Chapter 15: Equities
Equities
An ordinary share is a share in the ownership of a company. Ordinary shareholders has right to
attend and vote at general meetings of the company.
Order of distribution of profits:
Debt holders
Preferred shareholders
Ordinary shareholders
Payout ratio = Dividends per share / Earnings per share
Reasons for share repurchase
Company may have some excess cash, that it cannot use for profitability so it decides to
return it to s/h
Excess cash may only have been earning a deposit rate of interest, less than the return
earned on company’s other assets. Disposing of cash, should improve earnings per
share for remaining shares.
Tax efficient way to return investor's money: It could be tax efficient means of
returning capital to s/h if tax treatment of capital gains is more favorable than that of
dividends.
Signal to the market that the board thinks the company is strong.
Company may wish to change its capital structure from equity financing to debt
financing.
Push up the stock price: The stock repurchase reduces the float (number of stocks held
by the public) thereby causing a scarcity of the company's shares in the market.
Compensate for stock options & bonuses: Companies give out stocks to their
employees in the form of options & grants. This increases the number of outstanding
shares. Many companies want to keep their outstanding shares stable. So, they
compensate from the issue of new shares by buying back some of the old shares from
public.
Investment and risk characteristics of equities
Features of equities: SYSTEM T
1. Security:
Security of dividends depends on type and stature of company
Stability of profits, ratio of earnings to dividend
If company winds up, s/h will be paid after creditors have been paid
2. Yield (running Yields):
It is lower for equities, as capital gains are larger and income gains are smaller
than conventional bonds.
Yield (real vs. nominal):
Equities provide real yield in long term. (Yield is in excess of inflation). This
is because company profits tend to rise with inflation and economic growth
and hence dividends.
But there is no guarantee for inflation protection.
3. Spread (Volatility of capital values):
Equity price and dividends, both are volatile
Equity price is determined by S and D.
Some investors buy for short term speculation
Others buy according to present value of future dividends
4. Term:
Can be held in perpetuity
5. Expenses:
Linked to Marketability. (largest element of expense is spread between buying
and selling prices)
Dealing expenses greater than bonds (usually)
6. Currency risk:
Risk for investor who is investing in equities denominated in one currency but
has liabilities denominated in another
7. Marketability:
Varies enormously for different companies
Larger company would have better chances of marketability (better floating of
shares), given that number of investors are large
If few investors hold large proportion of shares, then marketability is low.
8. Tax:
Taxation on income gains and capital gains
May be different for quoted and unquoted shares
Capital gains tax is applied on selling of shares, therefore there is deferral of
tax in this case.
Quoted shares
Quoted shares are listed on a stock exchange and make up the majority of available equity
investment.
Quoted shares are generally:
more marketable
more secure (regulated)
easier to value than non-quoted shares
can be bought and sold in divisible chunks (this is known as divisibility)
Categorization of equities
Industry type
Size of company
Expected profits growth
Marketability
Market capitalization
Risk
Price earnings ratio / Dividend yield
Level of gearing (debt to equity borrowing)
Overseas earnings
Exposure to economic cycle
Why use industry groupings to categorize shares?
Shares are grouped by industry sectors because:
It is practical for analysts to specialize in one area
The share prices of companies in the same sector tend to be correlated.
Practicality to specialize in one area because:
To understand competition
More information can be obtained on industry basis
Hard to be expert in all areas
Helps in decision process, portfolio classification and management
Correlation of investment performance
Resources are similar in one sector
Similar Costs
Same market forces of Demand
Financial structure is similar
Same effect by changes in interest rates.
Problem of industry grouping
Companies may operate in several sectors
Complication happens if there is M & A.
Difficult to assign MNCs (working in different countries)
There may be existence of heterogeneity of companies within a particular sector
Preference shares
A preference share is a particular class of share that generally ranks ahead of ordinary shares.
Preference shareholders are normally entitled to a specified rate of dividend and, unlike ordinary
shareholders, are not entitled to residual profits.
Although part of a company’s share capital, from an investment perspective preference shares
are much more like fixed-interest bonds.
Features of preference shares:
1. Dividend = Fixed percentage of par value
2. Tax treatment is similar to ordinary shares
3. Dividend rate is quoted net of tax e.g. 7 % (net) preference shares
4. Dividend do not have to be paid if profits are insufficient
5. Rank before ordinary shares for repayment on winding up
6. Most preference shares have no final redemption date.
7. They do not normally carry voting rights