Equity shares are integral to the world of investing whether we trade in them or not
By: Tavaga Research
Equity investment or investing in the stock markets is the Holy Grail of proactive investing. Everything related to it — from the initial public offering (IPO) of a company’s equity stake, the shares of a company to dividends given out by a company — is discussed with great enthusiasm.
Equity shares are a major asset class and play a significant role in asset diversification of investor portfolios.
Of course, if we belong to a young generation, equity shares are also the ones our parents warn us against when they say — ‘Avoid the markets’ by way of parental investment advice.
But seldom do we read about the meaning of equity shares or stock, its different types, their nuances. With this blog, we hope to look at everything there is to know about equity shares.
What Are Equity Shares?
An equity share represents a part-ownership. In investing, this is ownership of a company. The extent of ownership is determined by the number of shares (or division of ownership) made by the company.
A company issues shares to the general public, including us, when it wishes to raise money. If it is issuing shares for the first time, it does so in an IPO, preceded by a prospectus, telling us about its business in detail.
In effect, the company’s initial owners or promoters dilute their ownership control to offer a share in it to the general public, while raising fresh capital with an IPO.
The monetary value of the ownership or value of a share is determined by the company’s market value, as that gets divided by the total number of shares to give us the worth of a single share or stock.
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Other rewards include when a company divides and distributes its profits among shareholders, paid as dividends.
We come by equity shares either on the primary market, through an IPO, or on the secondary market, with share-trading.
An equity shareholder is armed with a number of rights. Afterall, each shareholder in a public limited company is a part owner of that company (having monetarily contributed by buying into the stock).
The meanings: Equity and share
Equity means the quality of being fair and equal. And informally, it has also come to be mean ownership, especially in the context of sharing future profit and value appreciation. No doubt, a result of the investing world’s usage of the word.
A share means one part of a larger entity. The size can vary but it is a part belonging to someone. Much like a slice cut out of a pie.
In investing, a share refers to the right of ownership to equity, often symbolised by the requisite paper or electronic document.
Even though an equity share gives us but a fraction of the value of a company’s worth, it guarantees us a host of rights to ensure we are not overridden by larger shareholders (founders, institutional investors).
Buying equity shares comes with unfettered prospects of sharing the growth rewards of the company. On the other hand, debt instruments of those companies, if any, promise a fixed return on investment. Shareholding does not cap the eligibility to reap rewards while debt instruments do.
There are many benefits to buying equity shares of a company. We list the key four benefits of being a shareholder:-
Annual general meetings (AGMs) — The Companies Act, 2013, requires all listed companies to convene AGMs. Shareholders may attend the meetings.
We have seen shareholders make comments of all shades, even uncomfortable ones leaving management squirming in their seats, vent their anger at ineptitude, praise companies and pursue their questions of maximising returns single-mindedly and of course, vote on resolutions and decisions tabled at AGMs.
AGMs are the meetings empowering a vigilant shareholder to face the company’s management and as they say colloquially, take it to task ‘like a boss’. Because, an equity shareholder is in fact, within their rights to get all the answers pertaining to the company’s performance and profits.
Voting rights — Exercised at the AGM, equity shareholders enjoy one vote for each share they hold. One share-one vote.
The voting rights add more teeth to the role of a shareholder and gives them an executive role to play.
Equity shareholders have the right to vote on every resolution proposed in the meeting, including, but not limited to:-
- Any changes in the article of association (or AOA, defining all the rules and regulations for the operations, financial records, purpose, dealings) of the company
- Appointment of auditors
- New propositions of the management
Voting can take place by a show of hands, a poll or even via mail. The Companies Act, 2013, even decrees companies with more than 1,000 shareholders to arrange e-voting facilities.
Dividend – It is the part of profit the company (its board of directors with permission from the shareholders) decides to share with equity stakeholders. It be all of the profit or a part of it that gets redistributed.
If a part or none is paid out that year, the company usually ploughs back the profits, if any, into growing the business further. But of course, the call is taken after the shareholders vote on what is to be done.
The dividend can be paid as a cash reward, more units of stock or other forms to the shareholders.
A dividend is a source of income or return on our investment in equity shares without needing us to trade our shares. We do not have to sell units to realise a profit on our buying price but still get a return in a dividend year (when the company pays out dividend).
Capital gain or price appreciation – This is the gain we get if we sell our shares at a profit. It needs us to trade the shares at a price higher than our purchase price.
For public-listed companies, the share price is tracked on the stock exchange that it is listed on (since the IPOs of the companies). Even without selling ourselves, we may ascertain the current value of our equity share investment by tracking it on the stock exchange.
A little on shareholders’ rights and benefits makes it clear the perks of such ownership. But how often do we think about why a company’s founders or promoters want to share their ownership with the public? After all, it opens them up to scrutiny, mounts more pressure to perform well, and does away with their status of absolute owners.
