Equity Investment refers to as investment media representing an ownership position on assets in which the investor is an owner of the firm and is thus entitled to a residual share of profits. Equity instruments differ from fixed-income securities in that their returns are not contractual.
Returns can be much better or much worse than those from a bond. Equity ownership, however, arises out of indirect equity investment and direct equity investment.
Before going to describe the direct and indirect equity investment, we need to identify the components of equities.
Components of Equities/ Equity Investment
Capital structure refers to long-term sources of financing for a firm. It consists of long-tern debt and equities.
Shareholders’ equity is a residual item that is not fixed. It is the difference between the assets and all other liabilities of a firm which is found as:
Assets – Liabilities = Equity
However, the equities of a firm are comprised of the following components:
Common stock: The amount of money paid by the owners of the organization measured as the product of par value (face value) and number of shares outstanding. ii.
Surplus: The excess amount above each share of stock’s par value paid by the shareholders.
Undistributed profit: The net earnings after tax that is retained in the business rather than distributed to the shareholders as dividends
Equity reserves: Representing any fund for contingencies, providing a reserve for dividend expected, and a sinking fund to retire stock or debt in the future.
Preferred stock: The amount which is measured by the par value of any shares outstanding promising to pay a fixed rate of return in the form of fixed dividend. vi.
Subordinated debentures: Long-term debt carrying a convertible feature. The holders of them have the right to exchange their debt for shares of stock.
Equity commitment notes: Debt security is repayable only from the sale of stock.
Minority interest in consolidated debentures: The holdings of ownership shares of other business enterprises.
Equity Investment Explained
Equity investment allows investors to make huge profits in a frequently changing market. Though the profits are generated faster, the risk element is also quite high.
Once an investor decides to make an equity investment, they must approach a broker or a financial advisor who helps facilitate smooth trading. Trading is the process of buying and selling shares at the stock money market.
The stock market allows investors to buy and sell stock securities. The existence of these markets is a guarantee to investors that their interest in stocks payout when need be.
The rising and falling of share prices regulate when to buy or sell your shares. When the prices are low, one should purchase the shares and sell them when the price goes up.
When the investor invests, they will hold part of the company’s ownership. The investment helps the company to expand and create a more profitable business.
Keeping in mind the background of companies one wants to invest in helps the investor understand their performance and make an informed decision without risking their money to non-performing companies.
There are ups and downs in equity investments, and availing the service of a financial advisor can keep one safe.
Therefore, it is important to analyze the company of interest’s performance in stocks in the past few years. In addition, holding shares for different companies helps cushion the investor against risk.
Direct Equity Investment
Two major direct equity investments are common stocks and preferred stocks. When investing directly, investors can choose money market securities, capital market securities, or securities in the derivatives market that include options and financial futures contracts.
However, the followings are major direct equity investments:
Common stock:
Common stock may be defined as the residual ownership of a corporation, which is entitled to all assets and earnings after the other limited claims have been paid and which has basic voting control.
In short, common stock is the fundamental ownership equity. The investor in common stock thus occupies a position directly comparable to that of the owner of a firm or a factory.
Common stock bears the main burden of the risk of the enterprise and also receives the lion’s share of the advantages of success. Common stock has no maturity date rather its life is limited by the length of time stated in the corporate charter.
Common stock represents the ownership interest of corporations.
Among other things, the holders of common stock elect the board of directors; have a right to the earnings of the firm after all expenses and obligations have been paid; also run the risk of receiving nothing if earnings are insufficient to cover all obligations.
Holders of common stock receive a return in the form of the distribution of corporate income like dividends and capital appreciation. Common stockholders have only a residual claim against the income and assets of the firm.
Thus, the potential for gain is greater for holders of common stock than that for debtholders whose gain is fixed. On contrary, the risk for the equity owners is correspondingly greater since they have the last claim to the firm’s income and assets.
However, the characteristics of common stock can be summarized in the following manner:
It normally has control of the corporation and will exercise that control in its own interest.
It has unlimited ownership rights to the remaining gains from the business after other security holders have received their contractual payments.
It bears the principal hazards of the business.
Common stock may be sold by its holder to any willing buyer.
The earnings on the common stockholder’s equity may be unstable.
Dividends may fluctuate. It must depend on earnings, cash position, surplus position, expansion needs, debt situation and management policy. Common stock prices fluctuate extensively.
Learn more: What is Common Stock?
Preferred stock:
Preferred stock is a hybrid sort between a fixed and variable income security. It is an equity security with an intermediate claim between bondholders and stockholders on a firm’s assets and earnings.
In the event of liquidation, preferred stockholders have a claim on available assets before the common stockholders.
In addition, preferred stockholders get their stated dividends before common stockholders receive any dividends. Many issues of preferred stock are callable at a stated redemption price.
Preferred stocks are usually perpetual securities having no maturity date, although there are exceptions to the general rule.
However, the followings are the special features of preferred stock:
Some preferred stockholders have voting rights and some preferred stockholders do not have this right and voice in the management.
Preferred stockholders have a pre-emptive right to subscribe to additional issues of common stock but non-voting preferred stock has no pre-emptive right.
Most preferred stocks have a par value. In this case, the shares’ cash dividend rights are usually stated at a percentage of par value.
Cash dividends are the most significant aspect of preferred stock in which the stockholders should get more gain from dividends than from capital appreciation.
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