How do shareholders earn from a business?

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As we saw at the end of the previous lesson, when you buy the shares of a company that’s listed on the stock exchange, you essentially become a shareholder in that company. In the practical sense, however, what does that mean? Are there any benefits of being a shareholder of a company in this manner? And first of all, what are shares, anyway? Well, if these are some of the questions swarming around in your head, you’re about to discover the answers to them. 

What are shares?

Simply put,the capital of a company is divided into multiple units. Each unit is known as a share. Technically, a share is a single unit of ownership in a company. Depending on their nature, there are two main  types of shares.

  • Equity
  • Preference

Equity shares are the ordinary shares of the company. Equity shareholders are, therefore, the real owners of the company. If you invest in a company’s equity, the number of shares held by you represents the portion of your ownership in the company. Preference shares, as their name suggests, get precedence over equity shares in matters like repayment of capital when the company liquidates.

There are also many other points of difference between these two types of shares. Here’s a quick preview.

Particulars

Equity shares

Preference shares

Rate of dividend

Fluctuating rate, after all of the company’s liabilities are paid

Fixed rate on a preference basis

Convertibility

Cannot be converted to preference shares

Can be converted to equity

Repayment in case of liquidation

Repayment done after all other liabilities are settled

Repayment done before equity shareholders get their due

Risk levels

Higher risk

Lower risk

So, these are some of the differences between these two types of shares. By becoming an equity shareholder in a company, you now know that you obtain a residual claim on the profits of that company. We’ll discuss this in detail in a bit. However, that’s not the only way in which you, as a shareholder, can earn from a business when you buy its shares. Depending on how long you hold the share for, you’ll get to earn returns on your investment in more ways than one. 

How do shareholders get paid from their investment in a business?

So, before you invest in a business, it’s a smart move to get to know the answer to the question - How do shareholders get paid? Let’s look at the many ways in which shareholders like you can earn from a business through the stocks you hold.

Regular trading

This is probably the most common way in which traders earn from a business. Since the share prices of a company that’s listed on the stock exchange keep fluctuating, you can utilise the short-term price movement to your advantage. Let’s look at an example to understand this concept better. 

Suppose you buy 1 share of ABC limited for Rs. 100/- today and sell it for Rs. 150/- after a gap of around 15 days. You’ve effectively made a profit of Rs. 50/- from this simple activity of share trading. And here’s a fun fact for you. You’d actually be regarded as a shareholder of ABC limited for those 15 days during which you held the share of that company.  

Appreciation in the value of your shares

While the regular share trading approach may be good for short-term profit-making, it may not be the ideal way to create wealth. A better approach to do this would be to allow the value of the shares you hold to appreciate more significantly, over the long run. This is a long-term approach that can take anywhere from months to years. Let’s take a look at another example to understand this concept.

Say you bought 1 share of Infosys for Rs. 100/- in the year 2000. Assuming that you held onto your shares till the year 2020, your investment would have grown to about Rs. 600/-, which is an appreciation of almost 500% in the value of your share. And along the entire investment period of 20 years, as a shareholder, you would have also enjoyed plenty of other perks including dividend payouts and bonus share issues, about which you’ll learn in the next segment.    

Dividends

Listed companies periodically distribute a portion of the profits they earn by way of dividends. As we mentioned in the previous lesson, when you become a shareholder of a company by buying and holding its shares, you automatically become entitled to these dividends. 

Established listed companies pay dividends regularly to their shareholders on either a quarterly, half-yearly, or an annual basis. When you hold a particular stock for the long term, you may get to enjoy dividend payouts in addition to an appreciation in the value of the shares. Keep in mind though, that not all companies pay dividends.

Rights issue and bonus issue of shares

When you become a shareholder in a company, dividends are not the only way in which you get to earn. Occasionally, companies reward shareholders in non-cash ways as well. Rights issue and bonus issue of shares are two of the most popular ways in which this happens. Let’s delve a little deeper into these two concepts. 

At times, instead of a dividend payout, companies issue additional shares to their existing shareholders free of charge. This free issue of shares is termed as a ‘bonus issue.’ The bonus shares are generally distributed in proportion to the shares already held. For instance, if the company issues bonus shares on a 1:1 basis, you’ll get one bonus share for each existing share that you own. This bonus issue not only increases the number of shares you hold, but it also reduces the cost of your investment. 

From time to time, companies also announce a rights issue in place of a dividend payout. In a rights issue, the existing shareholders are given the option to buy additional shares at an exclusive price that’s significantly lower than the current market price. Again, similar to a bonus issue, a rights issue is also offered in a set proportion to the shares already held.  

How is shareholding different from other ways in which people put their money in a business?

As an individual investor, you become a shareholder in a company by buying the stocks of that company. However, there are other ways in which businesses raise money as well. Here’s where big players like banks and venture capitalists (VCs) come in. These parties also put their money in a business, either as an investment or as a loan. Let’s look at how they differ from shareholding.

Shareholders vs. venture capital investors

A shareholder can be anybody who invests in a company that issues shares. Venture capital investors, on the other hand, generally invest in startups and other young companies by infusing a significant amount of capital in them. In other words, they have a significant ownership interest in those ventures. 

Shareholders vs. lending banks

Both startups and established businesses often obtain loans from banks in order to fund major business processes. The nature of the funds obtained through this channel is entirely different from the kind of money that investors and shareholders put in the business. You see, the business must repay the loan they borrow, making the banks their creditors (and not their investors).

Wrapping up

Well, that brings us to the end of this chapter. Now you know the answers to many important questions like these.

  • What are shares?
  • What are the types of shares
  • How do shareholders get paid?

Let’s get into industry analysis - the first step of investment analysis - in the upcoming chapter.

A quick recap 

  • By becoming a shareholder in a company, you know that you obtain a residual claim on the profits of that company.
  • Since the share prices of a company that’s listed on the stock exchange keep fluctuating, you can utilise the short-term price movement to your advantage.
  • A good way to create wealth is to allow the value of the shares you hold to appreciate more significantly, over the long run. 
  • Established listed companies pay dividends regularly to their shareholders on either a quarterly, half-yearly, or an annual basis. When you hold a particular stock for the long term, you may get to enjoy dividend payouts in addition to an appreciation in the value of the shares.
  • At times, instead of a dividend payout, companies issue additional shares to their existing shareholders free of charge. This free issue of shares is termed as a ‘bonus issue.’ 
  • From time to time, companies also announce a rights issue in place of a dividend payout. In a rights issue, the existing shareholders are given the option to buy additional shares at an exclusive price that’s significantly lower than the current market price.
  • Shareholding is not the same as venture capital funding or bank financing.
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