What do you buy when you buy shares in a publicly traded company?

Today I would like to dive into the question of what you are actually buying when you buy shares in a publicly traded company.

Equity

If you are anything like me you’ve been thinking: “What’s the point of buying shares in the first place? Why would anybody want to do that?”

So why on earth would you want to buy shares in a publicly traded company?

Is it solely because the company pays a dividend or is there any other reason why you would want to invest your hard earned cash into something so intangible as a share?

In order to answer the question we first need to understand the capital structure of a company.

As always we come back to the fundamental accounting equation which looks like this:

Figure 1. The Fundamental Accounting Equation where Assets equal Liabilities plus Equity.

What this means is that when you have a publicly traded company you want your assets to be worth more than your debt so that the Equity portion is positive.

When the company is selling stock it is the Equity portion of the company divided by the number of shares outstanding that it is selling.

As always we can use Microsoft Excel to illustrate what we mean.

Let’s say that our company has a $1,000,000 in assets and $750,000 in liabilities. How much equity does the company have?

Figure 2. Screenshot of Microsoft Excel showing how to calculate the Equity portion by subtracting Liabilities (cell B2) from Assets (cell B1).

Then we can calculate how much Equity (or Book value) the company has per share by simply dividing Equity (cell B3) with number of shares (cell B4):

Figure 3. Screenshot of Microsoft Excel showing how to calculate the Equity per share by divideing Equity (B3) with Number of shares (B4).

The result in cell B5 is then of course $22.73. If the company has no Intangible assets the Book value is equal to the Equity.

Earnings

One consequence of buying shares of the Equity portion of the company is that the profits belong to the shareholders.

They do so since the Earnings are not part of the Liabilities (obviously), but part of the Equity portion of the company.

Negative equity

What happens then if the company has negative equity?

It is obviously a red flag and the analyst needs to look deeper into the financials to find an explanation.

Theoretically, if the company goes bust the shareholders owe money to different creditors.

Now, that is not going to happen because there are clear laws protecting shareholders from lawsuits, but it bears thinking about when buying into such a company.

In most cases negative equity is the result of preceding losses being carried forward.

Conclusion:

The fundamental accounting equation is as follows:

Assets = Liabilities + Equity

Why would you want to buy shares in a company? The reason is of course Equity which is the part of the business that is the “surplus”.