Shares – the basics. Why you shouldn’t be scared.

Shares – the basics. Why you shouldn’t be scared.

I love shares because they are an easy way to invest. I think a lot of people are scared, or prefer investing in property because they understand it better.With property you;

  1. Buy a house
  2. Rent it to someone for money
  3. Save on tax
  4. Sell the property when it’s gone up in value

However I think some people are more hesitant to invest in shares because they don’t understand the real basics as easily as they do property. So here it is!

A business can be owned a number of different ways. One of the most common ways is what is known as a Limited Company. This essentially means that for most purposes the company is treated as a fake person. Whatever the company earns it gets taxed on, it can hire people, it can own property, it can make a profit and have bank accounts.

Now a company itself can be owned by one person, or many. The profits of the company get distributed fairly to whoever owns it. So let’s say we have a company which has 100 shares available. That means that each “Share” of the company owns 1% of the company. There are 10 owners, each with 10 shares – each shareholder owns 10% of the company.

Having a share in a company gets you 2 benefits.

  1. A share of all the property it owns.
  2. A share of the profits it makes.

So if our company has $10,000 in the bank, a wharehouse and a shoe-making machine, each 1% share “owns” $100 + 1% of the warehouse + 1% of a shoe-making machine.

This company currently builds shoes, and they manufacture 1,000 shoes a year, each shoe selling for $10 profit. This means that the company is making $10,000 profit a year. Every “Share” of this company is going to give the person that owns it 1% of the profit, which is $100/year (Known as a dividend). Because the shareholders each own 10 shares, they will each receive $1000/year, provided the company continues to make 1,000/year each selling for $10 profit.

I think the whole reason people get confused or scared of buying shares, is because they really don’t truly understand those 2 most basic principles, and they get too caught up in other factors.

Now, valuing a share is a bit more difficult, but essentially it comes down to personal choice. If you could buy a share in this shoe-making company, what would you pay? 1 Share has $100 in the bank + 1% of a warehouse (let’s say 1% of a warehouse is worth $100) + 1% of a shoemaking machine (let’s again say 1% of a shoemaking machine is worth $100.)

This means you already own $300 worth of property for one share, and then you can expect it to make $100/year forever. Let’s assume there is no risk, and each share in this company will continue to make you $100/year forever, how much would you pay?

Myself? For me, the value of a share is based on all the future dividends I’ll receive. If there was no risk that I’d receive $100/year in dividends per share I own, every year without fail, well I’d pay around $800.

The speculation with shares is 100’s of factors come into play. Will people always wear shoes? Will these shoes always be desireable? Are management stupid? Are management really smart and expanding? Is there another shoe manufacturing company opening? Will shoe profits actually go up to $20/shoe? Will they drop to $1/shoe? is the shoemaking machine needing repairs? There are many many things to consider, and no-one ever knows them all, your best guess might be better/worse, but provided you understand the basics really well, you’ll never be too upset with your decision.

So don’t be afraid, just understand what you are doing.

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