Last Updated on May 24, 2022 by Anjali Chourasiya
Equity is an asset class that has the highest potential for reward but also bears the highest inherent risk quotient. Investors who are risk-averse are generally told to stay away from ‘equity’. However, with easy access to information and a plethora of investment option availability, investors are no longer shying from taking some exposure to the equity segment.
In short, equity represents the stake of shareholders in a company, gained through purchasing shares issued to investors upon the company’s listing in the stock market. Let’s find out what is equity and explore the types of equity in detail.
Table of Contents
What is equity?
Equity is issued to investors to raise the capital required to start, grow and expand businesses. In lieu of their contributions towards the company, investors are offered a stake in the company (in proportion to their investments).
The status of those who invest in equities is that of an owner. They receive certain rights that enable them to participate in the company’s growth and receive their share of earnings as dividends and capital gains in the future. The entire worth of any company is divided into small portions, and the smallest piece is called equity.
In case a company goes into liquidation, and all assets held by the company are realized, then after all the external liabilities are paid off, equity is the amount each shareholder will receive against their investments.
Mathematically equity is expressed as:
A = E – L
Where:
A represents the total assets of the company
E represents equity
L represents the total liabilities to be met by the company.
Even in real market scenarios, huge losses incurred by the company have wiped off the owner’s equity.
Features of equity
Limited liability
No matter what, equity investors are only liable to the company’s equity stake. They cannot be asked for anything else than the equity capital they hold. Even in the most extreme liquidation situation where assets are falling short of the liabilities, equity holders cannot be asked to bring the shortfall amount.
In most cases, companies don’t ask for the entire value of equity upfront. The remaining is asked as and when needed. The equity holders are only liable to pay these calls when asked for by the company.
Voting rights
Equity holders are part-owners of the company and thereby have rights to participate in the company’s affairs through voting rights bestowed upon by the company. Voting rights are assigned in proportion to the number of shares held in the company.
Redemption
Now, there’s no guarantee to that! Equity owners might get exponential unrealized capital gains and regular flow of income if the company does well and makes profits. Or on the contrary, stakeholders might end up realizing their investment in losses if the company makes losses, the market sentiment becomes negative or the company goes into liquidation.
There is no fixed maturity period for equity investments. Equity, once issued, is permanent and the company can only claim it back at the time of liquidation of the company. The company can however make requests through a process called buyback of shares.
Types of equity
Though there are different kinds of equity, one thing that is common between them is that all of them are market securities. Hence, the returns, incidentally, are not fixed but fluctuating.
Common stock: Whether privately-owned or publicly owned, the capital of each company is divided into fractions and the smallest fraction is called a share. Shares collectively are called common stock/common shares.
Investing in common stock gives proportional part-ownership to the investors. However, returns on common stock are directly linked with the financial performance of the company and the performance of the stock in the stock market if the company is listed. A part of the profits earned by the company is distributed among the common shareholders in the form of dividends.
Preferred stock: Preferred stock also remarks ownership in the company, however, the same doesn’t carry voting rights, i.e., the preferred stockholders have no say in the affairs of the company. They enjoy preference over common stockholders in payment of dividends as well as dues in case the company is forced into liquidation.
Retained earning: That portion of the current year post-tax profits which is not paid out as dividends, and is retained in the business for future needs is called retained earnings. This money is often held with the company to meet emergencies, however, the company may use this money for its expansionary motives or any other purpose it may deem fit.
Treasury stock: When the issuing company buys its shares from the common stockholder to realign their outstanding shares, the shares repurchased are held by the company as treasury stock. Treasury stock reduces the equity capital of the company, and thus the company is relieved from paying dividends on such shares.
Lastly, mutual funds are the table toppers when it comes to generating decent returns on equity while mitigating risk. Equity-oriented mutual fund investments invest 60% or more of their portfolio in the equity markets. While the risks are on the higher side, the returns follow the higher trajectory as well.
Downsides of equity
Highly risky
Equity is an instrument where you can lose your entire capital within a short time. Your corpus is exposed to the fluctuations of the market, and there’s no guarantee for returns. While its risk-to-reward ratio is impressive, not every investor may have the stomach to digest the risks.
Associated with performance
The fate of your investments is decided by the performance of the market, sector, and, more importantly, the stock. If the mood of the market is negative or the stock performs poorly, you may end up eroding your capital.
Impact of socio-political changes
Political and social matters impact the market significantly. For example, if the government announces a corporate tax cut or on the contrary increases it, your equity investments may exhibit like-to-like movement. The opening of 100% FDI can be taken as a good example here.
Liquidation
Every time a company is forced into liquidation, equity shareholders are paid at last. Moreover, the shares don’t fetch their market value at the time of liquidation. Hence in case of liquidation, investors will have to bear losses.
Conclusion
The concept of equity is of sweeping nature and covers every possible way a company can raise capital. Investing in equity brings ownership rights among other laudable benefits ranging from voting rights to dividends. However, the type of equity to invest in will largely depend on the investment time frame and purpose of investment.
From an investor’s point of view, equity investments are a great source of regular income in the form of dividends coupled with capital gains that can be reaped in the long term.
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