Value of a Share
The value of a share can be defined in a number of ways, some in a reasonably objective, and others in a quite subjective, manner. Calculations based on formal (e.g. stockholders' equity) or accounting variables (e.g. book net worth) are rigorous.
Calculations based on market variables, which continually fluctuate and always depend on judgments made by investors and markets (i.e. quotes, the prices that shares are bought and sold at), are more subjective and their validity must be assessed by each party. Calculations made by appraisers (e.g. price targets) depend, to be credible, on whether investors, the markets and other appraisers regard them as prestigious.
Face Value of a share
This is the portion of a company's stockholders' equity each share represents. Provided all shares belong to the same category, their face (or nominal) value will be the company's stockholders' equity divided by the number of shares issued. This is merely a formal amount and doesn't reflect on the company's appraisal. In certain countries (for example, in the USA), shares have no face value because it is deemed unnecessary.
Book Value of a share
This is the portion of the book equity capital (net book worth, i.e. the difference between assets and liabilities in a company's accounting records) represented by one share. It is calculated by dividing the value of the equity capital by the number of shares issued.
This calculation is not very rigorous when the company has different classes of non-fungible shares (i.e. with different rights). The share's book value, although more important than its nominal value, is not very significant when it comes to appraising a company.
Market value of a share
This is the value at which the shares are traded on the Stock Exchange. If the market is efficient, the share's market value is the best appraisal of the company, at a given time. A share's market value reflects the investors' expectations regarding the future development of the company issuing the share.
A number of factors affect these expectations, namely:
- expected gains (especially for short-term investors);
- expected dividends (the higher the expected dividend the more attractive the share);
- business uncertainty, which depends on company and sector risk, as well as of the overall economic environment;
- business potential, which depends on management quality and its sector's potential for growth, among other things;
- earnings from alternative investments, such as investments in deposits or public debt that affect the level of return investors demand for placing their money in risky instruments.
Earnings from shares
Earnings from investing in shares
Investments in shares produce several types of earnings, the most important being dividends and capital gains. Since these sources of income depend on companies' past (distribution of dividends) and future results (capital gains), investing in shares always involves a certain amount of risk, which manifests itself in the uncertainty of profit or loss.
Dividends represent the part of the company's profit that is distributed among its shareholders. Once the Profit and Loss account is known, a General Meeting is held to approve the Board's Annual Report and its proposal of how to invest the results and distribute the dividends (if there has been a profit). Dividends may be ordinary or extraordinary, paid out in cash or in products, or a purchase of own shares (value reverts to the shareholders who sell them).
If we divide the distributed dividend by the quoted price for the shares, we get a very simple ratio called 'dividend yield'. It represents the return rate of the investment in shares for the period the dividends pertain to, if the quoted price for the shares did not change.
Capital Gains (or Losses)
Capital gains are the difference between the offer and bid price of a share. You'll make a capital gain if the difference is positive (profit) and a capital loss if negative.
Capital gains or losses are potential when the security is not actually sold but its face value is only compared to its current market value. Capital gains are gross if you only compare the prices, and net if from this value you subtract transaction costs.
Non-cash benefits of shares
On top of cash benefits (dividends and capital gains) , shares also offer other benefits, namely the right to vote at the general meeting, right to participate in company management and a pre-emption right on the issue of new shares, among other benefits shareholders may chose to include in the company's Articles of Association.
Yield of an investment in shares
You can calculate the return of an investment in shares by dividing the sum of dividends received and capital gains/losses by the purchase price.
Yield = (Capital gains (or losses) + Dividends) / Purchase price
New shares issue
When public limited companies want to increase their capital, they issue new shares and sell them on the primary market. These issues are private if a small number of investors subscribe them, and public if open to a large and undifferentiated number of investors.
Companies that launch public share issues are called public limited companies. When there is a new shares issue, there is an increase in the company's Shareholders' Equity account.
There are ways to increase a company's share capital without having any money enter the company. This is basically a bookkeeping exercise where accounts are reorganised (capitalization of retained earnings) or creditors transformed into shareholders (capital increase by conversion of convertible bonds or capital increase by transforming credit into capital).
