Understanding Equity Shares

by Shweta Chopra


Equity shares are an important concept and a good investment opportunity in today’s economy. This article aims to provide you with some basic information about these shares, their characteristics and what role they could play in your lives.

In finance, ‘equity’ refers to ownership in any asset after all debts associated with that asset have been paid off. For example, a car or house with no outstanding debt (loans completely paid off) is considered the owner's equity because he or she can readily sell it for cash. But we use the term equity mostly in reference to shares. Shares are considered to be equities as they represent ownership in a company. To understand this, we need to look at the financial structure of companies.

Companies and Equity Funding

A company is an association or collection of individuals and/or other companies, each of whom provide some form of capital. This group has a common aim of earning profits. In India, the Companies Act of 1956, states that the term 'company' includes any company formed and registered under the Act or an existing company, i.e., a company formed or registered under any previous company laws. This collection or association of persons can be made to exist in law by registering it. It is then considered a ‘legal entity.’ This means that the law considers the company as a separate entity from its owners.

Equity funding is one method by which companies raise finance. Finance is necessary for any company to carry out its operations. The capital of a company is divided into a number of small units called ‘shares.’ Under equity funding, investors purchase shares of the company, which entitle them to part-ownership of the company. The company uses the money it receives as capital for the business. The amount invested in these shares need not be paid back by the company, and does not provide investors with any fixed rate of interest either. Equity investors must be prepared to forgo regular repayments of their money and risk losing their capital if the business fails.

On the other hand, if the business succeeds, shareholders stand to gain the return of their capital plus a share in the profits as well as the improved value of that business. The business is giving them an ownership stake in return for development capital and the expectation that their equity stake will rise in value significantly. Due to the high risk of losing their entire investment in case a business fails, equity investors seek far higher returns and scrutinise businesses to minimise risk. Thus, shareholders get to have a hand in the management of the company, to some extent.

It is an important feature of the ‘company’ form of businesses that there is a gap between the ownership and control over the affairs of the company. In a sense, the shareholders are the owners of a company, but it is managed by the directors who are elected by the company’s shareholders. Since the number of shareholders of any particular company is a huge number, giving each a hand in actual management would result in chaos and disorder. Hence, the elected representatives are very crucial to a company. It is absolutely necessary for a company to have a human agency, called the ‘board of directors,’ for management.

Returns on Equity Shares

Dividends

The return on equity shares, or the ‘dividend,’ is also an important point that must be understood. There is no fixed rate of interest on these shares unlike other safer securities. Dividend is essentially a part of the profits made by the company. The rate of dividend is decided on the basis of profits earned in a  particular year. The dividend is paid to the shareholders after returns on all other financial liabilities are paid off out of the profits. Thus in a year when a company makes low profits or losses, there is a chance that equity shareholders will get no return at all.

Capital Gains

Equity shares can also be traded on the stock market. Companies are listed on the SENSEX and Nifty, and the index shows the market value of the share of a company. These values are logically determined by demand and supply. If a company is doing well and earning high profits, a high rate of dividend can be expected on its shares. Its share price can also be expected to be higher in the future. This leads to a large demand for such shares vis-a-vis its supply and a high market value of those shares. On the other hand, a company making or expected to make losses, will have its shares priced low. Thus, the stock indices, in a way, reflect the success or failure of a company.

As mentioned before, a company does not have to return the money invested in its equity shares. These shares are initially sold in the primary market (when they are first issued as an Initial Public Offering, or IPO) and then later traded on the secondary market, where they exchange hands from one shareholder to another. All such transactions in shares are regulated by the Securities and Exchange Board of India (SEBI), which was formed to protect the interests of investors in such transactions.

The secondary market exchange is done on the basis of the share prices as listed on the stock indices. So if person A possesses 100 shares of a company, bought at Rs. 100 each, and the value of those shares rises to Rs. 200 each over the course of year, he can sell them off to B at that rate and make a 'capital gain' of Rs. 100 per share. A capital gain or loss is an increase or decrease in the actual value of a capital asset (investment).

So there are two ways of getting returns from investments in equity shares: dividends, which are annual but variable shares in profits that the company gives its shareholders and capital gains, which are an increase in the market value of the investment in shares.

Risks in the Share Market

The prices of shares fluctuate very often and with a lot of volatility. If you watch the news, you will notice the stock indices constantly changing in value. This is because trading shares is much less cumbersome than transactions on the primary market and since share prices change so frequently, investors engage in transactions very often to make use of even momentary rises or falls in prices. Also, the share prices listed on the indices are determined by the expectations of the economy on how companies will perform, which then determines how many people want to buy or sell a particular share.

