Even if you are not investing in the stock market, you must have come across the term equity shares or simply shares. But do you know exactly what are equity shares? What happens when you buy equity shares of a company? Do you become an owner in the company by buying equity shares? Do you get to participate in the management’s decision by buying equity shares? If these are some of the questions running in the back of your head, then this is the article will answer all your doubts about equity shares.
In this article, we will cover:
- What are equity shares?
- How do equity shares work?
- History of equity shares
- Why do companies issue equity shares?
- Why do investors buy equity shares?
- Advantages of equity shares
- Limitations of equity shares
- What are the other types of shares?
What are Equity Shares ?
Equity share is also known as a stock. It is a small portion of the company that an investor buys in anticipation of future profits. When you own a stock, you become a shareholder of the company. This makes you eligible for the company’s profits and losses.
Each shareholder gets voting rights through which he can vote on the company’s major decisions.
Besides profiting from any rise in value, equity shareholders might also receive dividends from the company. Typically, larger and well-established companies are most likely to pay dividends and bonuses as they have more assets and cash flow in hand.
How Do Equity Shares Work?
Equity shares work on the concept of demand and supply in the market.
- If more people are selling the stock of a company, then it will fall.
- If more people are buying the stock of a company, then it will rise.
People buy or sell stocks based on their assumptions about the future of a company.
- If they believe that a company will perform well in the upcoming years, they will buy the stock. This will push the stock prices up.
- If they believe that a company will perform poorly in the coming years, they will sell the stock. This will bring down the stock prices.
Demand (buying) and supply (selling) help in determining the price of a share in the market. You can profit from equity shares by anticipating the changes in demand and supply.
To understand more about what are equity shares watch the video:
History of Equity Shares
The history of equity shares goes back to the 1400s in a small town in Belgium. A group of merchants assembled in the middle of the town from all around the world. They started buying non-perishable goods in anticipation that the prices might rise in the near future. This initially introduced the practice of trading.
Later in 1611, the Dutch East Indian company shipped precious goods such as Gold, Porcelain, Spices and Silks across the globe. As the shipping costs were expensive, the companies approached citizens to invest money on the trip. In return, they offered a share of the profits that the trip would make.
This practice introduced the first stock exchange in the world called ‘The Amsterdam Stock Exchange’. For many years, the shares of the Dutch East India company were actively traded on this exchange.
Share Certificate of Dutch East India Company
At this point, other countries began creating similar stock exchanges and investors used to buy and sell shares of companies.
In the 1800s, this practice started in India where 5 stockbrokers met under a banyan tree. Here, they exchanged shares of different companies. Two decades later, as the number of brokers increased, a small group called ‘The Native Share & Stock Brokers Association’ was formed. Today, this small group is known as the Bombay Stock Exchange (BSE). BSE is the oldest stock exchange in India and Asia where more than 4,000 equity shares of companies are listed and traded on a daily basis.
Now that you understand what are equity shares, the main question is, why are equity shares issued? Why doesn’t the company take a bank loan if it needs capital?
Why Do Companies Issue Equity Shares?
The primary goal for issuing equity shares is raising capital from investors. The capital that is raised by the company can be used for multiple purposes such as:
- Acquisition of another company
- Creating future cash reserves
- Research and development of new products
- Growth and expansion in different markets or countries
- Repaying outstanding debts
- Launching new products or services
If the company opts for debt financing, they are liable to pay a fixed interest on the borrowed capital and this borrowed money acts as a debt on their balance sheet. To avoid such hassles, equity shares are issued. The major advantage of issuing equity shares instead of debt is that the company can conserve cash effectively. Debt financing require periodic interest payments which drains cash from the business. If companies fail to pay interest, then it can lead to rating downgrades too.
However, in the case of stocks, companies have no obligation to repay the borrowed capital. Even dividend payments are optional. This helps them conserve more cash.
Advantages of Equity Shares to Investors
1. Voting rights
When you buy equity shares, you get voting rights. This allows investors to vote on corporate policies and major business decisions. The more equity shares an investor owns, the more power they have over a company.
2. High returns and long term wealth creation
Over the years, equity shares are one of the few investment options which have provided inflation-beating returns. In the last 10 years, equities has provided a compound annual growth rate (CAGR) return of 17.60% which is much higher than any other investment option.
