What a stock is
A share means you own a small piece of a company. You get part of the profit, and in return you share the risk when things go badly.
Learning objective: After this lesson you can explain what rights and risks come with owning a share.
Take a bakery that has been split into a million equal parts. If Luca buys ten of them, he owns ten millionths: of the oven, the recipes, the customers and the profit.
Rights of a co-owner
As a co owner he has two rights. He gets part of the profit the bakery pays out, the dividend. And he may vote at the annual general meeting, though honestly hardly anyone there will notice his ten millionths.
The risk
In return he shares the risk. If the bakery does badly, there's no dividend. If it goes bust, his share is gone. But he can't lose more than he put in. That's an important difference from products with leverage.
Why the price moves
The price moves because other investors keep reassessing how the bakery will do in future. In the short run that often has little to do with the bread and a lot to do with mood. In the long run what decides is how much profit the bakery makes.
Legally, an ordinary share gives you a stake in a company's share capital. That includes the right to vote, the right to dividends, the right to new shares in a capital increase and a claim on whatever is left if the company is wound up. In a bankruptcy that puts you right at the back. Banks, suppliers and bondholders get their money first. Usually nothing is left for shareholders after that. Preference shares usually have no vote and pay a slightly higher dividend instead.
What a share is worth
In theory, what a share is worth can be expressed as the sum of all future payments to its owner, discounted to today. A simple version divides the next expected dividend by the required return minus expected growth. Even small changes in return or growth change the result a lot, so the calculation is of little use for an exact price. But it shows something important: a share price is always a bet on the future.
Market sentiment
Over short periods it's mainly mood that moves the price, meaning how much investors are willing to pay for one euro of profit right now. Over ten years or more, a share's return gets closer and closer to the dividend yield plus the growth in profits. The investor Benjamin Graham put it this way: in the short run the market is a voting machine, in the long run a weighing machine.
Summary
- A share makes you a co owner with a claim to part of the profit.
- In a bankruptcy you stand behind all creditors and usually get nothing.
- In the short run mood decides, in the long run profit does.
- Common mistake: putting the whole portfolio into a few individual stocks instead of spreading across many companies.
Did you get it?
What exactly do you own with a share?
A stake in the company with a vote, a claim to dividends and a lower ranking claim on whatever is left if it's wound up.
Where do you stand as a shareholder in a bankruptcy?
Right at the back. All creditors are paid first, then the shareholders.
What drives a share's return over ten years or more?
Mainly dividends and profit growth. Swings in mood matter less and less over time.
Check your understanding
Your task
A company has 2 million shares, and the price is $30. You buy 40 shares. Calculate your purchase amount, your ownership share in percent, your dividend at $1.20 per share, and your largest possible loss.
Sources and further reading
- Under Section 199 of the German Insolvency Code (InsO), shareholders of a company only receive any remaining surplus after every creditor has been paid in full. View source ↗
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