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A company, while seeking to raise capital, has two basic sources of capital to consider. It could take on debt by borrowing from lenders through a variety of debt instruments, such as debentures, which allows it to raise money from the public; or it could raise money through equity, i.e., by issuing shares. Here, the firm trades part ownership with investors in exchange for their capital. There are several types of shares, from preference shares to equity shares. In this article, we aim to better understand equity shares - how they function, the pros and cons of acquiring them, and some equity share strategies.
Key Takeaways
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Equity shares represent ownership in a company, offering voting rights and potential dividends. They are long-term financing instruments that enable investors to participate in a company's growth and profit from capital appreciation.
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Investors can buy equity shares via IPOs or stock exchanges using linked Demat, trading, and bank accounts, allowing seamless purchase, sale, and portfolio management through registered stockbrokers.
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Equity shares offer high liquidity, inflation-beating returns, and compounding benefits, but dividends are variable and investors bear greater risk, especially during a company's liquidation, compared to preference shareholders.
What are Equity Shares?
Equity shares are a long-term financing option for firms looking to raise capital. Each equity share represents a unit of part ownership in the company. Equity shares, also known as common stock or common shares, are offered to the public as an investment opportunity.
To compute Equity Shares, use the formula:
Number of Equity Shares Issued = Total Equity Capital Raised / Face Value per Share
For example, if a company issues ₹5,00,000 worth of shares with a face value of ₹10, the calculation is 5,00,000/10, yielding 50,000 equity shares. This metric represents the total number of ownership units issued by the company. It's essential to note that market conditions can influence the market value of these shares, and investors often consider additional indicators, such as Earnings Per Share (EPS) and the Price-to-Earnings (P/E) ratio, for comprehensive analysis.
Types of Equity Shares
Ordinary Shares
Ordinary shares are a primary vehicle for companies to secure long-term funds, granting investors ownership benefits and substantial voting rights. Investors with a significant holding of these shares wield considerable influence across various management aspects, but that influence is largely proportional to their ownership percentage.
Preference Shares
Preference equity shares, issued with the guarantee of receiving cumulative dividends before ordinary shareholders, lack voting and membership rights associated with common shares. The classification between participating and non-participating preference shares further impacts potential returns, as participating shareholders may receive additional dividends based on the company's performance during a specific financial period.
Bonus Shares
Bonus shares are derived from a company's retained earnings and give current shareholders extra stakes without altering the overall market capitalisation. Unlike other equity instruments, bonus shares symbolise the capitalisation of excess funds generated by business operations and are issued to existing shareholders at no cost.
Rights Shares
Rights shares, issued at a discount, serve as an invitation for existing shareholders to increase their stake within a specific timeframe. This strategic approach enables companies to raise the required finances for specific expenditures while giving current investors the first opportunity to increase their ownership stake.
Features and Advantages of Equity Shares
Unlike saving, investing has a higher risk but offers higher returns and, if done properly, takes a shorter time to reach financial goals. Equity shares are a long-term financing option for companies looking to fund their business operations. Stockholders of both equity and preference shares can enjoy several perks/advantages.
Voting rights
Arguably, the biggest plus point for possessing equity shares is that holders of equity shares are handed voting rights in the form of a say in the election of the Board of Directors, etc, as well as having a voice in business decisions of the company, since the operations of the company will have a direct effect on the returns they gain from the company. If you possess a large amount of equity shares, you are also granted substantial voting rights.
Admission to meetings
Those holding equity shares are allowed to attend the company's Annual General Meetings (AGMs) and any Extraordinary General Meetings (EGMs) held by the company, and they have a say in the company's business functions through their voting rights.
Dividend payments
Stockholders also qualify to receive dividends on their shares. However, there is a difference between the benefits holders of common stock receive and those holding preference shares. Dividend payments to equity shareholders are not fixed and can vary based on the firm's performance and contingent on meeting certain goals. Thus, while equity shareholders are eligible to receive dividend payments, these payments are not guaranteed. For preference shareholders, dividend payments are generally fixed but contingent on the company declaring a dividend.
Equity Shares are Irredeemable
The proceeds from equity shares are not refunded to investors during the company's lifetime.
Equity shareholders can either redeem their capital by selling their equity shares on the secondary market or receive a portion of the remaining assets when the company winds up and all prior claims have been settled.
Many companies issue only common stock, and more common stock is traded on exchanges than preferred stock. However, when a company fails, common stockholders have the lowest priority for recovering any of their money. Creditors who have lent money to the company get paid back with top priority. Even if some money is left after paying creditors, the holders of preferred stock are paid next. This is subject to a maximum amount. Only if money is left over after that do common stockholders get paid. It is common for common stockholders to receive nothing in a liquidation scenario.
