Understanding Business Accounting For Dummies, 2nd Edition (82 page)

If new shares are issued at a price equal to the going value of the shares, the value of the existing shares should not be adversely affected. But if new shares are issued at a discount from the going value, the value of each share after the additional shares are issued may decline. For example, assume you own shares in a business and the shares are selling for £100 per share. Suppose the company issues some shares for £50 per share. Each new share adds only £50 value to the business, which drags down the average value of all shares of the company. We quickly admit here that the valuation of company shares is not nearly so simple - but, our purpose is to emphasise that shareholders should pay attention to the issue of additional shares for less than the going market price of a company's shares. Management stock options are the prime example of issuing shares at below market prices.

Many publicly-owned companies give their managers share options in addition to their salaries and other benefits. A
share option
gives a manager the legal right to buy a certain number of shares at a fixed price starting at some time in the future - assuming conditions of continued employment and other requirements are satisfied. Usually the
exercise price
(also called the
strike price
) of a management share option is set equal to or higher than the present market value of the shares. So, granting the manager the share option does not produce any immediate gain to the manager - and these options can't be exercised for some time anyway. If the market price of the shares rises above the exercise price of the share option sometime in the future, the share options become valuable -, indeed, many managers have become multi-millionaires from their share options.

Suppose that the market value of a company's shares has risen to, say, £100 and that the exercise price of the share options awarded to several managers a few years ago was set at £50 per share. And, assume that all the other conditions of the share options are satisfied. The managers' share options will certainly be exercised to realise their gains. It would seem, therefore, that the management share options would have a negative impact on the market price of the company's shares - because the total value of the business has to be divided over a larger number of shares and this results in a smaller value per share. On the other hand, it can be argued that the total value of the business is higher than it would have been without the management share options, because better qualified managers were attracted to the business or the managers performed better because of their options. Even with the decrease in the value per share, it is argued, the shareholders are better off than they would have been if no share options had been awarded to the managers. The shares' market value may have been only £90 or £80 without the management share options - so the story goes.

Classes of shares

Before you invest in shares, you should ascertain whether the company has issued just one
class
of share. A class is one group, or type, of share all having identical rights; every share is the same as every other share. A company can issue two or more different classes of shares. For example, a business may offer Class A and Class B shares, where Class A shareholders are given the vote in elections for the board of directors but Class B shareholders do not get a vote. Of course, if you want to vote in the annual election of directors you should buy Class A shares. Laws generally are very liberal regarding the different classes of shares that can be issued by companies. For a whimsical example, one class could get the best seats at the annual meetings of the shareholders. To be serious, differences between classes of shares are very significant and affect the investment value of the shares of each class of share.

Two classes of corporate shares are fundamentally different:
ordinary shares
(called
common shares
in the US)
and
preference shares
.
Preference shareholders are promised a certain amount of cash dividends each year (note we said ‘promised', not ‘guaranteed') - but the company makes no such promises to its ordinary shareholders. If the business ends up liquidating its assets and after paying off its liabilities returns money to its owners, the preference shareholders have to be paid before any money goes to the ordinary shareholders. The ordinary shareholders are at the top of the risk chain: A business that ends up in deep financial trouble is obligated to pay off its liabilities first, and then its preferred shareholders, and by the time the ordinary shareholders get their turn the business may have no money left to pay them. So, preference shareholders have the promise of annual dividends and stand ahead of ordinary shareholders in the liquidation of the business. What's the attraction of ordinary shares, therefore? The main advantage of ordinary shares is that they have unlimited upside potential. After obligations to its preference shareholders are satisfied, the rest of the profit earned by the company accrues to the benefit of its ordinary shareholders.

The main difference between preference shares and ordinary shares concerns
cash dividends
- what the business pays its owners from its profit. Here are the key points:

A business must pay dividends to its preference shareholders because it has a contractual obligation to do so, whereas each year the board of directors must decide how much, if any, cash dividends to distribute to its ordinary shareholders. You can find details of the average dividend paid by companies at any one time in the
Financial Times
. At the time of writing, this average stands at 3.1 per cent.

Preference shareholders usually are promised a fixed (limited) dividend per year and typically don't have a claim to any profit beyond the stated amount of dividends. (Some companies issue
participating
preference shares
or convertible preference shares, which give the preference shareholders a contingent right to more than just their basic amount of dividends, something which gets too technical for this book.)

Preference shareholders don't have voting rights - unless they don't receive dividends for one period or more. In other words, preference shareholders usually do not have voting rights in electing the company's board of directors or on other critical issues facing the company. Needless to say, these matters can become complex, and they vary from company to company - no wonder there are so many corporate lawyers! If you need more information we recommend
Investing For Dummies
by Tony Levene.

Here are some other general things to know about ordinary shares:

Each share is equal to every other share in its class. This way, ownership rights are standardised, and the main difference between two shareholders is how many shares each owns.

The only way a business has to return shareholders' capital (composed of invested capital and retained earnings) is if the majority of shareholders vote to liquidate the business in part or in total. Other than that, the business's managers don't have to worry about losing the shareholders' capital. Of course, shareholders are free to sell their shares at any time, as noted next.