growth, value, and dividend equities, and see how they allow you to invest using different strategies.
Growth equities are companies that grow at a rate that is faster than average companies. This means that the share price of these companies are likely to increase at a rate faster than average, which in turn translates to capital gain for investors.
While these companies have strong growth and could produce great returns over the long term, most of these companies either pay out no or very little dividends as most of their earnings are reinvested back into the company.
This means that you can expect virtually no returns in the short term. The only opportunity you have to earn returns is to sell the stock at a price higher than the price at which you bought the stock by giving the company time to grow.
As such, growth equities have some risks associated with them since should the company fail to become successful, the share price may never increase, or even worse, decrease, causing you to lose the principal you invested over the long term.
As such, it is important to pick out quality stocks that can last the test of time and grow steadily. Often, this starts with identifying the core business of the company and their financial stability.
We have a guide that teaches you the basics of analyzing a stock that you can check out here!
Value equities are companies whose stocks are trading at a value below their expected price when compared to their performance.
Investors stand the chance to earn a substantial return when the market "realizes the true value" of the stock and the share price returns back to its "rightful value".
However, the problem is that the share price may not always return back to its rightful value, presenting a risk to all investors interested in value stocks. Whether or not this happens depends mostly on the company's actions, as well as the news.
If a company has strong financials and is producing a product with comparative advantage but is not well known enough for investors to even notice it, it is very likely that the stock will be undervalued.
Picking out lesser known brands is both risky and rewarding, unlike well known brands whose value is well recognized.
You can consider adding some of these equities to your portfolio if you have a good risk appetite and some spare cash to burn. Betting on some lesser known companies that you believe in can bring you great profits in the long run, just like all the Bitcoin millionaires that came about.
Last but not least, we have dividend equities, which are usually blue chips in the industry and have fairly stable earnings such that they are able to pay out dividends consistently.
The risks in dividend equities are much lower than both growth and value equities since you can get a return consistently while you invest instead of getting a lump sum (which may be negative) only at the end when you sell the stock.
We have talked about this in the previous part of this guide and if you haven't already read it, do check it out.
These equities are good for investors with a lower risk profile to gain returns over time instead of all at once at the end. Lower risk, lower reward.
That said, it is important to have a balance among all the different types of equities in order to get optimized returns based on your risk profile.
Adding equities to your portfolio
Equities are a good financial instrument to add to your portfolio since it spans across many industries, which then allows you to diversify.
Stocks are also one of the best performing investment assets over the long term, if not the best, so it's essential to at least add some to your portfolio. However, the type of stocks you add is crucial as well, lest you take on too much or too little risk for your risk profile.
As the saying goes, "Don't put all your eggs in one basket". It is very risky to invest only in one thing because if that fails, you lose everything. Diversification is one of the most important things that you must do when you invest.
Do check out our intermediate guide to investing to find out more about portfolio diversification if you're interested.
If one industry is strongly hit due to unfavourable circumstances, the companies in other industries that you own can help to support that. Instead of losing everything, only a small portion of your portfolio will be hurt.
Besides diversification, equities have historically provided approximately 6-12% returns, which is much higher than bonds and fixed income assets. Once again, with greater rewards come greater risks.
What do you do if you are one who would prefer not to spend a ton of your precious time researching individual stocks to invest in? Or what if buying individual companies for diversification is too costly for you?
Luckily, some time back, exchange-traded funds (ETFs) were invented - a collection of equities. This means that by investing in a single ETF, you are investing in a collection of companies, gaining a small number of shares in each of them in one transaction. And when you invest in a collection of companies, you diversify, reducing the risks.
In the next part, we'll explore more about ETFs, so stay tuned!
Next part: Coming soon!
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