Often lost in the conversation among amateur investors is the purpose of issuing stocks (or having an IPO) for the companies whose equity the stocks actually represent. Learning the fundamentals of a corporation’s motivation for issuing shares and the consequences that such action can have on shareholders is critical for a casual investor to accurately value their portfolio and inch closer to financial fluency.
What is a share?
A share of stock in a corporation is merely a finance term for owning a portion of the company. For instance, if a company issues 100 shares of stock, and an investor owns 5 of those shares, then that investor owns 5% of that company. The motivation for the company to issue these shares is simple: in order to raise money for future projects, the company sells a portion of ownership to the public. Thus, an investor should never forget that 100% of the shares (the market cap) of a company should equal the real value of that company.
Institutional investors spend a great deal of money determining what this “real” value is, generally by using a formula called Discounted Cash Flow, or DCF. Simple calculations for this are openly accessible for all publicly traded companies. When a company is “undervalued,” as in the market cap is less than the value of the company, an investor should buy shares in that company with the understanding that the share price will increase. Shares are the most basic form of equity, thus making it an important building block in achieving financial fluency.
What is an IPO?
An IPO, or Initial Public Offering, is merely the first time that a company openly sells ownership shares to the public. However, this is not the only time a company may sell its own stock to raise additional capital. The effect of further sale of shares is called “dilution,” as the new sale “dilutes” the value of each share of stock. To return to our earlier example of the investor with 5 shares in a company which has issued 100, if that same company were to issue 100 additional shares the investor would then own 2.5% of the company.
This reduces the value of each individual share, although the new capital raised by the company can offset this reduction by making the company itself more valuable. When faced with dilution, investors must thus reconsider the value of their investment in terms of the size of the dilution and the effects that the new capital will have on the company with regard to future growth. By surrounding yourself with a greater understanding of the markets, you can continue to step closer to financial fluency.