Overview
Investment is one of the many ways that investors can use to set aside money and grow their wealth long-term. There is a variety of stock market instruments that traders can invest including shares, derivatives, mutual funds, exchange-traded funds, and bonds.
When people buy shares in a company, they become a shareholder or a stakeholder as they now hold equity in that specific company. Because they own a fraction of the company, as a shareholder, they are entitled to a portion of the profits of the business, paid out in the form of dividends.
These dividends are one of the many ways in which shares can generate returns or a passive income for their holders. The company in question issues shares and they are subsequently sold to investors to raise funds when the company holds an initial public offer.
Once this initial sale is complete, the company’s shares are bought and sold on the stock market and various stock exchanges where the company is based, unless the company buys the shares back at some point.
When people refer to shares, stocks, or equities, they are referring to the same thing. These three distinct expressions are synonymous with one another in the context that they refer to one piece or a share of a company.
There are two main types of shares namely common and preferred shares. Both these types of shares represent ownership of a part of a company but they both function in different ways and provide owners with different rights.
Authorized versus issued shares
These are two terms that investors must know, with authorized shares consisting of a company’s shares issued by the board of directors and issued shares that comprise of a few shares that have already been given to shareholders, accounting for ownership.
For example, a company has 100,000 shares that can be sold, with 80,000 actual issued shares. This means that there are 20,000 shares in the company that can be issued by the Board but that have not yet been sold.
It is important to realize that the ownership that shareholders have can be influenced by the number of authorized shares, therefore shareholders may limit that number if they find a justifiable reason to do so.
When shareholders decide to increase the number of authorized shares, they will call a meeting wherein they discuss the issuing of shares and they come to an agreement. If the shareholders agree that the number of authorized shares must increase, they make a formal request to the state by filing articles of amendment.
Common Shares
Companies issue common or ordinary shares when they want to raise capital for the business. This type of equity stock provides shareholders with voting rights as well as access to dividends.
Dividends are distributed on shares according to the discretion of the board of directors, as per the availability of profits. Ordinary shares represent the ownership of shareholders in the company according to the number of shares that they hold.
Common shares are an excellent source of raising finance as there is no debt component tied to them. Holders of ordinary shares can attend annual general meetings and they can receive annual dividends as agreed by policy year-on-year.
If the company is liquidated, common shareholders will receive their share of the remaining net assets. The market value attributed to ordinary shares is typically determined by market forces, investors’ sentiments, market conditions, and overall demand and supply factors.
Characteristics of Common Shares
- Common shares provide shareholders with voting rights, with the number of shares indicating proportionate ownership in a company.
- Common shares provide shareholders with the right to dividends as indicated by management.
- Common shares have a limited liability component, which means that if the company is liquidated, every shareholder is liable to the company to the extent of the unpaid share capital which is held by that shareholder.
- Common shares do not have a specified maturity date unless the company buys the shares back or the shares are delisted.
The valuation process involved with Common shares
There are three main ways for the valuation of ordinary shares:
- Asset-Based
- Income-Based
- Market-Based
Asset-Based Method
In this approach, the net assets of a company are divided by the number of common shares that are outstanding, which will determine the value of one share. The net assets are calculated by deducting the total external liabilities from the total number of assets.
The asset-based method is typically used by manufacturers, distributors, and capital-intensive companies.
Income-Based Method
The income-based approach is further categorized into the discounted cash flow (DCF) method or approach.
This approach uses the discounted value of projected cash flow to calculate and determine the fair value of common shares, while the price earning capacity method (PEC), makes use of historical earnings to determine the value of a single share.
Market-Based Method
When using this method, the market value of shares is used for valuation and the market value depends on market forces, the type of business, and the sentiment of investors.
Pros and Cons of Common Shares
| PROS | CONS |
| Right to vote | Share prices depend on market forces which can be volatile and lead to fluctuation in share value |
| Excellent source of funding without the debt component | If the company faces bankruptcy, shareholders can lose their entire investment |
| Common shares can be traded in the primary and secondary market | Dividends are not fixed or predefined |
| Provides shareholders with the benefit of capital gains as well as dividends | Common shareholders are the last to be paid if the company is liquidated and may not receive anything |
| Companies have a lot of flexibility regarding the number of shares it wants in the market |
Preferred Shares
Preferred shares have a mixture of debt alongside equity, which means that equity does not have any maturity while debt has a fixed dividend percentage.
Preferred shareholders are also paid before common shareholders, which means that preferred shareholders have a claim to dividends as well as the distribution of assets if the company faces liquidation.
A company can issue preferred shares to raise money from the public and while preferred shareholders do not have any voting rights, they have a claim on the assets of the company after or below the debt holder.
Characteristics of Preferred Shares
- Preferred shares receive a dividend before common shareholders. If the company has not earned a certain amount of profit in a financial year, only preferred shareholders may receive their dividends while common shareholders do not receive anything.
