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.