In these cases the company's value is not increased, although there is a fiscal effect that could be negative in the case of transforming credit.
New shares issue (with entry of money or other values)
Normally when a company increases its share capital it wants to harness the means to finance its own growth and as such requires that a certain price be paid for the shares it sells on the primary market. Less frequently, a company will issue new shares that are traded for assets, such as buildings and materials that increase the company's means of production. Such operations are similar to company mergers, where one company is incorporated into another.
A capital increase by new shares issued with the aim of distributing dividends to company shareholders - not in cash but in shares - is similar to a financial gain in the sense that the value of the dividends is to all effects retained in the company.
Calculating the value of shares after a new shares issue:
The theoretical value of a share, after a capital increase by cash inflow, is the sum of the company's current value (no. of shares times its price) and the expected value of the cash inflow (no. of shares to issue times subscription price of a share), all divided by the total number of shares after the capital increase.
Regardless of the subscription price of a share, a shareholder that maintains the same percentage of ownership interests in the company's capital, before and after the capital increase, will make no extraordinary gains nor losses from the operation. If the subscription price is lower than the price on issue date, it is in the shareholders' interest to subscribe more shares than those they currently hold in the company's share capital.
When a company wants to increases its capital, it can also offer a rights issue whereby the current shareholders have the first right to buy these preferential shares (or in some cases, even the whole issue). This right is called Subscription Right and can be traded on the stock exchange if the shares are traded there.
When a rights issue is announced, information on when the last trading session with subscription rights and the first session without subscription rights will take place is also provided.
These subscription rights can be exercised to subscribe new shares in compliance with the issue terms and can be sold on the stock exchange while the rights are being traded. When sold, the ownership interests are transferred.
Shareholders who do not exercise their subscription rights will find the value of their holdings reduced in the same proportion as their rights value. If some shares have not been offered in the rights issue, the left-over shares can be allotted to shareholders who, exercising their rights, wish to apply for a portion of these shares.
Theoretical Value of Subscription Right =(Value of share in market - Subscription price) x Attribution factor
When capital is increased by capitalizing retained earnings, shareholders are granted a right that allows them to receive new shares for free pro rata (in the same proportion as their previous holdings).
Bonus issue rights can be traded on the same stock exchange the respective bonus shares are traded on. When a bonus issue is announced, shareholders are also informed of when the last stock exchange session for trading these rights will take place, as well as of the first session when the traded shares will no longer include these rights.
Theoretical Value of Bonus issue rights = Theoretical Value of share / No. rights required to subscribe a share
Effects of splits and dividends
Splits divide the face value of shares by increasing the quantity of shares representing the company's share capital. For example, in Portugal most companies divided the face value of their shares from 1,000$00 to 1 Euro, whereby an investor who had held one share from that time on held roughly 5 shares.
Shareholders do not inject any money into the company in a share split. It is merely an accounting operation where the face value of the shares is reduced. The company maintains the same share capital, only fractioned into a larger number of shares.
Effects of splits in quoted price of shares
Since no value is added in a share split, theoretically there shouldn't be any real impact on the quoted price of shares. However, history shows that after a security starts to trade on its new face value, it may not be exactly adjusted to the proportion of the split, and as such there may be a slight addition of value on behalf of the shareholders.
Normally this effect is explained as ensuing from a number of causes, such as an increase in liquidity or market capitalisation, or even the psychological effect in investors, who now perceive the share as being 'cheap', and therefore more attractive.
Dividend payments and quoted prices of shares
Dividends are the portion of company profits that are distributed to each shareholder, once the accounts for the financial year have been approved at a General Meeting and provided there are enough profits to pay out. When dividends are paid, in theory the quoted price should fall by the same value that is paid out as a dividend.
However, in practice this adjustment is nearly always partial, and in effect the quoted price rises. Even though these variations on the dividend payment date can be explained by a wide variety of events and data, it is generally agreed upon that there may be a positive effect on the quoted price.
Investing in the short term
Short-term investment goals
As a general rule, short-term investments are expected to last up to a year. The goal of a short-term investment is established for a reduced time span.
