The weird and wonderful world of corporate finance (by alaric)
Stock Markets
If I want to sell my share in a company, I need to find somebody who wants to buy it. Or perhaps somebody will find out I've got a share and come asking me to buy it.
One way to make this easier is for the company to list itself on a stock exchange (also known as a stock market). These are basically systems where people with accounts on the system can publish statements like "I have X shares of company Y, and you can buy them from me for £Z each" or "I want to buy X shares of company Y for £Z each", and then other people can accept those offers. It's all computerised, of course; you connect to the exchange via some kind of API and get real-time notifications of new offers being posted, and can post your own offers, or accept offers you see when they appear.
Companies need to meet certain requirements to be accepted by an exchange; they generally need to be above a certain size, and have more demanding requirements to file reports and stuff, and are subject to additional rules about statements they make to the public, because they're now in a situation where they could make some outrageous promise of future profits and the public might rush in and buy all the shares they can get, pushing the price up - the prices of shares traded on markets can be very volatile, because if there's sudden demand and people buy all the shares currently offered, people holding more of those shares will put them up for sale at higher prices, and if they all get bought, then more will be put on sale for even higher prices, and so on. Markets make it quick and easy to sell and buy shares, and people will naturally want their invested money to be invested in the companies with the best hope of future returns (more on that next!), so investors can shift their investment from one company to another on the slightest bit of news. This can get disastrous, so stock markets are carefully regulated and managed to try and stop things being so reactive and jumpy.
When a company "has an IPO" or "goes public", that's an Initial Public Offering, and means that company is first made available for sale on an exchange. The company will tend to publish a sort of prospectus explaining how wonderful they are and trying to convince people to buy shares in them, and on the agreed date, their current shareholders will put some or all of the shares they hold (and the company itself will probably make more shares to sell) onto an exchange for people to start buying. The price usually spikes up for a few days as all the excited people compete to buy the shares, then flops a bit, then stabilises. Those initial shareholders selling their shares tend to make a load of money in the price spike, so an IPO is done both as a way for the company to raise more money from the public at large, and for the initial shareholders to get some reward for having invested earlier, in the form of delicious cash.
Companies often give their employees shares as well as paying them a wage, and if the company IPOs, those employees often stand to earn a lot of money too.
The true value of shares
So, if you own a share in a company, what does that really mean? A few things:
As described above, you have voting power to appoint directors, change the M&A, that sort of thing! This isn't day-to-day control over the company, but it is control over the ways that day-to-day control of the company is allocated. However, if you have a tiny share, this vote is pretty worthless - whatever the majority shareholders want will happen, and you have no influence at all.
When the company makes a profit (more on this later), that profit is split between the shareholders, and called a "dividend". For instance, a company might pay quarterly dividends, so every three months the director decide how much of the company's profit to keep ("retained earnings") and invest in buying more factories or whatever to grow the company, and how much to give to the shareholders as a dividend. That dividend is then split. In theory, this is the real value: when a bunch of investors put money into a business, they do so for a share of the profit. But in practice it often doesn't work that way.
You can sell that share. A share in a company is property, and you can sell it (although in some contexts you might have signed a contract with the company promising not to sell the shares, they still can't stop you selling them - they can just take you to court for whatever fine you've agreed to in the contract, if you do).
The funny thing is, lots of companies (especially ones that are growing, so always have ways to spend money to grow more) don't ever declare a dividend. So all a share is really "worth" is voting rights, and as mentioned above, unless you have a lot of shares, or part of a big group of people who all want the same thing and collectively have enough shares, you will never win a vote so it's useless. So what use are shares in the company? Sure, you can sell them, but who would buy them if you don't want them?
Well, there's two groups of people who might want to buy a share in a company that has no dividends:
People who want to take over the company. If you own more than half the company, you have complete control over it, can appoint yourself and your friend as directors, and close the business down and sell everything or whatever you want. Like Elon Musk did with Twitter. But even if nobody is currently trying to buy the company, they might one day - and when that day comes, whoever holds the shares will be able to sell them at a good price, because that buyer is hungry to get lots of shares. To make a profit on that, you need to hold the shares before the potential takeover is announced, as when that happens everyone will be hoping to sell to the buyer, and won't sell them to you for a lower price.
