Understanding equities

I am a new investor into shares and would benefit from an overview of how the stock market works, regarding what determines a share price and how to value a share. Can you give such an overview?

Firstly, we must determine what a share is. In order to raise capital, a company may issue shares or equities, to sell to potential investors. In buying a share(s), the investor is in effect buying part of that company and its future profits. Becoming a shareholder also gives the investor certain rights, namely:

¤ part ownership of the company;

¤ access to attend and vote at annual general meetings;

¤ receipt of a dividend distribution;

¤ receipt of the company's annual results.

Share prices in the secondary market reflect the supply and demand for the individual share. The supply derives from shareholders wishing to sell their shares and the demand is derived from investors wishing to buy shares. If the demand for a share is greater than the supply (more people wish to buy than sell) then the share price rises and vice versa.

Many factors can affect the price of a share. In the long term the share price is a reflection of the company's financial situation and how well it is considered to be performing relative to the market. The dominant factors affecting the demand for shares can be categorised broadly as:

¤ macro factors - political events, legislative changes, unexpected events such as terrorism, interest movements and inflation forecasts; and

¤ micro factors - company announcements (including profit forecasts/warnings), merger and acquisition activity, and changes in management and competition.

There are many different ways to assess the prospects of both the company and the shares to determine whether they are good value:

¤ earnings per share (EPS), a calculation dividing the company profit by the number of shares in issue;

¤ price earnings ratio (P/E), to measure how highly investors value a company as a multiple of its earnings. It gives an indication of expected performance and earnings growth;

¤ dividend cover, a measure of dividend safety, indicating how many times a company can pay out dividends from its profit. The higher the dividend cover the less likely dividends will have to be reduced if profits fall; and

¤ net asset value (NAV), an indication of how the amount an investor can expect to receive if the company were to go bankrupt. Shareholders are on the bottom rung of the ladder and therefore bear the greatest risk of losing some or all of their capital.

One must also note that the stock market has the potential to deliver higher returns than other investments, such as savings and bonds. There is however significantly more risk involved and more detailed knowledge is required before buying individual stocks.

A convenient way to gain exposure to equities and to diversify risk is to invest into a collective investment scheme or fund. (Source: Royal Skandia)

Mark Hollingsworth is the director of Hollingsworth International Financial Services - licensed by the MFSA to provide investment services under the Investment Services Act 1994 (IS/32457). Address any financial questions to: Mark Hollingsworth, c/o The Sunday Times, PO Box 328, Valletta CMR 01. Alternatively, he can be contacted on 2131-6298/9984-2614 (office hours) or e-mail mh@hollingsworth-int.com

Past performance is no guide to the future and, except where amounts are guaranteed, the price of your investments (and the currency in which it is denominated) may fall as well as rise. Your personal tax situation will depend on residence. Always consult a professional adviser. This article does not intend to give investment advice and its contents should not be construed as such. Readers are encouraged to seek professional advice on their personal financial situation.