What is equity, and what are equity investments?

In financial terms, equity is the portion of a company owned by a shareholder. For instance, if Carol owned 5% of a million-dollar company, she’d be the proud owner of $50,000 in equity (5% of one million).

Investors can invest in shares of a company to buy a certain percentage of it. This is called investing in stock, or trading on the stock market. The value of each owner’s equity share is determined by valuation experts. The more valuable a company is, the more each of its shares costs.

Equity investments

An equity investment, thus, is money that is invested in a company by purchasing shares of that company in the stock market. While there are exceptions, most companies become available for investment to retail investors after their initial public offering (IPO).

To elaborate, equity investors purchase shares of a company with the expectation that they’ll rise in value. If a share previously priced at $10 apiece inflates to $11, the investor stands to earn $1 for every share owned. For that, of course, the stockholder will have to sell shares to another buyer on the stock market who’s willing to buy them at $11.

However, there is another way for investors to earn their money back, other than selling shares directly. If a company is acquired by a bigger entity, like another company, all shareholders get ‘liquidated’—which is market-speak for ‘bought out.’ Depending on the company’s valuation and the number of equity shares they own, shareholders get paid to sell their stock and ‘exit’ the position.

What is equity investments?

There are different types of equities and potential investors would do well to develop a reasonable understanding of the broad categories. Depending on your involvement in the company and your financial risk appetite, there are different types to choose from.

Stocks or shares

These are the most common type of equity investment. It represents the portion of ownership you have in a company. What’s interesting is that retail stock investing usually involves buying a certain number of shares out of the total number of shares a company has. Venture capital investing or angel investing, on the other hand, are the big leagues. Here, investments are usually made to buy up a certain percentage of a company, say 15% or 25% in a single trade.

Equity value = Value of one share * Number of shares owned.

Preferred stock

Preferred stocks are just like regular stocks, but their owners don’t have as many responsibilities. While major shareholders in a company are expected to perform certain executive functions in the running of the company, preferred stock owners are not required to play that role. Preferred owners usually don’t have voting rights. However, in the event of the company getting liquidated, holders of preferred stock receive payments up to a certain amount before any money is distributed to holders of common stock.

Treasury stock

Sometimes, companies sell too much of their stock. When that happens, the cost of capital rises and prices fall. When share prices fall, a company literally loses value. To keep its finances intact, the company might decide to buy back shares that it had already sold from its shareholders at market price and keep them in its own treasury. Hence, they are called treasury stocks or treasury shares. It might seem odd, but stock buyback is considered an effective corporate strategy, which is also very popular.

Brand equity

Brand equity isn’t the kind of equity you can tangibly invest in as an outsider. It is the commercial value that a company derives from the consumer’s perception of the brand rather than the brand itself.

For instance, a luxury goods brand could probably pull off selling cheaper quality goods to its customers if the buyers perceive the brand to be socially or culturally valuable. In other words, brand equity is the additional value that a company commands over and above its market value or the value of its regular equity.

What is the market value of equity?

Stock markets provide a platform for investors to buy and sell shares of companies.

When a company becomes ‘publicly traded’—available for investment by the public—it starts trading on the stock market. The price of a company’s equity share can change frequently, even during the course of a trading day. While traders bet on short-term price changes to earn capital through leverage (big money), investors hope that the company would become more valuable over a longer period of time.

The market value of equity is the price of a company’s stock at any given point in time. While determining the value of a private company is a guessing game, publicly traded firms are generally valued based on their current stock price as well as past and future earnings.

Advantages and disadvantages of investing in equities

Investing in equity comes with its share of advantages and disadvantages. Let’s find out how they stack up, beginning with advantages.

• Variable income: A lot of factors can drive up the price of a company’s stock. Since there’s no ‘fixed’ income, there’s no limit to the potential upside.
• No fixed holding period: Equity shares are not subject to any terms; you can hold them for 5 minutes or 35 years, depending on your goals and objectives.
• Dividend payments: As a shareholder, you are entitled to a portion of the company’s profits in the form of dividends. Profits are distributed according to the stake you have.
• Ease of investing: It is very easy these days to open a demat account, transfer money, and buy shares. Besides, there’s something for everyone to choose from in the stock market—penny stocks to blue chips, depending on how much you plan to invest.

Disadvantages:

• Uncertain outcomes: While there is potential for upside, you could end up losing money too. That’s why equity investing is often considered high-risk.
• Dependent on macroeconomic conditions: Unlike fixed deposits or other such instruments, returns on equity shares depend heavily on macroeconomic conditions. Recessions and economic downturns are dangerous for stock market investments.
• Management of the company: The value of a company is, for the most part, driven by its top management. Uncompetitive business strategies and poor management processes can often drive a company aground.

Understanding risk-return tradeoff is key to investing

Investing in equities is not for the faint-hearted. Such investments are risky because companies function with too many moving parts, and are extremely sensitive to the macroeconomic environment, industry changes, management decisions, corporate structures, or even buying or selling pressure in the stock markets.

It is important for traders to understand the risks and upsides of equity investments before taking the plunge. It is always important to study a prospective trade well, identify key advantages and weaknesses, and devise a proactive profit-booking strategy in the short term to stay profitable.

For the long term, it is imperative to start early, identify quality stocks, and understand the potential of the specific industry and economic trends before investing.

Although both strategies have their pros and cons, it is noteworthy that historically, equity shares have yielded much better returns in the long term. As always, DYOR.

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