People who are hoping for a future dividend. If the company is investing in itself and buying more factories and hiring more staff to make things and so on, so the company grows, eventually that growth will have to stop. At that point, the company owns lots of cool stuff, has lots of experience doing whatever it does, and without scope to spend money by keeping growing, it'll have to declare all its profits as dividends. If you hold shares in the company now, you can expect them to declare a dividend one day. The closer that day gets, the more the shares will cost as more and more people are anticipating that dividend. So if you buy shares now, you'll be able to get more of it for your money (and, thus, more dividends one day) than if you waited until that day was near.
The interesting thing about both of these is that the value of a share is entirely based around the hope of some future event - even if a company IS declaring dividends, it could stop at any moment, so you buy the share in it in anticipation of a future dividend. And yet, you might buy that share with no real interest in the future dividend - purely to sell it on to other people who ARE interested in that dividend, because you think they'll pay you more for it than you can buy it today.
So, really, the value of a share is very much "However much somebody who actually wants it is willing to pay for it", and for shares traded on markets, you can just look at the current buy/sell offers for that share to work out a number for that. Which can change on a second-by-second basis, and you'll often make more money by buying a share then selling it when the value has gone up than you'll ever get from holding onto it and getting the dividends.
Indeed, as long as there's people willing to buy the shares, then there's hardly any difference between a company declaring profits as a dividend, or just keeping them in a bank account in the company. If a company makes £10, they could give that £10 to you, or they could increase the value of your share in the company by £10 by keeping the money in a bank account. As long as there's a pool of people willing to buy the shares from you for a fair value, the extra £10 growth in the value is as good as cash to you, as you can just sell it when you want the cash.
The price of a share on a stock market is, in effect, a sort of weighted average of people's expectation of its future price, weighted by:
- How much money the person making the prediction has to invest
- What timeframe they're interested about
If a company looks set to make billions in a hundred years (perhaps they have a bunch of products that will be in high demand once we're colonising Mars) but is barely scraping by now, then people with money to invest that they aren't planning to spend for a century will all want to buy shares in that company. In ten years, those people will be joined by people with money they aren't planning to spend for 90 years: a slightly larger group, pushing up demand. Until in ninety nine years, as the first colony ships are preparing to set off, people who have some money to invest they want to spend next year will be wise to invest in this company - but by then the price will have gone up a lot, because loads of shares have already been bought be previous investors with longer time frames. So the profit you'll make when you sell those shares in a few years, once the Mars colonies are well established, will be that much smaller than if you'd invested a century ago. But on the other hand, you could have done something else with your money for that century.
In general, the return you get by putting your money into a share (or anything else with fluctuating value) is a statistically random number, with an expected distribution, and the higher the expected return, the higher the deviation in that return. This is an almost unavoidable rule, because these investments are all competing against each other on a market; and if there's a high return with low risk available, everyone will flock to that and not invest in the things with the same return but more risk, so they disappear. Different investors have different tolerances for risk, so there's a spectrum of desired tradeoffs, and anything offering a worse expected return than other things at the same risk:reward tradeoff just evolves into something offering a better return or disappears entirely. And there's also a spectrum of different timeframes for expected returns. And all of these desires from different investors go into this huge weighted average to control the market price.
Higher-Level Things
People have built all sorts of things on top of share trading, especially on stock markets which - with their accessibility via APIs - are inherently suitable for automation and experimentation that leads to interesting things.
Leverage
Ok, so say you see a share for sale on the stock market at £10, and you (being a person with advanced technical knowledge buzzword awareness of a particular industry) think that the business they're in will explode in a few years. You have £100 spare, so you buy ten shares. Sure enough, in two years, that company is the hottest hype and you can sell your shares for £100 each, making a tidy profit of £900.
But if you're pretty confident they're going to go up in value within two years, what if you borrowed £200 from a friend (to be paid back, plus 10% interest of £20, in two years) and bought thirty shares instead?