- If the company files for bankruptcy, the valuation of the company will be done, and all its assets will be liquidated. The proceeds from this liquidation will be paid to preferred shareholders before the common shareholders can receive anything.
- Preferred shareholders do not have voting rights which means that as opposed to common shareholders, preferred shareholders cannot participate in any decisions made by the company.
- Preferred shares are typically issued at higher dividend yields as opposed to the common share dividend yield. The fixed dividend payment is one of the things that makes preferred shares more attractive in the stock market.
- Some preferred shares have the option to be converted to common shares, especially if the common shares of the company perform well in the market.
- Like many callable bonds, preferred shares also have a scalability option that lies in the hands of the company.
Types of Preferred Shares
Preferred shares can further be divided into a few different types, including:
- Callable Preferred Shares – that allow the company to call the preferred shares if the price on the shares reaches a certain level in the market.
- Cumulative Preferred Shares – which means that dividends must be paid to preferred shareholders accumulate during times when the profit goals are not met, with shareholders being paid once the company makes the right amount of profit.
- Participatory Preferred Shares – which provides preferred shareholders with extra rights to profit sharing and extra dividends in addition to the fixed dividend that they receive.
- Convertible Preferred Shares – which is an option provided to preferred shareholders to convert their preferred shares to common shares.
Pros and Cons of Preferred Shares
| PROS | CONS |
| They have a higher claim over dividends | Preferred shareholders do not have voting rights |
| There is no maturity | Preferred shares are less attractive with increases in interest rates in the market as the fixed dividend rate will be lower |
| High claim during liquidation | |
| Additional features and benefits |
The Difference between Common and Preferred Shares
To overview the distinct differences between common shares and preferred shares, consult the table below.
| Common Shares | Preferred Shares |
| Indicates ownership that shareholders have in a company | It indicates preferential rights where dividend payments and capital repayment is concerned if the company is liquidated |
| Voting rights | Lack of voting rights |
| Dividends may or may not be paid to shareholders | Dividends will be paid at a fixed rate according to the agreement at the time when the shares were issued |
| If the company is liquidated, common shareholders are repaid if there anything remains after liabilities have been met | If the company is liquidated, preferred shareholders are paid before common shareholders |
| Common shares cannot be redeemed | Preferred shares have a redemption clause at the end of specified periods |
| Common shares cannot be converted | Some preferred shares have a conversion clause that allows them to be converted to common shares |
A few things to know about investing in shares
Before deciding on an investment in the stock market and the different types of individual stocks, it is important that investors first consider the following:
- Their personal investment goals and their financial goals
- Their risk tolerance and level of risk that they may face and their willingness to be exposed to such risks
- The different types of investment, other than shares, can form part of their investment portfolio
- Whether they have a solid investment strategy that accommodates their own financial goals and investment objectives
Pros and Cons of investing in shares
Before making any investment decisions, it is important to consider the pros and cons of investing in individual stocks or shares.
| PROS | CONS |
| Share investment can take advantage of a growing economy | There are a lot of risks involved and it is not always easy to have and keep a diversified portfolio |
| By investing in shares, retail investors can stay ahead of inflation | Common shareholders may not receive anything if the company is liquidated |
| Shares are easy to buy and sell | Selecting or hand-picking companies can be a time-consuming process |
| Many different trading opportunities and trading strategies to follow | Stock prices fluctuate rapidly and can have an impact on the emotions of investors |
| The option to keep a diversified portfolio | Institutional investors and professional traders have more time and capital to invest which means that retail investors face serious competition |
FAQ
What is a share?
A share is a unit of ownership interest in a company.
What is a shareholder?
A shareholder is a name given to a person who owns shares in a company. The shareholder becomes part of the company according to the number of shares that they hold.
Are shareholders and stakeholders the same thing?
No. The terms may be used interchangeably to refer to the same thing, but both serve different purposes. A shareholder owns a part of a company when they purchase shares or stocks of that company. A stakeholder is interested in the performance of a company for reasons other than share performance or appreciation.
What is the stock market?
The stock market is a central marketplace where financial instruments are traded including stocks, bonds, commodities, and several others.
Are the stock market and stock exchange the same thing?
No. The terms may be used interchangeably to refer to the same thing. A stock exchange is an entity that provides a channel for trading stocks while the stock market consists of primary and secondary markets and is a combination of over-the-counter markets, electronic communication networks, and many stock exchanges.
Can anyone become a shareholder?
Yes, anyone can become a shareholder, even with a small investment amount.
What are the two main types of shares?
The two main types of shares are common and preferred shares.
Does a shareholder play an active role in the operation of the business?
No, shareholders are not actively responsible for the day-to-day activities of the business unless the shareholders are also directors or employees of the company.
How many shares can a company issue?
The minimum number of shares that any company can issue is 1 and there is no legal maximum level set for companies.
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