Introduction to Equity

Key Features of an Equity Share

Equity is stock representing ownership interest in a company.

  • Democratic claim to Earnings – A shareholder has a proportionate ownership claim to the company. The benefits of ownership, such as dividends, rights, bonus etc. is same for all the shareholders, except that the majority shareholders get to manage the business as well. No shareholder, however can be asked to pay for the losses incurred by company.
  • Transferability of ownership interest – Price discovery is on stock exchange platform via interplay of demand & supply forces.
  • Liquidity – Low barriers to trading on stock exchange & financial leverage combine to make this asset highly liquid.
  • Volatility Stock Market is a proxy for economy’s health. Different opinions with respect to economy & fair value of businesses, makes price discovery quite volatile. Mass psychology, behavioral biases of investor & instruments of financial leverage in trading further add to this volatility.
  • Means to Wealth Creation – Efficiently run business are able to pass inflation onto its clients & generate return in excess of cost of capital. Compounding effect of such high returns translates into faster growth in valuation of business & its share price. Equity investment is a great vehicle for wealth creation.

Facets of Equity Investment    

  • Return ExpectationAt macro level, return expectation of equity asset is equal to nominal growth of economy. Broader stock market should give return equal to real growth of economy plus the inflation rate. Efficiency of business (competitive advantage, moat etc.) improves upon such expected return.
  • Asymmetric Payoff An asymmetric payoff is where the upside potential is greater than the downside risk. The maximum downside in any stock is 100%, however, there is no limit to how high a stock can go. At single stock level the risk of loss is very high but at the portfolio level, it becomes possible to reduce risks without sacrificing the unlimited upside potential. The payoff as result can be huge.
  • Relationship with Debt – GOI Bond Yield (risk free return) has a direct bearing on determining the attractiveness of equity as an investment destination. A case for equity asset class is only made out if it earns Risk Premium in addition to the Bond Yield & its Earnings Yield (EPS/Price) exceeds Bond Yield. At micro level too, lowering of bond yield leads to reduced cost of capital for business, thereby improving profitability & valuation of equity shares. Thus, flows into & out of equity asset class are heavily influenced by interest rate movement.
  • Volatility vs. RiskRisk implies uncertainty of a return & potential for permanent financial loss. Volatility is measure of uncertainty related to size of potential change in security’s value. It is a reflection of price action. It is this short-term volatility, that is perceived as risk. Such perceived risk of loss can be prevented from converting into an actual loss, through asset allocation & goal-based investment.

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