In the previous article of the series, we have seen why there are advantages to investing. This opens us up to numerous new questions though! The one that we will give a partial answer to today is the following: what kinds of investment can be made, or, where can one invest in? We call our answer partial because there are many categories of investments (called asset classes). The specific asset class we will talk about is “Equity”.
Uncle Joe’s Reusable Bottle Company
Uncle Joe is a lucky man. At retirement age, his father decided to pass on to Joe his fully-owned reusable bottle manufacturing company, Re-Bottle. Re-Bottle was, and still is, a private company now fully owned by Uncle Joe. This means that Uncle Joe, and his father before him, owned 100% of the shares of the company. This is equivalent to saying that they owned 100% of the equity of the company.
Ownership of a business entails a few concepts. Owning a certain percentage of the equity of a company means owning that same percentage of the profit the company makes. In Uncle Joe’s case, this means that whatever profits the company makes, he owns (remember he owns 100% of the equity)! The company in itself is an aggregation of assets (what the company owns) and liabilities (what the company owes).
While at the moment it is not important to learn all the complexities of balance sheets (the mixture of things owned and owed by a company) and accounting (the financial translation of these factors), it is worthy to mention that the various asset classes present in the market are all related to some specific part of the balance sheet. Uncle Joe is not very knowledgeable about corporate ownership, so when a banker passes by and suggests him to do an IPO (Initial Public Offering), he quickly accepts as it seems like a fast way to become rich! The banker explains it in simple terms “my bank will sell a certain percentage of your Re-Bottle’s shares to the public (financial institutions, funds, other people), and you will gain the money these people will pay for that percentage of shares”. The 30% and 70% ownership fractions post-IPO are symbolic, yet it is not rare for company owners to give up to losing control of their company after IPO’s (meaning they can end up owning less than 50% of the company).
Now that the company has gone public, investors can buy and sell its stock in the secondary market. The secondary market is where investors can trade securities between each other. These are usually traded on an exchange (such as the New York Stock Exchange, or the London Stock Exchange) electronically and through human brokers, even though the latter is currently less common. We will now dig deeper into the reasons someone would want to buy (invest in) a stock.
How One Can Make Money from Equity Investing
There are two possible ways of making money through stock investing. The first is through dividends. Dividends are the way businesses distribute their profits to their owners. Remember how owning a share in a company is equivalent to owning a certain percentage of the equity of that company, and therefore being entitled to that percentage of the profit of the company? When a company distributes its profits to shareholders through dividends, you are entitled to the same portion of dividends as your percentage ownership of the company. It is important to consider that the company’s management (those who make operational decisions for the company) is not obliged to distribute earnings as dividends. They may also decide to re-invest them into the company to enable growth or pay back debts. Many companies have though very fixed dividend schedules, and investors expect with near certainty the payment of dividends and often their size too. This can be a very good stream of income, especially if the investor reinvests the money made through dividends into new shares: this means they will be entitled to an even larger proportion of the dividends the next time they are distributed.
The second way of creating returns through investing in stocks is through capital gains. A capital gain is when the stock price in the market appreciates compared to the price you bought it at. There are many reasons for which this could happen, but, when investors’ collective opinion is that a company’s value is lower than the price represented by its share, they will buy them. This buying of shares pushes prices to higher levels. If you bought the stock before the price increase, you could now sell your shares at a profit. This can though, be a risky strategy. In the secondary market, share prices are changing continuously, and predicting what a stock’s price will be in the future is very difficult.
Risk & Limited Liability
Investing in stocks means the investors have a certain expectation of what the future will be. They might expect to receive dividends, or perhaps that the stock price will appreciate. The reality is, that there is the uncertainty of what the future will be. Investing in equity is therefore risky.
Say for example that Uncle Joe continues managing Re-Bottle after the IPO takes place. He isn’t a great manager though, and eventually, some of his mistakes result in the company not having enough money to pay back its debts. The company is therefore bankrupt. What does this mean for investors? The value of their shares might fall to $0, and cannot increase, as, the company has de-facto failed.
This is an extreme case. Perhaps shareholders notice the Uncle Joe is not a great manager, therefore replace him before he can make too big of a damage to the company. This could result in a fall in the stock’s price (due to Joe’s initial management mistakes), but not necessarily in it reaching the bankruptcy state. It is important to state that the shareholders of the company, whatever happens to it, cannot ever lose more than the money they invested in it.
Limited liability is a rule that protects company shareholders. It states that the owners of a public company are not liable for the debts incurred by it. This means that in case of bankruptcy, the people that are owed money by the company will seize its assets, but that equity holders are not obliged to make up for any additional loss.
Equity Derivatives: Options & Futures
There are ways for investors that don’t want to lose great amounts of money when their shares fall in value to protect their capital. Many financial “contracts” are offered as solutions to facilitate this.
Stock options, for example, are contracts that allow an investor to buy or sell a certain number of shares at a specific price if the share price surpasses a certain “strike” price within a specified time period.
Future contracts are another example: they allow the investor to buy/sell a certain security (not necessarily equity) at a specified price in a set amount of time.
It is useful to know that such risk management solutions exist, even though they may be very complex for ordinary investors. Sophisticated investors, particularly professional investors are often experts in using complex derivatives as ways to lower the risk of loss in their investments. Apart from their apparent role in risk-management though, derivatives are commonly used as tools for speculation.