In two years (if your prediction is correct) you sell your shares for £100 each and get £3,000 back. You put in £100 of your own, and had to pay back £220 for the loan plus interest, so your final profit is now £2,680 - nearly three times as much.
On the other hand, if the company collapsed entirely and your shares were worth nothing, you'd have lost £100 before but now you've lost £320. However, the prospect of at most £220 extra loss versus £1,780 extra profit (or more, if the company's value goes up more than you expected) is pretty attractive.
This process of borrowing money to buy shares, thereby multiplying your gain (or loss), is called "leverage". In our example, we had approximately "3x leverage" by borrowing twice the amount we put in, to multiply our investment by 3.
Short-selling a share
If you think a company will do well, you can buy shares in them, and sell them if the company succeeds. If you're really sure the company will do well, you can take out a loan and use leverage to buy more shares and multiply your earnings.
But what if you think a company will do worse than everyone is expecting, that you predict its value will fall?
Well, there's a weird trick you can do in that case. You can borrow shares from somebody who holds them (promising to return them at some point in the future, and paying a small fee to them for the borrowing). (Generally, any dividends you get from the share are owed to the real owner while you hold the shares, too).
Anyway, once you've borrowed those shares, you can sell them and get the equivalent cash. And then when the company's value drops, before you need to pay the shares back, you can buy fresh shares at the now reduced price, which you then return to the lender. And if you're correct and the value has dropped, you can buy them back for less than you originally sold them for. And if they've dropped enough, you make a profit on this, even after paying the "interest" for borrowing the shares.
Of course, if the company goes up in value, you still need to buy those shares to give them back. If the company goes up a LOT in value, this can cost you badly.
But if the company completely fails and its shares drop to zero in value, you only need to pay the lender back the "interest" agreed on borrowing and you get to keep almost all the sale price of those shares.
Interestingly, because when you short a share you sell the borrowed shares on the markets, somebody can buy them and lend them out to another short-seller, and this can happen multiple times to the same share. Therefore, the amount of a share being "shorted" by people can exceed the total amount of the company in existence.
This can lead to problems with supply and demand; when short sellers are forced to return the borrowed shares, they need to buy them. If the shares have been extensively shorted, there will be significant demand to buy the shares back. This might not be a problem, as shorters buy the shares back and return them to the people they borrowed them from who then sell them on at a profit. But if the share has been shorted extensively, and then people sensing an improvement in the company's fortunes buy a lot of shares to invest in (so they won't be selling them back), short sellers are then competing to buy the remaining available shares. This can push the share price up very high, albeit only temporarily, making huge losses for short sellers and potential massive profits for canny investors who wait to sell.
Bonds
Selling shares isn't the only way companies raise money. They can also sell bonds.
After all, if a company sells shares, it sells part of itself. Forever, unless it can do a buy-back. It hands out control, and a share in future profits. But there's a way to raise money without doing that.
"Selling bonds" is actually "borrowing money", but looked at back to front. Consider these two cases:
I borrow £10 from my friend, promising to pay them back £11 next week.
My friend buys a contract from me, that I will pay them £11 next week. They pay £10 for the privilege.
Both are exactly the same thing, except the latter converts "giving a loan" into "buying a thing", and if you already have a load of infrastructure for buying and selling things (eg, stock markets), rephrasing things into buying and selling means you can re-use that infrastructure and knowledge better.
So, bonds are just a way to make loans look like shares. The interest on a loan? That's the "yield" of the bond, like a dividend on a share. And the fact that a loan has to be repaid on a certain date (which is called "maturing" for a bond) can be kind of hand-waved away to make it look more like a share: the company can be raising the funds to pay the bond holders back when the bonds mature by selling more bonds, so there's a constant flow of money in and out of bonds. When the company needs more money, it sells more bonds than it repays. When it's doing well and has spare cash, it slows down selling bonds so it's repaying more bonds than it's selling new ones.
