The anatomy of a share

When people talk about investing they are usually talking about buying and holding the shares of companies listed on a stock exchange. But what does this actually mean? What is a share and what do you get if you buy one?

A share is a bit of a company

When people starting or running companies want to raise money to expand (or to survive), they can do so in one of two ways. They can borrow money either from a bank or by issuing bonds (IOUs) to investors. That's a good thing to do, for the simple reason that if you borrow money, you don't have to give away any ownership of the company as long as you pay the money back. But it's also a bad thing to do, because you have to pay the money back and that isn't always easy.

The alternative is to raise the money by selling part of the company as shares. A share is simply one unit of the divided-up value of the company. So if a company is worth £100m and there are 20 million shares, each share is worth £5. You can issue as many or as few as you like: if there were 50 million each, one would be worth £2. Issuing shares is a great way to raise money: it is "permanent capital" you never have to pay it back. However, there is a major downside to it too: selling shares in the company means you lose full ownership over the company. You have shareholders and, in theory at least, you have to pay attention to them.

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Why buy shares?

You can see why companies issue shares to get money now. But why do we buy them? The answer there is just as simple: we buy shares in order to get the right to a share of profits in the future. We hope that the capital the company has raised will be used efficiently to drive growth, and then to pay out a share of profits in the form of dividends in the future. We can then either hang on to the shares and collect the dividends, or sell them on to someone else who wants to collect the dividends. Either way, we buy in the expectation of making either an income, or a capital return.

What is a share worth?

How do you know what to pay for a share? You'll hear lots of complicated answers to this. But it boils down to one thing. A company is worth the present value of the total sum of money it is ever expected to pay out, be that as dividends or as a cash return on its liquidation. All valuation methods are, one way and another, an attempt to figure out what the total very long-term return from the company is likely to be. A share rises in price mainly as a consequence of the expectation that a firm's profits will rise, and that as a result the company's dividend payout will also rise: the better a firm's profits are expected to be, the more the shares will be thought to be worth.

Two simple valuation techniques

The simplest ways to look at whether you are getting value from a share or not are to look at the dividend yield, and at the price/earnings (p/e) ratio. The dividend yield is just the annual payout to shareholders expressed as a percentage of the share price (so if the price is £1 and the dividend is 5p, the yield is 5%). A high yield is good unless there is concern that the company's profits won't be good, and it will have to cut the dividend. In that case, high is bad!

The p/e ratio is the company's share price divided by the profit that it makes per share (also known as earnings per share, or EPS). So if the price is £1 and the company made 5p per share last year, its p/e is 20 times. That tells you how many years, at the given profit level, it will take the firm to make as much money as you are paying for the share in other words, how long it will take to double your money.

Don't just invest in one company

If you are going to buy shares, you need to own them in more than one company if you want to maximise your chances of getting richer rather than poorer. Markets change, economic conditions change and companies change. So you need to keep your risks down by holding a selection of shares in companies in different businesses: one might fail, but it is unlikely that they all will.

Don't pay tax on your gains

You hold shares to make money over the long run. To do that as well as you can, you must ensure your costs are low in terms of both trading and tax. So look for a low-cost stockbroker (see last week's article) and then hold your investments inside a tax-free wrapper. George Osborne just put the Isa allowance up to £20,000 a year in his budget. Use that and neither your dividends nor your capital gains (when you sell) will attract a penny of tax.