2.7 Why Do We Invest In Shares?

INVEST IN SHARES BECAUSE

But obviously, making money is the motive to invest in shares. This can be divided into two reasons - expectation of dividend and capital gain.

As long as you are the owner of shares in a company you can also receive a dividend provided the company makes profits. Dividend is your personal share of the company’s profits, in proportion to the number of shares you own. However, loss-making or companies with marginal profit do not declare any dividend. Remember that dividend is computed on the face value of the share. Therefore 20 per cent dividend of Infosys share means that you will not get 20 per cent of the market value but 20 per cent of the face value. In the case of Infosys, this is Rs 5 and therefore you will get Rs 1 for each share. Dividend is generally paid to you by cheque every six months.

Capital gain is another important way of making money from shares. For example, if you buy a share of a company for Rs 150 today based on the strong fundamentals of the company, the company’s share price is bound to go up. It could shoot up to Rs 250. So in this case your capital gain out of selling this stock is Rs 100. Right? In most of the cases, people invest in stocks expecting this capital gain. The reason is that the stock prices are bound to go up over the years as companies grow. However, in some cases the share prices come crashing down due to unexpected market conditions.

Look at what happened recently. All of you would have heard of the sudden fraud that was unearthed in Satyam Computers. When this was publicly announced on January 7, 2009, the stock prices of the company went down by 78 per cent. That was a tremendous loss to shareholders.

Bonus shares

Bonus shares are nothing but shares issued free of cost to the shareholders of a company. If a company makes high profit for a few years, it is eligible to make a bonus issue. The number of shares gifted is proportional to the number of shares held. The usual ratios in which bonus is issued are 1:5, 2:5, 4:5, 1:4, 1:1 etc (1:2 implies one share gift to every two shares held). Companies like Microsoft decide not to pay out dividends to shareholders even when they are making profits. Instead they reinvest all the money in the business to try and make it more competitive and more successful and give out bonus shares. reinvest all the money in the business to make it more competitive, and give bonus shares.

Stock splits

Stock splits are a relatively new phenomenon in the Indian context. It is important that investors understand the reasons that companies may split their shares and how a stock split is different from a bonus issue. In a stock split, the capital of the company remains the same, whereas in a bonus issue the capital increases and the reserves decrease. However, in both actions (a stock split and a bonus) the net worth of the company remains unaffected.

A typical example is a 2-for-1 stock split. Say a company announces a 2-for-1 stock split. This means following the stock split, the company’s shares will start trading at half the price from the previous day. Consequently, you will own twice the number of shares you originally owned and the company, in turn, will have twice the number of shares outstanding.

The question that arises is that if there is no difference to the wealth of the investor why does a company announce a stock split? The primary reason is to infuse additional liquidity into the shares by making them more affordable. It needs to be reiterated here that the shares only appear to be cheaper, though it makes no difference whether you buy one share for Rs 3,000 or two for Rs 1,500 each.

Share Buybacks

A share buyback is quite different from a bonus issue or a stock split. Essar Oil, Reliance, Siemens and Infosys are some examples of companies that have bought back their shares. A buyback is essentially a financial tool in the hands of the corporate that affords flexibility in the capital structure. A buyback allows the company to sustain a higher debt-equity ratio. It is also a tool to defend against possible takeovers. Generally, companies buy back their shares when they perceive their own shares to be undervalued or when they have surplus cash for which there is no ready need for capital investment.

Rights Issue

A rights issue is a way in which a company can sell new shares in order to raise capital. Shares are offered to existing shareholders in proportion to their current share holding. The price at which the shares are offered is usually at a discount to the current share price, which gives investors an incentive to buy the new shares - if they do not, the value of their holding is diluted.

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