And since bonds can be traded on markets, as a bond holder you don't have to wait until your bonds mature: you can sell them to somebody else. If you buy a bond that will repay £11 in a year for £10, then after six months you might be able to sell it for something like £10.50 - but, of course, there's always the fear that the company will go bankrupt and never repay you, so if the company is doing badly you might only be able to sell it for £10, or even £5. Nobody would ever want to pay more than the maturity value of a bond, though, so there's a maximum price - unlike a share.
And the fact that the company has to repay the bond at its maturity date is really just like the company buying the bond back, at a guaranteed price.
If a company closes down, bond holders get higher priority to be repaid than shareholders (who usually get nothing), and bonds do have the (unless the company fails) guaranteed price at maturity. So bonds are a less risky investment than shares. But on the other hand, they can't rise arbitrarily in value like shares. So bonds have lower returns, but much less risk, than shares.
The interest on a bond is called its "premium", and a company chooses what premium to offer on bonds carefully. If it can't sell enough bonds that repay £10 in a year for £9 (a £1 premium) it might need to try selling them for £8. What price it can sell bonds at reflects on a mixture of investor's confidence in the company being able to repay them, and whether there's easier ways to make money elsewhere; you won't sell bonds if people can just put the same money into a savings account and get a better return, unless they really want to help your company out for some other reason (like, you're doing a good project they like).
Also, governments sell bonds. They can't really sell shares in themselves, but they sure can sell bonds. Government bonds are known sometimes as "gilts" because, notionally, they're golden, or before computerised markets they were represented with bits of paper with gold leaf on the edges or something. Government bonds are considered pretty safe as it's rare for governments to collapse and not repay, so the risk is lower, and therefore, so is the reward: they tend to have smaller premiums than more exciting and risky bonds - because governments don't need to offer such a high premium to get people to buy their bonds, because they're trusted to repay. As with share prices, it's a risk/reward/time tradeoff; and since bonds compete for the same investment money as shares, the tradeoff coefficients end up exactly the same.
ETFs, unit trusts, funds
All this fiddling around with individual shares is risky, as individual companies' values can be quite volatile. Making the best of it requires careful study and understanding, and monitoring news about a company, and their own announcements, to try and gauge their future success or failure; because others will certainly be following them carefully, and any news will cause the price to change, as the weighted average of everyone's expections that defines the price adjusts to the market's best estimate of the true value of the company.
For people who just want to invest for a pension or something, and want some reasonably safe way of generating reasonable growth in their investment, this is all a bit too risky and stressful. So there is a whole market of things called ETFs, unit trusts, or funds.
They're all basically the same idea, just implemented slightly differently in ways that don't really make much difference. ETFs are the currently most popular kind, because they're quite efficient (low fees) and easy to use, so let's just use the word "ETF" from now on.
What an ETF is, is effectively a bunch of shares in certain proportions. A (unrealistically simple) ETF might be 50% in company A, 40% in company B, and 10% in company C. If you invest £100 in the ETF, the ETF will invest 50% of your £100 in company A, 40% in company B, and 10% in company C. As the values of the underlying shares vary, the value of your share in the ETF varies correspondingly. However, for the trouble of providing this service, the ETF provider will continuously take a tiny fraction of the value of your investment. This will be expressed as an annual percentage fee, but it's taken continuously rather than in a big lump once a year; after all, you can invest into an ETF one day and then sell your slice in it the very next day, and if they took the fee in a lump sum once a year, people would just sell out right before then!
Often, an ETF will choose its proportions of the underlying shares based on the total values of the companies involved (which can be worked out as: the number of shares that company has in circulation, times its share price). So ETFs usually just publicise the list of shares they hold, and it's taken for granted that the proportions are based on the total values of the companies involved.
There's a range of ETF providers, varying in the range of different ETFs they provide and what their management fees are. They tend to have names like "All-world all-cap" (meaning: they take a list of all the companies listed on all the markets in the world ("all-world"), without filtering them by the size of the company ("all-cap"), and invest your money in them according to the usual split by company value), or "Developing markets small-cap" (small companies in the developing world), or "European energy" (energy companies listed on European markets), and so on. The ETFs are traded on exchanges just like shares (the name literally stands for "Exchange Traded Fund") so it's pretty easy to buy and sell them.