Important Facts to Know About Dividends
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Companies may pay annual, quarterly, or special one-time dividends from their profits, but are not legally obligated to do so, except for certain structures such as REITs.
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In India, income from dividends became taxable in the hands of the investor from April 1, 2020, under the Income Tax Act, 1961.
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Companies can pay either variable dividends, based on earnings, to common shareholders (common dividends), or fixed-rate dividends to preferred shareholders (preferred dividends).
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Companies are not legally obliged to pay dividends, but once a dividend is declared, it becomes a legal obligation.
Dates to Remember
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Declaration Date: When the company's board of directors approves and announces the dividend, specifying the amount, ex-dividend date, record date, and payment date.
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Ex-Dividend Date: The cutoff date that determines which shareholders are eligible to receive the dividend. You must buy the stock before this date to receive the dividend. The stock typically trades at a lower price on this date to reflect the dividend payout.
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Record Date: This date follows the ex-dividend date and is when the company checks its records to determine which shareholders are eligible.
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Payment Date: The date when the dividend is paid to eligible shareholders.
Benefits of Dividends to Investors
Dividends provide investors with a stable return on their investments, which is low risk. In addition, as organisations continue to grow, dividends increase, raising the value of the stock for investors. They also allow you to reinvest your dividends.
Investors need to bear in mind that higher dividends do not always mean better, as companies paying high dividends are unable to sustain them in the long term.
Companies in the stock market that have a consistent track record of distributing profits as dividends to shareholders are referred to as dividend stocks. Since they’re well-established and have already peaked and matured, these stocks usually have a much lower future growth potential than growth stocks.
Among the category of dividend stocks, there are two primary sub-categories – dividend growth stocks and high dividend stocks. Dividend growth stocks possess a greater potential for future dividend rate increases. On the contrary, high dividend stocks may or may not increase the dividend rates in the future, since they’re already paying out a significantly high rate.
Why Should You Invest in Equity Shares?
Investing in equity shares with a goal of long-term wealth creation and potential results can yield you enormous benefits. Not only does investing in equity shares provide the benefit of dividend income, but it also allows you to easily buy and sell shares and gain an ownership stake in the company with associated voting rights.
Here are some key reasons to invest in equity shares:
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Potential for high returns: Traditionally, equities have delivered higher returns than other assets, such as bonds or fixed deposits, over the long term. As the company grows and profits increase, the share price also rises, leading to significant capital gains for investors.
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Can Beat Inflation: Investing in equity shares can serve as an effective hedge. Not only can it help you to preserve, but it can also grow your wealth.
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Dividend Income: Dividend income is often seen as a steady secondary source of income. If and when a company makes a profit, it may reserve a portion of its earnings as dividends for shareholders.
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Ownership and Voting Rights: Along with being a part-owner of the company, purchasing equity shares also grants an important right: the right to vote on key corporate matters, including the election of the board of directors and other major business decisions.
Equity vs Other Investments
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Equity requires low investment: Unlike Fixed Deposit, Gold & Real estate, you can enter the equity market with a much smaller capital.
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Equity offers higher returns: It is historically proven that Equity offers better returns than FD, Gold & and Real Estate.
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Returns on equity investments help maintain and grow your purchasing power over time (beating inflation), but they are not completely tax-free in India. Long-term capital gains (LTCG) exceeding an exemption limit of ₹1.25 lakh per financial year are taxed at 12.5%. Short-term gains are taxed at 20%.
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Equity offers high liquidity. Equity can be bought & sold very easily & converted to cash pretty fast.
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Equity is the best-performing asset class. Equity increases your wealth faster over the long term due to compounding, capital appreciation & dividend income.
How to Buy Equity Shares?
To engage in stock market investments and acquire equity shares, a crucial trio of accounts is necessary. Firstly, a Demat Account is essential, serving as the repository for holding shares in the investor's name. Secondly, a Trading Account is imperative, allowing the placement of buy and sell orders through a stockbroker registered with a stock exchange. Lastly, a Linked Bank Account completes the trio, facilitating seamless financial transactions.
Different Investment Methods:
IPO Way [H4]
When a firm initially goes public, investors can buy equity shares through an IPO. During an IPO, investors can apply for shares via their net banking accounts (using systems like ASBA - Application Supported by Blocked Amount) or bid on the company's shares on stock markets. This strategy enables anyone to become a shareholder in a firm by making its shares publicly available for the first time.
Stock Market Purchase
Besides IPOs, investors can buy and sell equity shares on the stock exchange throughout the year. This entails creating a Demat and Trading account connected to your bank account. After this, log in to the trading account, select the desired shares, and determine the purchase price. Once the order is executed, the shares are automatically credited to your Demat account, and the amount is debited from your trading account margin without manual transfer. This allows investors to actively engage in the stock market, respond to market trends, and adjust their portfolios as needed.