There are usually three main reasons for investing in the short term:
- to hedge short-term risk
- to finance upcoming expenses
- or to speculate on prices and volatilities
Investing in the short term to hedge risk
Some types of short-term investments act as a risk-hedging mechanism for that same time span.
For example, if you know you need to make a payment in a foreign currency within a month or two, you can invest in that debt by repaying it now and thus neutralise the exchange-rate risk till the repayment date. Likewise, if you hold certain company shares you want to sell, but can only do so (for whatever reason) in a month's time, you can sell futures on that security now, thus neutralising the price risk of holding them.
This form of investment aims to reduce asset portfolio liability and risk.
Investing in the short term to finance expenses
Sometimes we have momentary access to money that has to be used to pay for a liability in the short term. For example, you sell a house and have to pay for the new house within two months. In these situations, the goal of preserving capital will carry the most significant weight in your investment choice and only instruments of very low or no risk will be considered. Term deposits and variable-rate money-market funds or bond funds are good choices in such situations.
Only funds that do not ask for subscription or surrender fees within that time period should be taken into account.
Investing in the short term to speculate on prices
This is one of the riskiest ways of investing. Instruments that bear a significant price risk, such as shares, futures and options, are chosen by investors who wish to invest in the short term to try to earn high return rates in a short amount of time. Studies show that in general it's very difficult to outperform the markets in a sustainable manner, so this kind of strategy rarely pays off.
In the short-term, market prices rise and drop, sometimes with high variations, creating many opportunities for profit. But investors have no way of knowing, in a sustainable manner and in the context of efficient markets, about these price variations beforehand. So making short-term investments is very risky business.
Investing in the long term
Long-term investment goals
Most investors and investments have long-term goals, i.e. more than three years. Related investments are those aimed at building, for example, additional retirement savings, inheritance plans, a nest-egg for your children's university studies, etc.
Choosing the best assets for a long-term investment always depends on both the investor's and the investment's risk profiles. We must, however, keep in mind that the risk of financial instruments is not constant - it varies depending on the investment horizon.
Long-term vs. short-term risk
In a short-term perspective, shares have a high risk due to fluctuating shares prices, which can lead to investment losses. Nonetheless, the history of financial markets shows that, in the long term, investing in shares rarely means that investors suffer negative returns.
Investing in shares in efficient and more developed markets for periods of over 5 years usually means low capital devaluation odds and high returns. In general, investing in shares (in a diversified portfolio) has a very high short-term risk and a relatively low long-term risk (over 5 years).
Long-term investment and profit
The general rule is that more risk means higher returns. This is true for the following principles: that we're talking of expected results, of portfolios of securities and not of individual securities, and in the context of developed and efficient markets.
Investing in the long-term in individual securities or diversified portfolios
The above-mentioned rules of thumb apply to diversified security portfolios, such as stock exchange indices and investment funds - not to individual securities. The performance of diversified share portfolios tends to follow the performance of the market itself, which in turn tends to follow that of the economy it operates in.
An individual security depends on the growth of its company and the specific factors that limit it. The market is clearly one of those factors, but there are others, internal to the company, that may supercede it. For example, a diversified portfolio of Portuguese shares will supposedly follow the evolution of the Portuguese stock exchange index. In turn, the latter will also follow, in the long term, the evolution of the Portuguese economy. Well, it's not unlikely that even in such a scenario, a certain company's shares might completely drop in value or even go bankrupt as a result of purely internal factors (a fire, outdated products, etc.).
In summary, as a rule we should always invest directly in a security portfolio (or through investment funds) to hedge market risk.
Build a defensive share portfolio
Defensive stocks are shares that offer less risk than the overall market risk. These shares are less volatile than the market, which is represented by an index. In quantative terms, the Beta index of defensive stocks is under the unit (the Beta index measures market risk of securities, and the market has a Beta index of 1).
Defensive stocks are usually shares of companies that operate in business sectors with little fluctuation (on account of the nature of those sectors' political and economic cycles and decisions).
These are usually business sectors related with the supply or service provision of basic services (utilities), or in mature phases of their business cycle.
Investing in defensive stocks
Investing in defensive stocks is a strategy that aims at a smaller risk premium than that of the market in general. On the other hand, it will be less exposed to risk and share price fluctuations.