Accounting and finance: the rationale

I’ll do my best to describe my understanding of finance, based on my accounting and finance classes this term, my discussion with the lecturer last week, and some thoughts I’ve put together since then. This post will be long and specific but some people have asked for it.

I will break up the topic into two posts. A 2000 word essay on accounting might be a bit much to take for readers of what Blogshares calls a humorous blog. This post looks at:

  • What is my function as a shareholder?
  • What does it mean, to own a ‘share’ in a company?
  • It seems like only the initial investors provide the needed capital. Why should subsequent investors get dividends and control of the company too?
  • So why does a company’s share price go up and down so much? Surely its assets don’t fluctuate from day to day?

The next post will be released in a few days and will consider:

  • Why does a company exist to profit shareholders?
  • What happens when a company fails? Who suffers the most?
  • Should companies be blamed for bad behaviour?
  • Is capitalism the answer? Is there are better way, waiting to be imagined?

I have been thinking about whether or not it is fair or desirable for people to live off a passive income from their share holdings. Companies operate to maximise profits to shareholders and in doing so, they may do things that I intuitively think is unfair, like downsize (‘rightsize’) their workforce, pollute the environment, avoid tax (legally), and lobby to keep perverse subsidies. What do shareholders do to justify such unswerving loyalty from the company? Well, I don’t do an awful lot, yet I’m getting money from dividends. And so, I’ve been worried that it is unethical for me to invest on the sharemarket.

What is my function as a shareholder?

Another way to ask this question is ‘How do shareholders contribute to the productivity of society?’ The traditionally held notion is that productivity requires three things: land, labour and capital.

In the past, aristocrats had a monopoly on land, which is the limiting factor in an agrarian society. Land is no longer so important, especially with the rise of knowledge-based services and the mass production of crops.

With the abolishment of slavery, nobody owns labour except their own (and maybe some powerful employee unions). Labour is not an asset; it does not show up on financial statements because a company cannot own its employees. Because you can only control your own labour, you will not get rich by working for a living.

Finally, society’s productive endeavours require capital, some means of obtaining the goods (shovels, computers, buildings) to do something. The function of shareholders is to provide capital. They also take on the residual risk, which I will talk about in the next post.

What does it mean, to own a ‘share’ in a company?

A ‘share’ is a claim on the assets of a company. The assets may be tangible, like property or equipment. They may be intangible, like money owed to the company and patents.

However, when an investor buys shares in a company, they’re not really interested in what the company owns at this moment. Its current assets are insignificant compared to the income that the company will generate over its life in the coming years. People choose to invest based on if they believe that future income will justify their initial outlay of cash and if they think they will do better here than putting their money in the bank, property or other stocks.

It seems like only the initial investors provide the needed capital. Why should subsequent investors get dividends and control of the company too?

When a company wants to raise money, it tries to convince potential investors that they will do better buying its stocks than anyone else’s: ‘Give me capital now and in return, you have a claim on my future income.’ The investor weighs up the risks and chooses to invest.

At some point, though, they decide they don’t want this risk anymore. In their opinion, the company’s fortunes are going down or they find an investment that they believe will give them better returns. So the initial investor says to the market, ‘Who would like to buy off me the risk of owning this company?’ and someone says, ‘Based on my analysis of the company’s prospects, I will buy the risk for this amount.’ If the price is acceptable, the exchange takes place.

So why does a company’s share price go up and down so much? Surely its assets don’t fluctuate from day to day?

Shares are a measure of a company’s value. Some of the value is based on its assets and liabilities (debts and obligations) but the most important things to a company’s prospects cannot be represented on a balance sheet. Things like research investment, many patents, staff experience and skills, brand, relationships with existing clients, company leadership, company strategy, all these aspects cannot be valued financially and/or controlled by the company, so do not show up on the balance sheet.

