Sunday , 25 June 2017

Chapter Five: Equity Basics

An equity share is a unit of ownership in a company. Every company issues a certain number of shares to its promoters, i.e., those who participate in its formation. The company issues additional shares to the public, when it raises money by way of an Initial Public Offer (IPO). Hence, in addition to the promoters, the public too become shareholders of the company. So, if you hold 100 shares of a company which has issued 10,000 shares, you own 1 per cent of the company.

Benefits to a shareholder:

Why should you purchase shares of a company? What are benefits that accrue to you as a shareholder? Apart from the right to vote and decide the future course of action that a company takes, the real benefit that you, as a shareholder has, is in form of participation that you get in profit made by the company. At the same time, your liability is limited only to the face value of the shares held by you. The benefits distributed by the company to its shareholders can be: 1) Monetary Benefits and 2) Non Monetary Benefits.

Monetary Benefits:

1) Dividend: An equity shareholder has a right on the profits generated by the company. Profits are distributed in part or in full in the form of dividends. Dividend is an earning on the investment made in shares, just like interest in case of bonds or debentures. A company can issue dividend in two forms: a) Interim Dividend and b) Final Dividend. While final dividend is distributed only after closing of financial year; companies at times declare an interim dividend during a financial year. Hence if X Ltd. earns a profit of Rs 40 crore and decides to distribute Rs 2 to each shareholder, a holding of 200 shares of X Ltd. would entitle you to Rs 400 as dividend. This is a return that you shall earn as a result of the investment made by you by subscribing to the shares of X Ltd.

2) Capital Appreciation: A shareholder also benefits from capital appreciation. Simply put, this means an increase in the value of the company usually reflected in its share price. Companies generally do not distribute all their profits as dividend. As the companies grow, profits are re-invested in the business. This means an increase in net worth, which results in appreciation in the value of shares. Hence, if you purchase 200 shares of X Ltd at Rs 20 per share and hold the same for two years, after which the value of each share is Rs 35. This means that your capital has appreciated by Rs 3000.

Non-Monetary Benefits:
Apart from dividends and capital appreciation, investments in shares also fetch some type of non-monetary benefits to a shareholder. Bonuses and rights issues are two such noticeable benefits.

1) Bonus: An issue of bonus shares is the distribution free of cost to the shareholders usually made when a company capitalises on profits made over a period of time. Rather than paying dividends, companies give additional shares in a pre-defined ratio. Prima facie, it does not affect the wealth of shareholders. However, in practice, bonuses carry certain latent advantages such as tax benefits, better future growth potential, an increase in the floating stock of the company, etc. Hence if X Ltd decides to issue bonus shares in a ration of 1:1, every existing shareholder of X Ltd would receive one additional share free for each share held by him. Of course, taking the bonus into account, the share price would also ideally fall by 50 percent post bonus. However, depending upon market expectations, the share price may rise or fall on the bonus announcement.

2) Rights Issue: A rights issue involves selling of ordinary shares to the existing shareholders of the company. A company wishing to increase its subscribed capital by allotment of further shares should first offer them to its existing shareholders. The benefit of a rights issue is that existing shareholders maintain control of the company. Also, this results in an expanded capital base, after which the company is able to perform better. This gets reflected in the appreciation of share value.

Risks In equity investment:

Although an equity investment is the most rewarding in terms of returns generated, certain risks are essential to understand before venturing into the world of equity. These can be described as follows:

1) Market/ Economy Risk: The performance of any company depends on the growth of an economy. An economy, which continues to prosper, ensures that companies operating in it benefit from its growth. However, an equity shareholder also runs the risk of any downturn in the economy affecting the performance of his company. Economy related risks are usually reflected in the factors such as GDP growth, inflation, balance of payment positions, interest rates, credit growth etc. A slowdown in the economy pinches almost all sectors, especially infrastructure, services and manufacturing companies.

2) Industry Risk: All industries undergo some kind of cyclical growth. Shareholders get rewarded most during the expansion stage. For instance, the last few years have been very rewarding for investors in real estate. However, once the industry reaches a maturity stage, the rewards from investment are limited. Further, companies belonging to industries where growth has retarded incur losses or declining gains. Industry specific government regulations too impact returns from investments made therein.

3) Management Risk: The management is the face of an enterprise. It is the team which gives direction to the future course of action that a company will take. Quality of management is hence paramount. Management changes often have a serious impact on policy matters of companies, thereby impacting the share price. A management which is unable to meet the challenges posed by competition is likely to suffer in performance.

4) Business Risk: Business risk is a function of the operating conditions faced by a company and the variability that these conditions inject into operating income and hence expected dividends. Business risk can be classified into two broad categories: external and internal. Internal business risk is largely associated with the efficiency with which a company conducts its operations within the broader environment imposed upon it. External risk is the result of operating conditions imposed upon the company by circumstances beyond its control.

5) Financial Risk: Financial risk is associated with the way in which a company finances its activities. A company, borrowing money for business, creates fixed payment obligations in form of interest that must be sustained. Beyond a specified limit, the residual income left for shareholders gets reduced, thereby affecting the returns on shares. More importantly, it increases default risk, i.e, a heavily leveraged company, is at a greater risk of not being able to meet its liabilities and hence going bankrupt.

6) Exchange Rate Risk: Companies today earn sizeable revenues from outside their parent country. Hence, any appreciation in the currency, as was recently witnessed with technology companies, adversely affects earnings, which results in falling or stagnant share prices.

7) Inflation Risk: Rising prices or inflation reduces purchasing power for the common man resulting in a slowdown in the demand in the economy. This has implications for all the sectors in the economy. Hence, in an inflationary environment, share prices of most companies face a downturn as the expected fall in demand reduces their future expected income.

8) Interest Rate Risk: Interest rate risk refers to the uncertainty of future market values and size of future income, caused by fluctuations in the general level of interest rates. Rising interest rates increase cost of borrowing, which results in an increase in the prices of products and a corresponding slowdown in demand. Hence, an interest rate hike affects share prices of companies cutting across the board.

How to overcome risks: Most risks associated with investments in shares can be reduced by using the tool of diversification. Purchasing shares of different companies and creating a diversified portfolio has proven to be one of the most reliable tools of risk reduction.

The process of Diversification: When you hold shares in a single company, you run the risk of a large magnitude. As your portfolio expands to include shares of more companies, the company specific risk reduces. The benefits of creating a well diversified portfolio can be gauged from the fact that as you add more shares to your portfolio, the weightage of each company’s share gets reduced. Hence any adverse event related to any one company would not expose you to immense risk. The same logic can be extended to a sector or an industry. In fact, diversifying across sectors and industries reaps the real benefits of diversification. Sector specific risks get minimised when shares of other sectors are added to the portfolio. This is because a recession or a downtrend is not seen in all sectors together at the same time.

However all risks cannot be reduced: Though it is possible to reduce risk, the process of equity investing itself comes with certain inherent risks, which cannot be reduced by strategies such as diversification. These risks are called systematic risk as they arise from the system, such as interest rate risk and inflation risk. As these risks cannot be diversified, theoretically, investors are rewarded for taking systematic risks for equity investment.

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