Introduction to Equity

Stock is a share in the ownership of a company. Stock represents a claim on the company’s assets and earnings. As one acquires more stock, the person‘s ownership stake in the company becomes greater. Share, equity, or stock, mean the same thing. As an owner, the shareholder is entitled to the company’s earnings and voting rights attached to the stock. As equity capital is not redeemed i.e., not returned to the shareholders; it becomes a permanent source of capital for the company1.

Introduction to Equity

When stocks were in physical form, they used to be represented by stock certificates. A stock certificate is a piece of paper that acts as a proof of ownership. In today’s computer age, these records are kept electronically or in a dematerialized form.

Introduction to Equity

After reading this article, you should be able to understand:

  • The concept of equity
  • The difference between Debt and Equity
  • Risk and rewards associated with equity
  • Different Classes of equity
  • Significance of share capital reflected in a company‘s balance sheet

1.1 Equity as a source of ownership capital for a company

There are principally two sources of capital: Equity capital and debt capital. Equity represents ownership capital. A common stock or an equity share is the primary source of capital for the business without which a business cannot exist. Debt capital comes from non-owners or outsiders. It is like a loan given to a company by outsiders.

1.2 Debt vs. Equity

At some point, every company needs to raise capital to fund its business. In fact, companies may have to raise capital quite regularly. To do this, companies can either borrow or issue stock. A company can borrow by taking a loan from a bank or by issuing bonds. This is called debt financing. On the other hand, if a company raises capital by issuing stock, it is called equity financing. Some important differences between debt and equity capital are as follows.

  • Debt capital is outside capital. Hence debt holders do not enjoy rights of equity holders, especially voting rights.
  • Equity is ownership capital, hence it takes all the risks associated with ownership. That means equity owners have no priority on claims of the assets of the company.
  • Equity capital is not required to be returned to the shareholders. On the other hand, debt capital, whether in the form of loan or bonds, has to be returned to the lenders.
  • Interest, which is a reward to be paid to debt holders, is a charge against profit and has to be paid whether profit is adequate or not. Dividend, reward for shareholders, may or may not be paid. It is not mandatory to pay dividend.
  • For security of bond holders, a charge on the company‘s assets may be created. Thus, in case of non-payment of interest or principal by the company, these assets can be sold off to clear the dues of the debt holders. Even if a charge is not created on assets, debt holders have a priority on a company‘s assets.
  • As far as return potential is concerned, there is no upside potential for debt capital. For example, if a company does well, it still pays the same rate of interest applicable on the loan. Equity holders benefit in terms of higher dividend or higher capital appreciation in case the company does well. Upside potential for equity is unlimited.
  • Investors who want fixed returns invest in debt securities. It is a low-risk, low-return product compared with equity. Investors who desire high returns and are prepared to take higher risk choose equity investment.
  • Considering that equity is risky capital, investor expectations on returns are also high. Compared with this, expectations on returns from fixed income investors are low. That is why, over the long term, equity markets have outperformed the debt markets, providing better returns.

1.3 Rewards associated with equity

Dividend

The importance of being a shareholder is that shareholders are entitled to a portion of the company‘s profits and also have a residual claim on assets. Dividend is of following types.

  • Cash Dividend – Dividend is generally paid in cash. A part of profit is paid out in the form of cash dividend.
  • Stock Dividend – Dividend is given in the form of shares. This means shareholders are given additional shares in certain proportion to their holdings free of cost.

Share repurchase

This involves buying back equity shares from shareholders in a certain proportion. Thus, instead of using cash to pay dividend, cash is utilized by the company to repurchase shares. The price at which the shares are bought back is generally higher than the current market price, resulting in a gain for shareholders.

Capital Gains

Capital gains refer to an increase in prices of shares of a company. In fact, this is the reason why most investors hold equity shares. In most cases, a large part of total return which a shareholder gets for investing in equity comes from capital appreciation.

Right to subscribe to new shares

A company may come out with a rights offering. That is, it may offer additional shares at a certain price to existing shareholders. This is the privilege that shareholders enjoy. Many times, rights may be offered at a significantly discounted price compared with the current market price as a reward to shareholders.

Right to Vote

Being owners of the company, shareholders can vote in Annual General Meetings and other shareholder meetings on important matters that affect the company‘s businesses. These matters include increasing capital of the company, auditors‘ appointments, directors‘ appointments etc.

Right to information

Shareholders have right to receive timely information about the company‘s operations. On a regular basis, they receive annual reports, quarterly reports, and other corporate information.

