Understanding the basics of stock is a prerequisite to being a good investor. Wouldn’t you love to be a business owner without ever having to show up at work? Imagine if you could sit back, take a holiday in the Bahamas, watch your company grow, and collect the dividends (a form of remuneration) as the money rolls in! This situation might sound like a pipe-dream, but it’s closer to reality than you might think. As you have probably guessed, we are talking about owning stocks.
This excellent category of financial instruments is, without reservation, one of the greatest tools ever created for building wealth. Stocks are a part, if not the cornerstone, of nearly any investment portfolio. When you start on your road to financial freedom, you need to have a solid understanding of stocks.
Today, we will focus on a detailed explanation of stocks and risk involved in buying stocks.
What are Stocks?
A stock is a share in the ownership of a company. Stock represents a claim on the company’s assets and earnings. As you acquire more stock, your ownership stake in the company becomes greater. Shares can also be referred to as equity.
Holding a company’s stock means that you are one of the many owners (shareholders) of a company and, as such, you have a claim to everything the company owns. This means that technically you own a tiny sliver of every piece of furniture, every trademark, and every contract of the company. As an owner, you are entitled to your share of the company’s earnings as well as any voting rights attached to the stock.
A stock is represented by a stock certificate. This is an elegant piece of paper that is proof of your ownership. In today’s computer age, you may not actually get to see this document because your brokerage house may keep all these records electronically, which is also known as holding shares on the Central Securities Depository (CSD). This is done to make the shares easier to trade. Previously, when an investor wanted to sell his or her shares, that investor physically took the certificates to the brokerage house to initiate the process. Now, trading with a click of the mouse or a phone call makes life easier for everybody.
A person who owns shares has one vote during annual meetings in the event of electing the board of directors, as well as the right to vote on management issues. Being a shareholder of a public company does not mean you participate in running the day-to day activities of the business. For instance, being a Microsoft shareholder doesn’t mean you can call up Bill Gates and tell him how you think the company should be run. In the same line of thinking, being a shareholder of Unilever Ghana Company Limited doesn’t mean you can walk into the factory and grab a free bar of soap!
For ordinary shareholders, not being able to manage the company isn’t such a big deal. After all, the belief is that you don’t want to have to work to make money. The importance of being a shareholder is that you are authorised to a portion of the company’s profits and have an entitlement on assets. When an investor buys shares, returns made are either in the form of dividend payment or price appreciation.
A dividend is a distribution of a portion of a company’s earnings, decided by the board of directors to its shareholders. Dividends are mostly quoted in terms of the dollar or cedi amount each share receives (dividends per share); it may also be quoted in terms of a percent of the current market price, referred to as dividend yield. Thus, the more shares you own, the larger the portion of dividends you get.
Another extremely important feature of stock is its limited liability, which means that as an owner of a stock you are not personally liable if the company is not able to pay its debts. Other companies, such as partnerships, are set up so that if the partnership goes bankrupt the creditors can come after the partners (shareholders) personally and sell-off their house, car, furniture etc. Owning stock means even if a company ib which you are a shareholder goes bankrupt, you can never lose your personal assets.
Debt vs Equity
Some investors wonder why companies may decide to share their profit among several shareholders rather than keep it to themselves. The reason is that at some point every company needs to raise money. To do this, companies can either borrow or raise funds by selling part of the company, which is known as issuing stock. A company can borrow by taking a loan from a bank or by issuing bonds. Both methods fit under the umbrella of debt financing.
However, issuing stock is called equity financing. Issuing stock is advantageous for the company because it does not require the company to pay back the money or make interest payments along the way. All that the shareholders get in return for their money is the hope that the shares will someday be worth more than what they paid for them. The first sale of a stock, which is issued by the company itself, is called the initial public offering (IPO).
It is important that you understand the distinction between a company financing through debt and financing through equity. When you buy a debt investment such as a bond, you are guaranteed the return of your money (the principal) along with promised interest payments. This is different with an equity investment. By becoming a shareholder, you assume the risk of the company not being successful – just as a small business owner isn’t guaranteed a return, neither is a shareholder.
As an owner, your claim on assets is less than that of creditors. This means that if a company goes bankrupt and liquidates, you as a shareholder don’t get any money until the banks and bondholders have been paid; this is called absolute priority. The good news, however, is that shareholders earn a lot if a company is successful – but may also lose investments made if the company is unsuccessful.
Shares and Risk
It must be emphasised that there are no guarantees when it comes to individual stocks. Some companies pay out dividends, but many others do not because there is no obligation to pay out dividends. Nevertheless, without dividends, an investor can make money on a stock through price appreciation in the open market. On the downside, if a stock goes bankrupt, an investor may lose out.
Although risk might sound all negative, there is also a bright side. Taking on greater risk demands a greater return on your investment. This is the reason why stocks have historically in the long-term out-performed other investments such as bonds or savings accounts. Historically, it has been shown that stocks will upsurge given the fullness of time.
Conversely, there are no guarantees when it comes to, mainly, individual stocks. Unlike a bond, which promises a definite rate of return at the end of a specified period, the only assured return from a stock is if it appreciates on the open market (While many companies pay shareholders dividends out of their earnings, they are under no obligation to do so). The worst-case scenario an investor can ever think of is when a company may go bankrupt and the value of your investment evaporates. Fortunately, that’s rare. More often, a company will run into short-term problems that depresses the price of its stock for a while, but usually it will have growth in the long-term.
Despite the risk in purchasing stocks, there are ways to minimise an investor’s exposure. The best is to diversify the risk by owning a variety of stocks. That way, no single company can erode your investments.
ABOUT OMEGA CAPITAL
Omega Capital Limited is an Investment management, private equity and investment advisory firm. The Company is authorised and regulated by the Securities and Exchange Commission of Ghana.
Kumapremereh Nketiah (JP)
Sophia Obeng –Aboagye
Omega Capital Research
The Alberts, 1st Floor
No. 23 Sunyani Avenue
Phone: +233 302 201538
Fax: +233 302 734 745
Additional information is available upon request. Information has been obtained from sources believed to be reliable but Omega Capital Limited (“Omega Capital” or “The Firm”) does not warrant its completeness, accuracy or veracity. The firm is licenced and regulated by the Securities and Exchange Commission of Ghana (SEC). This material is for information purposes only and it is not intended as an offer or solicitation for the purchase or sale of any financial instrument. The opinions and estimates herein do not take into account individual client circumstances, objectives, or needs and are not intended as recommendations of particular securities, financial instruments or strategies to particular clients. Periodic updates may be provided on companies/industries based on company specific developments or announcements, market conditions or any other publicly available information.