Their effects, however, do show up on the income statement, which shows how much money the company made over the year. Investors trying to decide what a good price for a company is will look at the income statement and extrapolate it into the future. In doing so, they have to make assumptions about the company’s growth rate, tax obligations, industry and political factors, the time horizon, and so on. All those things depend on the hard-to-value factors like brand and staff.

So, the reason why share prices go up and down so readily is that it relies on people’s different judgements of the company’s prospects and their own value of risk. This is why a stock price might plunge if a company is taken to court or spike if there is a new CEO. These factors are generally more important than how many buildings or bulldozers it owns.


  1. joanium says:

    Comments open!

    I accidentally clicked ‘Do not allow comments’. Of all entries, this one is one that prompts discussion! Silly me.

  2. Beldar says:

    Regarding share prices going up and down: a point that I think is often missed in these sorts of discussions is that as people/institutions use their judgement to determine how much a share is worth, they are also trying to judge how everyone else is judging their worth too. It can get viciously circular, as they also try to judge how other people judge how other people their worth, and so on. After a while of thinking like this it gets absurdly circular, but the point is that you soon start to have factors that influence the value of the share that are not directly indicative of the company’s income, investments, brand name, goodwill, etc. To put it another way, suppose you think a share is worth $20 based on all these factors, and that you have much experience at valuing shares so that this is a very accurate assessment. However, let’s say the current value is $15, and that you also have good reason to believe that the most of the rest of society will value the share at $15 for the next few years. Then, even though it looks like a bargain by your valuation, you still wouldn’t invest.

    To what extent this sort of effect actually happens is hard to say. It certainly happens when you get speculative bubbles, so I don’t think you can argue that it never happens. However, bubbles are at the extreme end of the scale because they can burst and generate a lot of attention, so I think smaller versions happen more often. I also suspect that higher liquidity amplifies such effects, which makes shares quite vulnerable to it. I believe that’s why they are often criticised for not really reflecting the ‘reality of the company’ very well – in the sense that the share price is not an accurate indicator of company performance, but is instead just a reflection of mass psychology.

  3. joanium says:

    In one of the lectures, the lecturer commented that the share price of large, established companies (like Microsoft, like BP) is the most accurate indicator we have of the company’s value. This is because the share price represents the findings and research of thousands of analysts. There is a strong incentive for them to get it right.

    If an investor values a company above the rest of the market, I would not say that one was ‘right’ and one was ‘wrong’. Company valuation is subjective. Either the investor has access to different information, values different things to the market, or has a fundamentally different point of view about the company’s or industry’s prospects.

    I suspect the kinds of speculative bubbles you’ve mentioned, Beldar, are more likely in the absence of good information. This means that small stocks with less investor interest (and less research available) are more prone to being priced ‘incorrectly’.

  4. Beldar says:

    I agree with you that the notion of a ‘right’ or ‘wrong’ share price is tricky, given the subjective nature of valuation. Perhaps some better terminology would have made my point clearer.

    I also agree with you that an absence of good information (and an absence of expertise to interpret the information) is likely to lead to bubbles, and that it is more likely for small stocks. However, that doesn’t mean they have a small effect. Remember the dotcom bubble – while they were mainly small stocks, they were thought of as one big class of stocks by investors who just poured lots of money into them, effectively treating them as one big stock. Leading to one big bubble.

    Here, the experts were feeding off each other. They weren’t really generating their own point of view on the company, even if they thought they were. They invested because others invested, and didn’t want to be left out.

  5. Beldar says:

    Sorry, what I was meant to say was:

    The experts may or may not be forming their own view of the company. The ones that are will most likely be basing their valuation on limited information. The ones that aren’t will be playing the me-too game, and feeding the bubble. There are always some of those.

  6. joanium says:

    I get the feeling that the dot-come frenzy was the product of group think and greed. To what extent can we limit the excesses of human nature? I don’t know what mechanisms in stock markets allow, promote or discourage that kind of thing. Perhaps someone out there will enlighten me?

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