How investments work – Shares
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We are still working through this section about the different assets you can invest in and how they work. In this episode we are looking at shares. What does it mean to invest in shares? To answer that we need to look at what a company is and what a shareholder is and how money is made by investing in shares.
So what is a company? You may never have stopped to think about it so to make it clear I checked the Government’s website, www.gov.uk. It provides the following description of a company:
A limited company is an organisation that you can set up to run your business – it’s responsible in its own right for everything it does and its finances are separate to your personal finances.
Any profit it makes is owned by the company, after it pays Corporation Tax. The company can then share its profits.
Ownership; Every limited company has ‘members’ – the people or organisations who own shares in the company.
Directors are responsible for running the company. Directors often own shares, but they don’t have to.
Let’s start by translating what that all means. A company is responsible for its own affairs and its finances are separate from those of the business owner. If you are the business owner, that is good news; because if the business goes bust and owes money, you are not usually liable for the debt. (There are some exceptions depending on the debt where a director can be liable).
When a limited company business goes bust and has insufficient assets to meet its liabilities it is in the same position as an individual going bankrupt. Bankruptcy for companies is called insolvency and when that happens, an insolvency practitioner is appointed. Their job is to
- Settle any legal disputes or outstanding contracts
- Sell the company’s assets and use the funds to pay the creditors
- Make payments to creditors
- Complete all the relevant paperwork
- Pay the final VAT bill
- Settle the liquidation costs using funds raised through the sale of company assets
The creditors are not paid out equally as there are rankings of creditors to decide who gets paid first. The order of preference is,
- Secured creditors who have a legal right or charge over the property. This called a fixed charge and can be made over various assets such as machinery, vehicles and equipment.
- Preferential creditors – mainly employees in respect of their unpaid wages or unpaid pension contributions.
- Floating charge creditors – a floating charge is one that is secured against other assets in the company such as fixtures and fittings, stock, raw materials and cash. A fixed charge on such assets would be impractical – taking security for every chair and desk would be a nightmare
- Unsecured creditors – these are creditors who have no security and include the likes of trade creditors, suppliers, HMRC for VAT (of course they were never going to be last on the list!) and then others.
- Connected unsecured creditors – refers to where directors or employees have provided loans to a company on an unsecured basis. Usually it is by family members or spouses.
- Shareholders are at the back of the queue.
Of course it’s bad news if you had lent money to the business; you cannot sue the business owner for your loss. Your only recourse is to rely on the insolvency process finding enough assets in the business to pay out something to you. Remember in the last episode I mentioned about corporate bonds being sold as deposit accounts to unsuspecting investors? That is exactly what happened to them.
As a shareholder or investor in the company’s shares you would rank below corporate bond holders in the insolvency process. You get back what’s left, if anything, after everyone else has been paid. In some cases you could lose your entire investment. No wonder people are nervous about investing in them.
When you buy shares you are puting your faith in the directors to run the business profitably.
Let’s run through an example of how someone might set up a business as a company and why. Steve is setting up a trading business, Steve Wood Supplies. He wants to ensure that his personal wealth is kept separate from the business but he is looking to put £100,000 of his own money into his company. He doesn’t want to risk his house or other assets and for that reason chooses to set up a private limited company, Steve Wood Supplies Ltd. He will own all the shares and the £100,000 will be his share capital which he will use to pay bills, buy stock, and pay rent. He is confident that he will be bringing in business long before the money runs out. For Steve the limit of his liability is £100,000, because the company finances are separate from his personal finances. No-one can take him to court to make a claim on his own wealth.
Steve starts to trade and soon has his first orders. He is buying and selling timber around the world. He buys it at a cheap price at source in South America and arranges shipping, insurance and delivery to sawmills in Europe. The timber sells for a higher price in Europe, which includes a profit margin of 25% for Steve’s company. In the first year he has made a profit of £10,000, after paying himself a salary, which he takes as a dividend. A dividend is a way of distributing the profits the company has made, each share receives the same dividend payment.
In year two he has a similar trading year and takes another £10,000 dividend. The following year Steve has increased his profit to £20,000 and is doing well – his dividend is now double what it was in his first year.
In the first year, Steve made a return on his £100,000 investment of £10,000 in the form of dividends, that is, a 10% return on his capital. By year three he has received £40,000 in dividends. If he carries on at the same rate he will soon have had all his original investment back.
In year five there is a recession in the wood trade and Steve has his first bad year when he breaks even, making no profit. He cannot afford to pay himself a dividend but learns a valuable lesson; rather than taking all the profits out each year, in future he will hold some back in reserve, so that if he has to go through another tough trading year, there will still be money in the company to provide a dividend.
Ten years later, Steve is making steady profits. The dividend he receives is now £30,000 each year and he has reserves in the business to pay out for two years (£60,000) if there is a downturn in trading.
Let’s try and put a value on Steve Wood Supplies Ltd. He has £60,000 in the bank, he has orders which he is meeting that will generate another £30,000 in the next twelve months and he has assets (car, computer, office furniture and stock) of £10,000. The total assets of the business are worth £100,000 (60,000 +30,000 + 10,000 = 100,000) so the business could be worth £100,000. If you were to buy it, though, you could afford to pay Steve a salary and still expect to generate the same levels of trading in the coming years. The profits from those future years can also be factored into the value. Let’s say they are worth £80,000, so the total value of Steve’s business is £180,000. If he has 100 shares then each one is now worth £1,800 (100 x £1,800 = £180,000). Lucky Steve!
What would the return on your investment be if you bought the company? A purchase price of £180,000 would provide you with the dividends of £30,000 each year. If that were expressed as an interest rate it would be 16.67% a year. Not bad!
If only investment in shares were always that simple and profitable!
There is one aspect of the returns we haven’t covered in this example. That is what happens to the share price? If the profits keep going up and up, it will affect the value of the shares. Without going in to too much detail, what would happen if Steve’s business kept increasing profits every year? Increased profits mean increased dividends. If you bought the business for £180,000 and the dividends continued to rise over the next ten years to say treble their current level that would be £90,000. That would equate to a dividend yield of 50%. In reality that is highly unlikely to happen, because the value of the shares would go up accordingly.
That is probably enough for one episode so make sure you tune in to the next one when we will continue the look at shares.
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Till next time thanks for listening and goodbye!