How Does Buying Shares Make Money?

Have you been wanting to buy shares but haven’t done so because you want to have a better understanding of how they work? Then this article is written just for you: A share is a unit of ownership in a company.

When a company lists on the Malawi Stock Exchange (MSEX) they offer the market a fixed number of shares at a given price.

People who want to buy the shares submit their firm interest by stating how many shares they want to buy and providing a cheque to that value.

Example:

If Mandasi Okoma Ltd decided to list 100, 000 shares at a value MWK500 each it would mean the company is valued at MWK50,000,000 (100,000 x MWK500).

If you wanted a 0.1% ownership in the company you would buy 100 shares for MWK50,000 (100,000 shares x 0.1% x MWK500). You are now one of the owners of the company. So, how do you make money? There are two ways.

Dividend Income

Firstly, periodically the company shares some of its profits with its shareholders via the payment of a dividend. When you work, you earn a salary; when you lend, you earn interest; when you buy shares, you earn a dividend.

This then becomes an (additional) source of income for you. Some retired people in the developed world with large, well-diversified portfolios live primarily off dividends with no need for another source of income. Wouldn’t that be nice?

Capital Growth

Secondly, you get capital growth. What does this mean?

If the company you have invested in does well, that is, it grows its customer base and starts to earn more revenue then it becomes more valuable.

In the above example the company starts off with a value of MWK500 per share. If the value increases over a period of time to say, MWK600 per share, then your MWK50,000 investment becomes worth MWK60,000. You make a profit of MWK10,000.

What are some of the issues you might encounter in dealing shares?

1. You don't get allocated as many shares as you want.

If there are more people wanting to buy shares than the number of shares available then you might not get any shares at all or you'll get allocated less than what you tendered for. The company selling 100,000 shares may get payments equivalent to 200,000 shares. We say the share offering is “oversubscribed” to define this situation of excess demand. In that case, the company’s investment bankers might give everyone half of what they asked for. However, that’s not usually how it works.

If the share offering is "oversubscribed" those that want a small amount will normally get all they ask for and big tickets will get cut by a large amount.

Why does this make sense?

Large shareholders carry a lot of power: they have more influence on corporate policy and if they decide to sell their holding all in one go, they would cause the share price to fall by a large amount. No company wants this, they would rather have many small shareholders than a few large ones.

2. Share prices can go down as well as up.

This is probably the biggest problem you'll face. When you buy shares and become a part owner in a company you can lose all your money. If something goes wrong lenders, such as banks, are paid back first and if there's nothing left to pay the shareholders then so be it. We'll discuss this in more detail next week.

"Rule No. 1: never lose money; rule No. 2: don't forget rule No. 1." Warren Buffett

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