By investing in such an ETF, you can effectively invest in a representative distribution of all the companies in the given sector the ETF is based on. This means that the individual variations between companies are averaged out, making your investment a lot less volatile. You just get to choose what sectors you think will grow better than others, and pick an ETF. Or you can just go for the All World All Cap and not try to be clever. Or you can take a middle ground - those All World funds at the time of writing are nearly one quarter large tech companies like Microsoft, and if you think they're over valued right now due to easily-fooled investers going nuts over AI hype, you might think that having only one tenth of your money invested in tech companies is better; so you could look at the proportions of different ETFs and do a bit of mathematics to work out a combination of ETFs that produce roughly the overall mix of shares you want (maybe put most of your money in the All World but then the rest of it into non-tech-biased ETFs to shift the proportions).
When shares in an ETF pay dividends, two things can happen, depending on how the ETF is set up. Either the dividends are distributed to the investors in the ETF, by the ETF just declaring a dividend like any other company would; or the dividends can be accumulated inside the ETF, being used to buy more shares in the underlying company, so the value of your share in the ETF just goes up a bit when dividends happen. This is usually put into the name of the ETF, as "(dist)" or "(acc)" or something like that. Many ETF providers make pairs of ETFs, each being distributing or accumulating "versions" of the same underlying mix of shares.
And, of course, there are bond ETFs (and combined share+bond ETFs). They buy bonds in companies, and when the bonds mature, they just use the money to buy more bonds, and as with shares: they either distribute the "interest" on the bonds as a dividend or accumulate it inside the ETF by using all the money from the bond maturity to buy more bonds.
Options
Instead of buying something (such as a share, but it could be anything - a bond, a barrel of oil, a potato, etc) you can buy an "option" to buy that thing at a specified price.
As it's an option, I don't need to take it. So it gives me more choice than just directly buying the thing, and as such, it should be no surprise that this will cost me a little more. I will either have to spend more money to buy the option to buy a thing at a likely price, or for less money I can get an option to buy it at a higher price than it's likely to be available at when the option is used.
Of course, if the thing goes up in price a lot more than the option seller expected, then if I use the option they'll be forced to sell the thing to me at under the price they could have sold it on the markets.
So, why do this? Why sell or buy an option?
Well, you might do it as a more complicated form of the whole price-prediction/gambling side of trading stocks. If you are confident something will go up in price, rather than buying it now, you might want to buy options to buy it at the current or a slightly higher price. This means you still have your money to do other things with in the meantime; and if the thing fails to go up in price as much as you'd hoped, you can cut your losses by just not using the option, and so never buying the thing. To make a profit on this, you need to think that the price will be higher than the people selling the options expect (or they wouldn't sell you the option at that price) - and you need to be right.
It might also be used as a way to dodge, er, pay less tax, or pay tax at a more convenient point. If a company gives its employees shares in the company to motivate them to work harder, then that's income those employees have earned - and they'll be taxed on the value of those shares (which can be hard to agree on, as well, if the company isn't being traded on a market at the time). Also, that tax will be due in cash while the shares are not cash, so the employee will have a bigger tax bill that they'll need to find cash to pay, somehow or other.
So, more often, a company will gives its employees "share options". The options will be valued very cheaply (so won't cause a huge tax burden on the employee when they're given), and will be options to buy the company's shares at a very very low price, under certain circumstances. Clearly, they have basically the same value as the shares on that basis, but national tax bodies tend to agree to an exception to the usual rules in this case, and tax them at their small notional value or not at all when they're issued - but they'll be taxed at the full value when they're used.
However, when the conditions of the option are met (generally something along the lines of "The company is being acquired or is about to IPO" then the employee can use the option to buy the shares for a pittance. As the options are used when shares are in high demand (acquisition or IPO), the employee can sell a portion of their shares right away to pay the tax bill, and their choice of how much they sell for cash to spend or keep in the hope of future growth.
Cryptocurrency, Society | alaric | 
Tue 8th Oct 2024 5:25 pm
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