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MEANING

The part of something - asset, house or company - which you own. What the professionals call shares.
If you lend a company money, you have made a loan and rank as a creditor who, under normal
circumstances, would expect repayment of the loan plus interest at a future date. If you buy ordinary
shares in a company you become an equity-holder in that company, which means you share in its
profits (and losses) and have a less clear-cut idea of your future returns than does a lender. As an
ordinary shareholder, you stand in line behind debenture-holders for settlement, should the
company be wound up. You cannot rely on a fixed return, and you run the risk of loss, but in return
for this you have a share in the company's surplus during good times. You also have equity in that
part of the value of your house above the amount borrowed from the lender which has the mortgage
over your house. Economists, as well as other people, use 'equity' in its original sense of fairness or
impartiality.

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The following are the main features of equity

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The liability of a shareholder is limited to the amount he invested in a company. In
case the company goes bankrupt his personal assets can¶t be claimed against the losses made by the
company.

   
Investors enjoy unlimited participation in the earnings of the firm. Theoretically there is
no limit to the returns, which an equity investor can get i.e. if the company earns multifold profit and
wants to distribute it as dividend. Of course certainly there is a risk of non-functioning/ less (or no)
profitability of the company in which case the share price goes down and dividend may not be paid out.

    
Equity stocks are generally highly liquid instruments, which can be bought and sold
easily in the equity markets. Ownership stake in the company changes with every buy and sell. An
investor can acquire ownership and sell off his ownership quite easily whenever he wishes to do so.

    
Equity stocks come with certain rights including the voting rights to which the
investors are entitled.

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Equity shares are those shares which are ordinary in the course of company's business. They are also called
as ordinary shares. These share holders do not enjoy preference regarding payment of dividend and
repayment of capital.Equity shareholders are paid dividend out of the profits made by a company. Higher the
profits, higher will be the dividend and lower the profits, lower will be the dividend.


0

 



 

 Equity share capital is owned capital because it is the money of the shareholders who
are actually the owners of the company.

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  Every share has fixed value or a nominal value. For example, the price of
a share is Rs. 10/- which indicates a fixed value or a nominal value.

 
 !  Every share is given a distinct number just like a roll number for the purpose of
identification.

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 A share gives its owner the right to receive dividend, the right to vote, the right to
attend meetings, the right to inspect the books of accounts.

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 Every shareholder is entitled to a return on shares which is known as dividend.
Dividend depends on the profits made by a company. Higher the profits, higher will be the dividend and vice
versa.

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 Equity shares are easily transferable, that is if a person buys shares of a particular
company and he does not want them, he can sell them to any one, thereby transferring the shares in the
name of that person.

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  When a company makes fresh issue of shares, the equity shareholders are given
certain rights in the company. The company has to offer the new shares first to the equity shareholders in the
proportion to their existing share holding. In case they do not take up the shares offered to them, the same
can be issue to others. Thus, equity shareholders get the benefits of the right issue.

*)  )



 Joint stock companies which make huge profits, issue bonus shares to their
ordinary shareholders out of the accumulated profits. These shares are issued free of cost in proportion to the
number of existing equity share holding. In case they do not take up the shares offered to them, the same
can be issued to others. Thus, equity shareholders get the benefits of the right issue.

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!  Equity shares are always irredeemable. This means equity capital is not returnable during
the life time of a company.

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 The nominal or par value of equity shares is fixed but the market value
fluctuates. The market value mainly depends upon profitability and prosperity of the company. High rate of
dividend is paid with high rate of profit, the shareholders capital is appreciated through an appreciation in the
market value of shares. (i.e. higher the rate of dividend, higher the market value of the shares.)



    
There are a number of types of equity, each with different charactenstics.



     

Common stock, as it is known in the United States, or ordinary shares, according to British terminology,
is the most important form of equity investment. An owner of common stock is part owner of the
enterprise and is entitled to vote on certain important matters, including the selection of directors.
Common stock holders benefit most from improvement in the firm's business prospects. But they have a
claim on the firm's income and assets only after all creditors and all preferred stock holders receive
payment. Some firms have more than one class of common stock, in which case the stock of one class
may be entitled to greater voting rights, or to larger dividends, than stock of another class. This is often
the case with family owned firms which sell stock to the public in a way that enables the family to
maintain control through its ownership of stock with superior voting rights.
 