Courtesy crackerjackfinance.com

Expectations are not perfectly measurable and accurately predicting the way prices will move is not possible. Any small news (or rumour) that makes people believe that a company will make losses in the future could ruin the performance of that company on the stock market. It is no wonder that we see breaking news like 'SENSEX Crashes' and 'Market Collapses’ so often. These situations hamper the growth of an economy. This illustrates the kind of risk associated with investments in equity shares. It is just as likely for your share price to double within a year as it is for you to lose your investment and end up losing money.

Investment in shares involves purchasing shares of companies you think will provide high capital gains and a steady rate of dividend in the future. Depending on how your particular company, and the economy as a whole, is doing, the share price will fluctuate. Suppose you have invested in the shares of Reliance Petroleum Ltd. If certain government policies lead to falling profits of the petroleum sector, the demand for Reliance’s shares will fall. Its share price will fall and leave you with a capital loss. Depending on whether you think things will improve or get worse, you decide whether or not to sell your shares. It is entirely possible that within a week Reliance discovers and gains control over a new oil rig and the economy regains confidence in its performance, restoring your shares to the price at which you bought them, or even leading to a capital gain. Now just imagine this kind of volatility at the scale of hundreds of different companies. That is how complicated and volatile the market can get. Keeping track of it and winning against its roller coaster fluctuations is very difficult.

Mutual Funds

To neutralize some of the risk associated with investment in shares and other securities, banks and other financial institutions have come out with a new financial instrument called ‘mutual funds.’ A mutual fund is a type of professionally-managed collective investment vehicle that pools money from many investors to purchase securities. Mutual funds are operated by fund managers, who invest the fund's capital and attempt to produce capital gains and income for the fund's investors. Thus, investors need not take the headache of management of their investment on a day to day basis. A mutual fund's portfolio is structured and maintained to match the investment objectives stated in its prospectus. 

One of the main advantages of mutual funds is that they give small investors access to professionally managed, diversified portfolios of equities, bonds and other securities, which would be quite difficult (if not impossible) to create with a small amount of capital. Each shareholder participates proportionally in the gain or loss of the fund. Mutual fund units are issued and can typically be purchased or redeemed as needed at the fund's current ‘net asset value per share’ (NAVPS).

Equity funds are a type of mutual fund that invest in the equity shares of companies. Besides leaving the management of the investment to a fund manager, they also provide the advantage of diversification. Instead of an individual putting all his money into the shares of one company and then depending completely on its success or failure, equity funds have a mixed portfolio. They invest in different sectors of the economy or concentrate on a particular mix of sectors. The rationale behind this is that since not all sectors can collapse or start making losses at the same time, it is less risky.

Depending on the whether fund objective is income or growth, the portfolio of the mutual fund is decided. An income fund's main focus is to provide a steady flow of income to the investors, and so it invests in steady, secure securities. A growth fund focuses on maximizing capital gains and so invests in more volatile securities like shares, which have huge potential for rapid growth.

Equity Investments and You

An average individual with a different primary occupation and a family does not have the time to manage investments in shares directly. It also becomes very risky as such an investment lacks diversity. The kind of returns that mutual funds provide, can be much higher than the interest on safer securities like government bonds and term deposits with banks. That is why Mutual Funds are the most important avenue through which to invest in shares.

Highly risk-averse individuals stick to safer avenues of investment like government securities and fixed deposits, but they miss out on the growth potential of equity shares. For those who enjoy the thrill of risk, direct investment in shares is also a possibility. But that involves a lot of prediction, keeping track of indices, and high risk of losses. There is a trade off between high return and high risk when it comes to financial investments, so depending on the personal preferences of individuals, investment portfolios can be decided upon.

Now that you have some background on equity shares, a new option for investment could have opened up for you. It is always better to make an informed choice rather than being ignorant and living with less options. The vague, risky and dangerous avenue of investment in shares that some consider as risky as gambling, is hopefully no longer as vague to you.

References

"Section 2: EQUITY." Kotak Securities. Kotak Securities, n.d. Web. 02 Oct. 2012. <http://www.kotaksecurities.com/university/Equity2.html>.

"Mutual Fund." Definition. Investopedia, n.d. Web. 02 Oct. 2012. <http://www.investopedia.com/terms/m/mutualfund.asp>.

"Company." Wikipedia. Wikimedia Foundation, 21 Sept. 2012. Web. 02 Oct. 2012. <http://en.wikipedia.org/wiki/Company>.