1.4 Risks associated with Equity

Residual Capital

Equity is a residual capital. That means claims of equity holders can be satisfied after claims of all others such as lenders and creditors etc., are satisfied. Hence equity holders take maximum risk. However, unlike owners of partnership, equity shareholders have a Limited Liability. This means that, the owner of a stock is not personally liable if the company is not able to pay its debt. In case of partnerships, on the other hand, if the partnership goes bankrupt, the creditors can hold the partners (shareholders) personally liable and sell off their house, car, furniture, etc. to realize their dues. Owning stock means that, no matter what, the maximum value a shareholder can lose is the value of his/her investment. Even if a company goes bankrupt, the shareholder can never lose his/her personal assets.

Capital Losses

Share prices are highly volatile. They keep changing as per market‘s perception about a particular company. Just as there is no upward limit to which share prices can go, there is no downside limit as well. Hence, shareholders may lose substantial or entire part of their investments if share prices go down.

Liquidity Risk

Sometimes shares may suffer from poor liquidity. This means that shares are not traded regularly or even if they are traded the trading volumes are low. This is called liquidity risk. If a company‘s shares become illiquid, shareholders will not be able to sell them off at any price.

1.5 Different Classes of Stock

Companies may issue different classes of common stock. This is because the company may want a particular group of shareholders to have voting rights. Hence, different classes of shares are given different voting rights, provided the law of country allows this. For example, one class of shares would be held by a select group who are given ten votes per share while a second class would be issued to the majority of investors who are given one vote per share.

When there is more than one class of stock, the classes are traditionally designated as Class A and Class B. The different classes of shares trade at different prices and they are given different identification symbols.

1.5.1 Classification of Stocks

Classification of stocks based on market capitalization:

NameSize
Mega-capOver $100 billion
Large-cap$10 billion–$100 billion
Mid-cap$1 billion–$10 billion
Small-cap$100 million–$1 billion
Micro-cap$10 million-$100 million
Nano-capBelow $10 million

Market capitalization is calculated by multiplying the number of a company’s shares outstanding by its stock price per share.

Large Cap

This classification is based on stocks that have market capitalization of $ 10 billion or more. They are mainly large well-known companies that have businesses across various industries/ sectors. Market capitalization is calculated by multiplying the number of a company’s shares outstanding by its stock price per share.

Mid Cap

This classification is based on the company that has been established in a specific sector/ industry and has a capitalization between $1 billion – $10 billion dollars.

Small Cap

This classification is based on small caps typically having capitalization of less than $1 billion dollars. Usually, it is a lesser-known company that may not be tracked by sell-side analysts and investment banks.

Other methods of classifying stocks

Growth Potential

A growth stock is usually defined as a company with incredible growth potential due to market analysis, product, segment, or situation. Examples would be a company that manufactures some special pharmaceutical exclusively like biotechnology.

Geography

Stocks can be classified based on geography. A geographic segment can vary greatly in terms of market performance compared with another segment. Thus, there is certainly merit in exploring stocks with geographic diversity.

Value Stocks

The term ―value stock‖ usually refers to a stock that is undervalued in terms of its trading price vs. book value. The book value per share is equal to shareholders equity – preferred stock/average outstanding shares while trading price is the market price at which the stock is traded on the exchange.

1.6 Share Capital as shown in the balance sheet of the company

  • Capital is the money that a company needs to run its business. Equity capital is shown in the following classes in balance sheet of a company.
  • Authorized capital is the maximum number of shares that a company is allowed to issue for raising capital as per the Memorandum of Association (charter) of that company. If authorized capital needs to be changed, shareholders‘ approval is to be obtained and Memorandum of Associated needs to be altered.
  • Issued capital is that part of Authorized capital that has been issued by a company. Companies generally do not issue their entire Authorized capital to the public and withhold part of it for future issues.
  • Called up capital is that part of issued capital for which the shareholders are required to pay.
  • Paid up capital is also called Subscribed capital and is that part of the called up capital for which payment has been received from investors. If the entire issued capital has been paid for by the investors, it is said to be fully-paid up and if the entire issued capital has not been paid for by the investor, then it is called partly-paid up capital.
  • Par Value Shares – Par value of a share is the face value of the share. It is of little economic significance. It may be mandatory to have par value or shares without par value can also be issued. Country regulations may differ. In the US, par value is not mandatory.

Summary

The objective of this article was to provide you with some exposure to the equity markets. It covers how equity is a source of ownership capital for a company. This is followed by major differences between debt and equity. Later it covers the different risk and rewards associated with equity. It also covers different classes of stock. Finally, it shows how share capital can be shown in balance sheet of the company.

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