Also called preference shares, preferred stock is more akin to bonds than to common stock. Like bonds,
preferred stock offers specified payments on specified dates. Preferred stock appeals to issuers because
the dividend remains constant for as long as the stock is outstanding, which may be in perpetuity. Some
investors favour preferred stock over bonds because the periodic payments are formally considered
dividends rather than interest payments, and may therefore offer tax advantages. The issuer is obliged to
pay dividends to preferred stock holders before paying dividends to common shareholders. if the
preferred stock is cumulative, unpaid dividends may accrue until preferred stock holders have received
full payment. In the case of non cumulative preferred stock, preferred stock holders may be able to
impose significant restrictions on the firm in the event of a missed dividend.

   

This may be converted into common stock under certain conditions, usually at a predetermined price or
within a predetermined time period. Conversion is always at the owner's option and cannot be required
by the issuer. Convertible preferred stock is similar to convertible bonds.



Warrants offer the holder the opportunity to purchase a firm's common stock during a specified time
period in future, at a predetermined price, known as the exercise price or strike price. The tangible value
of a warrant is the market price of the stock less the strike price. If the tangible value when the warrants
are exercisable is zero or less the warrants have no value, as the stock can be acquired more cheaply in
the open market. A firm may sell warrants directly, but more often they are incorporated into other
securities, such as preferred stock or bonds. Warrants are created and sold by the firm that issues the
underlying stock. In a rights offering, warrants are allotted to existing stock holders in proportion to
their current holdings. If all shareholders subscribe to the offering the firm's total capital will increase,
but each stock holder's proportionate ownership will not change. The stock holder is free not to
subscribe to the offering or to pass the rights to others. In the UK a stock holder chooses not to subscribe
by filing a letter of renunciation with the issuer.

 

Few businesses begin with freely traded shares. Most are initially owned by an individual, a small group
of investors (such as partners or venture capitalists) or an established firm which has created a new
subsidiary. In most countries, a firm may not sell shares to the public until it has been in operation for a
specified period. Some countries bar firms from selling shares until their business is profitable, a
requirement that can make it difficult for young firms to raise capital.

  

Flotation, also known as an initial public offering (ipo), is the process by which a firm sells its shares to
the public. This may occur for a number of reasons. The firm may require additional capital to take
advantage of new opportunities. Some of the firm's original investors may want it to buy them out so
they can put their money to work elsewhere. The firm may also wish to use shares to compensate
employees, and a public share listing makes this easier as the value of the shares is freely established in
the market place. The flotation need not involve all or even the majority of the firm's shares. Table 7.3
shows that the annual value of Ipos in the United States grew sevenfold during the 199os before
collapsing in 2ool. The value of Ipos in the UK, although much smaller, has been less volatile.
Some of the biggest flotations in recent years have involved the privatisation of government owned
enterprises, such as Deutsche Telekom in Germany and YPF, a petroleum company, in Argentina. Such
large firms are often floated in a series of share issues rather than all at once, because of uncertainty
about demand for the shares. According to the OECD, privatisations raised nearly $6oo billion between
1996 and 2000, much of which was financed by issuance of shares. Another source of large flotations is
the spin off of parts of existing firms. In such a case, the parent firm bundles certain assets, debt
obligations and businesses into the new entity, which initially has the same shareholders as the parent.
Among the largest spin offs in recent years have been Lucent Technologies, formerly part Of AT&T,
and Delphi, the component manufacturing unit of General Motors Corp. A third source of large
flotations has been decisions by the managers of established companies with privately traded shares to
allow limited public ownership, as in the case of ups, an American package delivery company.

   

Rather than selling its shares to the public, a firm may raise equity through a private offering. only
sophisticated investors, such as moneymanagement firms and wealthy individuals, are normally allowed
to purchase shares in a private offering, as disclosures about the risks involved are fewer than in a public
offering. Shares purchased in a private offering are common equity and are therefore entitled to vote on
corporate matters and to receive a dividend, but they usually cannot be resold in the public markets for a
specified period of time.

    

A secondary offering occurs when a firm whose shares are already traded publicly sells additional shares
to the public called a follow on offering in the UK or when one or more investors holding a large
proportion of a firm's shares offers those shares for sale to the public. Firms that already have publicly
traded shares may float additional shares to increase their total capital. If this leaves existing
shareholders owning smaller proportions of the firm than they owned previously, it is said to dilute their
holdings. if the secondary offering involves shares owned by investors, the proceeds of a secondary
offering go to the investors whose shares are sold, not to the issuer.

