What Are Equity Shares?

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Equity Share Meaning

Equity shares are one of the most common ways people invest in the stock market. Many people invest in equity shares in the hope of earning high returns that stocks have historically offered. 

For example, in the decade between 2011-2020, India’s benchmark index, the Nifty 50 Index, delivered a compounded annual growth rate of 8.81%. In simple words, if an investor had invested INR 5,000 in the Nifty 50 in 2011, the investment would have been worth INR 11,630 in 2020. 

For the same period, the BSE Sensex Index delivered a compounded annual growth rate of 11.12%. That means if an investor had invested INR 5,000 in the BSE Sensex in 2011, the investment would have been worth INR 14,350 in 2020.

What Is A Share?

A share is a partial ownership in a company. When a company is formed, the initial capital requirement is fulfilled by partners or investors who own the company. As the company grows, its capital requirements increase. The company can raise capital in various ways like business loans, adding partners, approaching new investors, among others. 

The most common and preferred way to raise business capital is by issuing shares, a process known as going public or launching an initial public offering (IPO). These shares are issued to investors with an option of trading them on a stock exchange like the National Stock Exchange (NSE) and the Bombay Stock Exchange (BSE).

Being a shareholder also entitles the investor to partake in the profits and growth of the company. The company issuing shares ensures that profits are shared with all shareholders in the form of dividends. 

Every company specifies the rights and responsibilities of shareholders via two documents – the Articles of Association (AoA) and the Memorandum of Association (MoA). These documents comprise details such as the business objective(s) of the company and rules relating to the distribution of dividend among shareholders.

Types of Shareholding

Shares are broadly classified into two main types—preference and equity. 

Difference between Equity Shares and Preference Shares

Preference Shares

When an individual holds preference shares, they have a preferential right to:

  • Receive dividends at a fixed rate. When a company books profits and extends the same to its shareholders, the amount thus distributed is called a dividend. This is usually calculated from net profits after deducting essential expenses. The rate at which the dividend will be handed out is determined by the company’s board.
  • Receive repayment of the capital if the company winds up. Winding up is a process of dissolving a company. When a company winds up, it stops doing business and sells its assets to pay off creditors, partners, and shareholders.

Preference shareholders have limited voting rights as compared to equity shareholders and they can vote only on matters affecting their rights.

Equity Shares

All shares that are not preferential shares are equity shares and are also known as ordinary shares.

A person who holds equity shares has the right to vote in the company’s decisions. 

As an equity shareholder, you are entitled to receive a claim to any profits paid by the company in the form of dividends. It is important to note here that when a company books profits, its management has the right to decide if:

1. It wants to reinvest the money into the business for growth and/or expansion; or

2. Pay out a part of the profits to shareholders in the form of dividend. 

This is decided by the board of directors and shareholders have no influence over this decision. 

There are some companies that do not declare dividends at all. Also, if a company has declared dividends in the past, there can be no assurance that it would continue to do so in the future.

Benefits of Investing in Equity Shares

Investing in equity shares offers certain benefits. These include: 

Potential to Earn a High Income

When you invest in equity shares, you have a two-fold earning potential:

1. Capital appreciation due to the increase in stock price. 

Once a company issues shares, they are listed on a stock exchange to allow investors to trade in them. Based on the demand and supply of a particular share, its price can go up or down. If you have purchased a share at a lower amount and its demand increases while the supply remains limited, then you have an opportunity to generate wealth. 

For example, let’s say that you purchase a share of a pharmaceutical company at a market price of INR 100. After a year, the demand for the stock of the company increases since most investors expect the pharmaceutical sector to grow and the stock price increases to INR 150. This gives you an opportunity to earn capital appreciation at a rate of 50% within one year.

2. Regular income if the company declares dividends

If the company decides to share profits by declaring a dividend, then shareholders have the right to claim them. If you are invested in companies that declare dividends every year, it can add to your regular income.

Protection Against Inflation

A product that was worth INR 50 in 2010 will cost much more ten years later. As time passes, money loses value and we have to spend more to buy the same goods and services. This phenomenon is called inflation. 

In India, the current inflation rate is around four percent. This means that a product that is worth INR 100 today will be worth INR 104 by the end of the year. Or, in 10 years, the price of the product will increase by around 50%. Therefore, it is important to ensure that you invest your savings in a manner that they generate returns at a rate higher than the inflation rate. 

If you keep your fund in a savings account then you might not succeed in beating inflation rates at all times. Hence, many investors opt for higher-return-generating financial instruments such as equity shares to preserve the buying power of their money.

For instance, bank fixed deposit rates have varied between six and nine percent between 2011 and 2020. On the other hand, stock investments have shown the potential of generating double-digit returns if we look at compounded annual returns of market indices such as the Nifty Bank Index that clocked a compounded annual return of around 13.44% and Nifty FMCG Index that gave a compounded annual return of around 15.24%.

