Chapter 4: Overview of Equity Securities

1 The Importance of Equity Securities

Equity securities represent a partial ownership stake in a corporation. This ownership grants the holder rights to a portion of the company's profits (dividends), voting power in key corporate decisions, and a residual claim on assets in the event of liquidation. As a key asset class, equities offer higher potential returns than government bonds, but also come with higher risk and volatility.

Market Capitalization vs. GDP

The ratio of a country's total stock market capitalization to its Gross Domestic Product (GDP) is often used as a valuation metric for the overall equity market. A short-term ratio that is significantly above its long-term average may suggest the market is overvalued, while a ratio below the average may suggest it is undervalued.

2 Types of Equity Securities

Equity securities are broadly categorized into common shares and preference shares, each with distinct features.

Common Shares

Ownership Interest: Represent the primary ownership and control of the company.

Voting Rights: Holders can vote on the board of directors, mergers, and other major issues.

Residual Claim: Have a claim on assets and income after all liabilities and preference shareholders have been paid.

Dividends: Not fixed or guaranteed.

Callable/Putable Features: Can include options for the company to repurchase shares (callable) or for the investor to sell them back (putable).

Preference Shares (Preferred Stock)

Hybrid Nature: Combines features of both debt (fixed payments) and equity (ownership).

Dividend Priority: Receive dividends before common shareholders. Dividends are often fixed.

Liquidation Priority: Have a higher claim on assets than common shareholders in a liquidation, but rank below debt holders.

No Voting Rights: Typically do not have voting rights.

Types: Can be cumulative (missed dividends must be paid later), participating (can receive extra dividends), or convertible (can be converted to common stock).

3 Public vs. Private Equity

Public Equity

Securities of publicly listed companies that trade on stock exchanges. They are liquid, have transparent pricing, and are subject to strict regulatory and disclosure requirements.

Private Equity

Issued via private placements and not listed on public exchanges. Private equity is illiquid, has no public pricing, and involves less disclosure. Types include:

Venture Capital (VC): Funding for early-stage companies.

Leveraged Buyouts (LBOs): Acquiring an established company using a significant amount of borrowed money.

Private Investment in Public Equity (PIPE): A public company selling shares at a discount to private investors.

4 Investing in Foreign Equity

Investors can gain exposure to foreign companies through direct or indirect methods.

Direct Investing

Buying shares directly on a foreign stock exchange. This requires knowledge of local market systems and currency exchange.

Indirect Investing (Depositary Receipts)

Buying securities that represent ownership in foreign shares.

American Depositary Receipts (ADRs): Trade on U.S. exchanges in U.S. dollars.

Global Depositary Receipts (GDRs): Traded outside both the issuer's home country and the United States.

5 Risk and Return Characteristics

Calculating Total Return

The total return from an equity investment comes from two sources: capital appreciation (price changes) and dividend income.

Total Return (Rₜ) = (Pₜ - Pₜ₋₁ + Dₜ) / Pₜ₋₁

Where Pₜ is the price at time t, Pₜ₋₁ is the price at time t-1, and Dₜ is the dividend paid during the period.

Illustrative Example: Total Return

An investor buys a stock for $50. After one year, the stock price is $54, and it paid a dividend of $1.

Capital Gain = $54 - $50 = $4

Total Return = ($54 - $50 + $1) / $50 = $5 / $50 = 10%

Understanding Equity Risk

The primary risk in equity investing is the uncertainty of the total return, measured by the standard deviation. This risk stems from uncertainty about future cash flows and dividend payments. Generally, common stock is riskier than preferred stock, and callable shares are riskier than non-callable shares.

6 Equity and Company Value

Companies issue equity to raise capital for various purposes, such as funding operations, acquisitions, and expansion. The goal is to maximize shareholder wealth by maximizing both the book value and the market value of equity.

Book Value vs. Market Value

Book Value of Equity

The value of the company's assets minus its liabilities, reflecting historical costs.

Market Value of Equity (Market Cap)

The current share price multiplied by the number of shares outstanding, reflecting investor expectations about future cash flows.

The Price-to-Book (P/B) ratio compares these two values

A high P/B ratio suggests investors have high growth expectations

Cost of Equity and ROE

Cost of Equity

The minimum rate of return shareholders require to invest in the company. It is a key input for the Weighted Average Cost of Capital (WACC).

Return on Equity (ROE)

Measures how effectively management generates profits from shareholders' equity. A higher ROE indicates more efficient use of capital.

ROE = Net Income / Average Book Value of Equity