Source: RBI and BSE website
Data as on 31st March 2021
3. Limited legal liabilities
Beyond financial investments, profits and voting rights equity shareholders have limited legal liabilities. So, if the company gets into legal issues, the shareholders are not responsible in any case.
Equity shares can be easily bought and sold by investors on the stock exchange. This high liquidity helps investors not only buy shares quickly but also sell them if the company is not performing.
Disadvantages of Equity Shares
1. No priority over dividend pay-outs
Most of the time, dividends are declared when a company makes profits. But unfortunately, equity shareholders have the last claim on these profits. Dividends are first paid to the bond holders then the preference shareholders. Whatever remains is then paid to equity shareholders. If a company has high debt, then a substantial portion of the profits will be paid to bond holders. This leaves very little distributable profits for equity shareholders.
2. Market risks
A bond holder has no market risk. Irrespective of the stock price, their interest payment is guaranteed. But returns from the stock market are not guaranteed. If the company’s performance is poor, then it can lead to falling share prices and investors might have to sell their shares at a loss. Hence, equity shares are risky in nature.
Why Do Investors Buy Equity Shares?
Investors are constantly looking for ways to grow their hard-earned money. Moreover, equity shares have historically provided the best returns amongst all other asset classes.
Hence, investors buy equity shares to:
- Participate in the growth of the company
- Earn regular income in the form of dividends
- Earn bonus shares to increase their shareholdings
- To acquire voting rights and be a part of key decisions.
How to Make Money by Investing in Equity Shares?
There are two ways to make money by investing in equity shares.
1. Active investing
Active investment is where an investor actively buys and sells stocks. The duration of active investing can be – a few seconds (scalping), a few minutes to hours (intraday trading), a few days (swing trading)
The primary aim of active investing is to generate quick profits. It is ideal for individuals with a high-risk profile and who can actively track market movements.
Recommended watch: Best intraday trading strategies
2. Passive investing
Passive investment is a long-term investment strategy that works on the buy and hold principle. In passive investing, investors buy stocks with an aim to hold them for the long term.
Coffee-can investing is a classic example of passive investing. This investment strategy is suitable for investors with a moderate to low risk appetite and a long-time horizon.
What Are The Other Types of Share?
Companies normally issue two types of stocks:
- Equity shares
- Preference shares
While both equity and preference shares represent ownership of a company, they are not the same. Let us look at the differences between equity shares and preference shares.
|Parameters||Equity shares||Preference shares|
|Meaning||Equity shares represents ownership in a company. When you own equity share, you become a part owner and are entitled to the company’s profits and losses.||Preference shares are different from equity shares. Here the company promises to give the preference shareholder preference in profit sharing over equity shareholders.|
|Voting rights||Equity shareholders get voting rights.||Preference shareholders do not get any voting rights.|
|Claim on dividends||Equity shareholders are the last to get dividend payments.||Preference shareholders are the first to receive dividends.|
|Preference while winding up||Equity shareholders are the last to get paid in case of bankruptcy.||Preference shareholders get paid before equity shareholders in the event of bankruptcy.|
|Cost of issue||The cost of issue is high.||The cost of issue is low|
|Unpaid dividends||Paying dividend to equity shareholders is optional.||Preference shareholders have a fixed dividend rate. If the company does not declare dividends for a few years, the unpaid amount is treated as arrears.|
|Risk||Equity shares are ideal for investors with high risk appetite.||Preference shares are ideal for investors with medium risk appetite.|
|Redemption||Equity shares cannot be redeemed.||Preference shares are redeemable.|
|Convertibility||Equity shares cannot be converted.||Preference shares can be convertible or non-convertible.|
To explore more about preference shares – Click here.
What are Equity Shares? – Final Thoughts
The best way to create wealth from equities is fairly simple. You just need to select the right stock and invest in it. But finding good quality stocks is difficult. It takes ample knowledge, expertise and a keen eye on the fundamentals of the stocks.
We have introduced Samco’s Stock Ratings to make your life easier. It evaluates and rates more than 4,000 listed equity shares. You must invest only in stocks that get 4 or 5 star ratings and avoid the rest. Making money from equity shares was never this simple.
[Suggested Reading: Best Large-Cap Stocks to buy now in India]
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