Therefore, investing in shares offers you an opportunity to beat inflation rates and maintain the value of your savings.

Diversification Across Assets

In the simplest terms, investing is about purchasing assets that have the potential of generating profits. The different investment options available can be categorised into asset classes like equity, bonds, real estate, commodities, among others. These asset classes are categorized based on the risk to the capital, tax treatment, and the approximate return potential. 

Traditionally, most Indians invested in bank fixed deposits. This has been a low-risk investment option where investors receive a fixed rate of return on their investments. However, when the central bank slashes interest rates, the returns of your investment can drop. If you have invested all your money in fixed deposits, then you may see a drop in returns.

Hence, it is prudent to invest in a mix of asset classes such that negative performance of one does not impact your total returns. Even if the interest on fixed deposits falls but the value of stocks you have purchased rise, you can still generate reasonable returns. This concept is referred to as diversification. By spreading your investments across different asset classes, you reduce risks and generate relatively steady returns.

Risks of Investing in Equity Shares

You aren’t assured positive returns when you invest in equity shares. While historically many equity shares’ prices have risen over time as companies succeed and grow and investor demand increases, there are no guarantees. You could lose all of the money you spend on an equity share. 

Even if you don’t lose everything you invest, you could still face a situation where, whether due to company performance or overall market sentiment, a company’s share never returns to the price you paid for it. These are risks you take on as an investor in the hopes of making more money and building wealth.

The most common risks associated with investing in equity shares are: 

Capital Loss

The market price of a share is determined by its demand and supply. If most investors feel that the company will perform well in the future, then they would want to invest in it and try to purchase its shares. This leads to an increase in demand and consequently, a jump in the market price of the stock. Having said this, the opposite is also possible. 

If most investors believe that a particular company might suffer losses or possibly wind-up in the future, then they will start selling its stocks. Therefore, there will be more sellers than buyers in the market for the said stock resulting in the supply surpassing the demand and a drop in the market price of the stock. Hence, there is a risk of losing money instead of earning returns when you invest in shares.

For example, let’s say that you buy 100 shares of ABC at INR 100 per share and invest a total amount of INR 10,000. A few months later, some policy changes announced by the government make investors feel positive about the future of the company. Hence, the demand for shares increases and the price reaches INR 150. If you sell the shares at this stage, you book a profit of INR 5000. 

On the other hand, if the policy change announcement makes investors feel negative about the company’s future, then the demand could fall resulting in the share price falling to say INR 75. If you sell your shares then, you will book a loss of INR 2500.

Therefore, when you invest in shares, the investment carries a risk of capital loss.

Volatility 

Volatility is the fluctuation of the market price of a share over a given period. So, if a share’s market price fluctuates between INR 100 and INR 200 in a day, then it is said to be more volatile than a stock whose market price fluctuates between INR 140 and INR 160 in a day. 

Since the market price of a share is determined by the general sentiment of investors towards it, and is influenced by a range of external factors such as social, political, macroeconomic, stock prices can turn volatile in no time. 

When you decide to purchase a stock, you would want to buy when the price is low so that you can earn returns even with a small increase in price. However, if the stock price is highly volatile, then you carry the risk of buying a stock when the price is high, pushing your profit price higher. The same is also true for investors selling stocks that are highly volatile.

While risks are unavoidable with investing, there are steps you can take to reduce the risk you take on. You can invest in mutual funds or exchange traded funds (ETFs) that provide exposure to hundreds or thousands of stocks and bonds, which decreases many of the risks described here. While they aren’t a guarantee against loss, they do drastically reduce the risk you’ll lose money over investing in one company’s equity share.

How to Buy Equity Shares?

To invest in the stock market, you need three essential accounts: 

  1. Demat Account – to hold the shares in your name.
  2. Trading Account – to place buy and sell orders you need a trading account with a stockbroker registered with a stock exchange.
  3. Linked Bank Account 

There are two ways to invest in stocks:

The IPO-way

When a company launches shares for the first time, it announces a public listing called an IPO. As an investor, you can apply for an IPO through your net banking account or place bids for the company’s shares via stock exchanges. 

Buying from the stock market

Apart from the IPO, you can buy or sell stocks around the year on the stock markets by following this process:

  • Open a demat account and trading account with a linked bank account.
  • Log in to your trading account.
  • Select shares that you want to purchase.
  • Finalize the price at which you want to buy.
  • Once the transaction is confirmed, transfer the money and complete the transaction.

Bottom Line

As an investor, it is important to look at equity shares as an asset class rather than an investment instrument. Investing directly in shares requires a detailed research of the fundamentals and financials of the company. 

This requires time and a fair understanding of the financial markets too. So before you go ahead, make sure you understand the basics, and invest according to your investment profile.

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