A company, while looking to raise capital, has two basic sources of capital it can consider. It could take on debt, wherein it borrows money from lenders through a variety of debt instruments such as debentures that allows them to raise money from the public; or, it could raise money through equity i.e. by issuing shares. Here, the firm trades part ownership of the firm with investors in exchange for their capital. There are a number of types of shares, from preference shares to equity shares. In this article, we will aim to better understand equity shares, how they function, pros and cons of acquiring equity shares as well as some equity share strategies.
What are equity shares?
Equity shares are defined as long-term financing options for firms looking to raise capital. Each equity share represents a unit of part ownership in the company. Equity shares are also referred to as common stock, or common shares, and are offered as an investment opportunity to the public.
Features and advantages of equity shares
Unlike saving, investing has higher risk, but gives higher returns and if done properly, takes a shorter time to reach financial goals. Equity shares are considered to be a long-term financing option for companies looking to fund their business operations. For holders of preference shares, there are a number of perks/advantages they can enjoy.
Arguably the biggest plus point for possessing equity shares is those holders of equity shares are handed voting rights in the form of a say in the election of GMs 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 a seat at any annual and/or general body meetings the company has, alongside a say in the business functions of the family granted to them by their voting rights.
Holders of equity shares also qualify for dividend shares. However, here is where there is a difference between the benefits holders of common stock receive when compared to those holding preference shares. Dividend payments to equity shareholders are not fixed and can vary based on the performance of the firm and contingent on it meeting certain goals. Thus, while equity shareholders are eligible to receive dividend payments, these payments are not guaranteed. For preference shareholders, however, dividend payments are fixed.
Equity shares are irredeemable:
The money raised from equity shares is not refunded to investors during the lifetime of the company. Equity shareholders can either redeem this capital by selling their equity shares, or will receive it when the company winds up, based on what their equity shares are worth at the time.
Many companies only issue common stocks, and there are more common stocks sold in the exchanges than preferred stocks. However, when a company fails, the common stockholders have the lowest priority when it comes to getting back 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 the creditors, the holders of preferred stocks get paid next. This is subject to a maximum amount. Only if money is left even after that, common stockholders get paid.
What are preferred stocks?
There are two main reasons why these stocks are called preferred stocks. Holders of preferred shares receive regular dividends which are higher than those received by holders of common stocks. Preferred stocks pay dividends which are agreed upon beforehand unlike common stocks which pay dividends based on how profitable the company is. One difference between common stocks and preferred stocks is that preferred stocks do not have voting rights.
In some ways, preferred stocks are like a bond. They have a par value based on which the dividend is calculated. Let us say that a preferred stock is worth Rs 1,000 and the dividend is 5 percent. Then the stock must pay Rs 50 as dividend every year as long as the stock is outstanding. When it comes to risk, a preferred stock is riskier than a bond but less risky than a common stock.
Unlike common stocks, prices of preferred stock are not likely to go up by much, even when a company performs well. So, the holder of a preferred stock has fewer chances of making large profits.
Preferred stocks can be of a few types. In the case of convertible preferred shares, you have the option to convert a preferred stock into a common stock. Preferred stocks may also be cumulative. This means that the company may postpone dividend payments when it is not performing well. But when the situation improves, they have to pay the dividends in arrears. This has to be done before any payment is made to common stockholders. Another type is a redeemable preferred stock where the company has the right to redeem the stock at a date in the future.
Important Facts to Know about Dividends
- Most companies pay an annual or quarterly or even special one-time dividends based on the total profits made during the year.
- Income earned from dividends is taxable as per the Income Tax Act, 1961.
- Companies can either pay fixed rate, referred to as preferred dividends, or they can pay variable dividends based on the earnings, known as common dividends.
- Companies are not obliged to make these payments by any regulatory guidelines.
Dates to Remember
Declaration Date: when the company determines the payment date for the dividend, the ex-dividend rate, and the dividend amount.
Record Date: The companies compile the list of all the shareholders who are eligible to receive the declared dividends.
Ex-Dividend Date: This is often a few days before the record date when pending transactions, if any, are completed prior to the record date.
Benefits of Dividends to Investors:
Dividends provide investors a stable return on their investments, which is low risk. In addition, as the organisations continue to grow, the dividends increase, which raises the value of the stock for the investors. They also allow you to reinvest your dividends.
Investors need to bear in mind that bigger dividends do not always mean better as companies paying high dividends are unable to sustain these rates in the longer period.
The category of companies in the stock market that possess a consistent track record of distributing their profits as dividends to their 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.
Equity vs Other Investments
- Equity requires low investment: Unlike Fixed Deposit, Gold & Real estate, you can enter the equity market with a much smaller capital.
- Equity offers higher returns: It is historically proven that Equity offers better returns in comparison to FD, Gold & Real-estate.
- Returns on Equity beat inflation & are completely tax-free.
- Equity offers high liquidity. Equity can be bought & sold very easily & converted to cash pretty fast.
- Equity is the best performing asset class. Equity increases your wealth faster over a long time due to compounding effect, capital appreciation & dividend income.
It is a malpractice where the traders carry out a transaction based on the non-public or unpublished information they got access to, which can be necessary for making investment decisions.
The three essential elements of insider trading are:
- Material non-published or price-sensitive information
- The information obtained from an inside source
- A trader must have dealt with the securities based on the information obtained
What is the efficient market hypothesis (EMH)?
The efficient market hypothesis assumes that any and all available information related to an asset is already factored into its current price. This effectively means that an asset trades at its fair value, making it impossible to identify undervalued or overvalued stocks.
The efficient market hypothesis essentially states that the market is so efficient that it is capable of quickly factoring the impact of the new information in the prices of the assets. It also states that irrespective of how many analytical techniques you use, as a trader or an investor, it is simply not possible to beat or gain an edge over the ‘market.’
Based on the level of efficiency, markets experience efficiency of three forms – weak, semi-strong and strong.
Risks in predicting the Equity Markets
As per the Random Walk Theory by Burton Malkeil (1973), beating the market is not an actual mathematical possibility, and there is no sure way of doing it. There are enough scientific studies claiming authentically that prove the lack of predictability (Ball and Brown, Fama, Jensen, Goyal and Welch, Pontiff, Martineau etc) and effective return predictors (Rosenberg, Reid and Lanstein, Campbell and Shiller, Jegadeesh and Titman).
What are the methods of Equity Trading prediction?
In the most fundamental level, there are two methods for explaining and prediction of equity value. These are technical and fundamental analysis.
Technical analysis is largely based on analysing past stock behaviour to find out how stocks will react in the future. The idea is to find patterns of behaviours- like ‘head and shoulders’ or ‘wedges’ or ‘triangles’ which help in finding indications of equity markets behaviour. Around 10% of trade analysts use technical analysis according to Burton Malkeil.
Fundamental analysis on the other hand is based on the real life indicators of a company’s health and value. Malkeil suggests the most effective indicators are- its internal expectations of growth, dividend payout and ofcourse its history of price volatility.
Recession vs Depression
|Definition||A contraction in economic growth that lasts for a couple of quarters to a year||A severe form of an economic downturn that lasts for many years|
|After effects||People and businesses reduce spending, investments are down||The after-effects are much deeper, wherein investors’ confidence is at an all-time low|
|Influence||Recession can hurt a specific country or some countries in a region||Depression is felt on a global scale that impacts trade and investments|
|GDP||Negative GDP growth for two consecutive quarters||A drop in GDP growth by more than 10% in a financial year|