   

Before issuing shares to the public, a firm must engage accountants to prepare several years of financial
statements according to the Generally Accepted Accounting Principles, Or GAAP, of the country where
it wishes to issue. In many countries, the offering must be registered with the securities regulator before
it can be marketed to the public. The regulator does not judge whether the shares represent a sound
investment, but only whether the firm has complied with the legal requirements for securities issuance.
The firm incorporates the mandatory financial reports into a document known as the listing particulars
or prospectus, which is intended to provide prospective investors with detailed information about the
firm's past performance and future prospects. in the United States, a prospectus circulated before
completion of the registration period is called a red herring, as its front page bears a red border to
highlight the fact that the regulator has not yet approved the issuance of the shares.

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Explain in detail the method of valuing an ordinary share?

Cash flows of an ordinary (or equity) share consist of the stream of dividends and terminal price of
the share. Unlike the case of a bond, cash flows of a share are not known. Thus, the risk of holding a
share is higher than the risk of a bond. Consequently, equity capitalisation rate will be higher than that
of a bond. The general formula for the share valuation is as follows:

DIV1 DIV2 DIV1 + Pn

P0= -------- Ô


 












n

(1 + ke)1 (l + ke)2 (l + ke)n

As the time horizon,


becomes very large (say, extends to infinity) the present value of future
price approaches zero. Thus the term

disappears from the formula, and we can use the
following equation to find the value of a share today:

If dividends do not grow, then capitalising earnings can determine the share value. Under no-
growth situation, earnings per share (EPS) will be equal to dividends per share (DIV) and the
present value is obtained by capitalizing earnings per share:
_ EPS1

P0= ke

In practice, dividends do grow over years. If we assume dividends to grow at a constant rate, 

then 


(1 + 








(1 + 
and the share price formula
can be written as follows:

p _
0
=

This formula is useful in calculating the equity capitalisation rate 
when the price of the share
 
is known. Under the assumption of constant growth, the share value is equal to the
capitalized value of earnings plus the value of growth opportunities as shown below:

P=
0 V
=+
 The price of a 'growth stock' is not merely the capitalised value of earnings but it also includes
the present value of growth opportunities.

Given a firm's EPS, ROE, the equity capitalisation rate, retention ratio and constant growth, the
growth opportunities can be valued as follows:

_ NPV1 _bxEPS1(ROE-ke)
8
~ke-g~ ke(ke-g)

A firm's total assets minus its total liabilities. Equivalently, it is share capital plus retained earnings
minus treasury shares. Shareholders' equity represents the amount by which a company is financed
through common and preferred shares.

Also known as "share capital", "net worth" or "stockholders' equity".

Equity share can be classified into following categories based on stock market analysis:
1 Blue Chip shares
2 Growth shares
3 Income shares
4 Cyclical shares
5 Speculative shares

Return on equity

å   (å ) measures the rate of return on the ownership interest (shareholders' equity) of
the common stock owners. It measures a firm's efficiency at generating profits from every unit of
shareholders' equity (also known as net assets or assets minus liabilities). ROE shows how well a
company uses investment funds to generate earnings growth. ROEs between 15% and 20% are
considered desirable.[1]

 


ë2]

ROE is equal to a fiscal year's net income (after preferred stock dividends but before common stock
dividends) divided by total equity (excluding preferred shares), expressed as a percentage. As with many
financial ratios, ROE is best used to compare companies in the same industry.
‰igh ROE yields no immediate benefit. Since stock prices are most strongly determined by earnings per
share (EPS), you will be paying twice as much (in Price/Book terms) for a 20% ROE company as for a
10% ROE company.

The benefit comes from the earnings reinvested in the company at a high ROE rate, which in turn gives
the company a high growth rate. The benefit can also come as a dividend on common shares or as a
combination of dividends and reinvestment in the company. ROE is presumably irrelevant if the
earnings are not reinvested.

© The sustainable growth model shows us that when firms pay dividends, earnings growth lowers. If the
dividend payout is 20%, the growth expected will be only 80% of the ROE rate.
© The growth rate will be lower if the earnings are used to buy back shares. If the shares are bought at a
multiple of book value (say 3 times book), the incremental earnings returns will be only 'that fraction' of
ROE (ROE/3).
© New investments may not be as profitable as the existing business. Ask "what is the company doing with
its earnings?"
© Remember that ROE is calculated from the company's perspective, on the company as a whole. Since
much financial manipulation is accomplished with new share issues and buyback, always recalculate on
a 'per share' basis, i.e., earnings per share/book value per share.