This is why:-
1. Going public helps the company raise a large amount of funding, which can be used for purposes like capital expenditure, operational expenditure, expansion etc.
2. Offering company shares to the larger public, reduces the cost of capital for the company.
3. Getting listed on a stock exchange gets associated with increased credibility because of the attendant compliance the company is expected to observe. This boosts the company’s brand image, which is an intangible asset for a company.
Equity shares, however, are not the only form of shares given out in the Indian markets.
Here is a lowdown of different type of shares issued in India:-
Preference shares are a kind of equity share but differ from regular equity shares we have discussed so far.
Preference shares pay a fixed rate of dividend to the holder, every year for the length of tenure, except when the company is in loss.
Holders of preference shares are above ordinary equity shareholders when it comes to distribution of dividend, as they are paid first, before regular shareholders. They also get priority over regular shareholders if the company is liquidated.
But preference shareholders have no voting rights.
Preference shares behave like a debt instrument, furnishing us with a yearly dividend, paid at a fixed rate, for a predetermined tenure. Once the shares mature, the principal amount is redeemed, ie. given back to the shareholder. The Companies Act, 2013, mandates that a company cannot issue preference shares which cannot be redeemed.
Some preference shares can be convertible as well, ie. at the end of the tenure, they may be converted into regular equity shares, turning them into tradeable liquid assets.
Non-convertible preference shares are allowed (since 2013) to be listed on the exchange, making them liquid as well, as a shareholder can sell them without waiting for the tenure to get over.
Preference equity shares can also be cumulative or non-cumulative. In the former, dividend in a loss-making year is held up and carried over to the next year, and accumulates for each such year, to be paid in the next profitable year or on maturity. With non-cumulative preference shares, the dividend in a loss-making year is written off due to lack of profits and not carried forward.
A participating preference share arms the holder with the right to enjoy profits available to ordinary equity shareholders, while a non-participating preference share does not grant this right.
Differential voting rights (DVR) shares
Shares with DVR allow either more or less voting rights a share than the common equity share.
For the longest time, India (ie. the regulatory body of Sebi) allowed DVR that allowed less voting rights than the regular shareholder. Instead of one vote on an equity share, the holder was entitled to a predetermined fraction of a vote on an equity share (referred to as fractional rights or FR), as part of their ownership rights.
FR shares allow the promoters to raise capital without diluting the existing ownership to a large extent, since fractional voting rights decrease the legal voice of the DVR shareholder in company resolutions.
Companies like Tata Motors have DVR shares besides ordinary shares in the market, offering one-tenth of a vote on an equity share while promising a higher dividend in its stead.
The other kind of DVR, that with superior rights (SR), allowing multiples of one vote on an equity share, has only been recently (earlier this year) allowed. It has been prevalent in other markets such as in Canada, Hong Kong, Singapore and the US.
Sebi has allowed founders or promoters to list IPOs of unlisted companies with SR shares.
The promoters can hold shares granting them between two and 10 times a vote on an equity share, letting promoters retain greater control while still seeking funds from the public with an IPO.
Given that SR shares call for stringent corporate governance to safeguard the ordinary shareholders’ interests, Sebi has allowed only certain sectors to launch SR shares. Companies using sharply-defined technology or intellectual property, for example.
Their operations are often hard to replicate and hence, have a competitive edge, ensuring better returns for their investors.
We should remember that it is still early days for SR equity shares, and its impact is yet to be ascertained.
For a retail investor, it means we can partake the growth of such companies if we are not too bothered by our right to vote.
DVR shares, especially with SR, cannot be converted into ordinary equity shares before a lock-in period.
DVR (both FR and SR) shares are geared to vest certain owners with greater control compared to the rest. The Ministry of Corporate Affairs in August this year, raised the proportion of such shares a company could issue, from 26 percent to 74 percent (of the paid-up capital). Companies don’t have to generate distributable profits for three consecutive years to issue such shares either, which used to be an earlier requirement.
Employee stock option plan or Esop
An Esop (also known as the employee stock ownership plan), is a plan offered by a company to its employees, giving them the right to buy the company’s shares on a later date (often after a lock-in period), at a discount (or sometimes, even for free), compared to a potential higher market price of the stock. Such rights are called stock options.
Esops are offered as part of an employee’s compensation. Start-ups, for example, deploy these to work around paying high salaries in the beginning when not flush with funds, and offer a stake instead, in the company’s potential future prosperity. For unlisted companies and their employees, Esops get monetised only after listing.
These plans are said to help foster a sense of ownership and inclusiveness among employees, considered to be a company’s key internal stakeholders, much like equity shares making external investors feel responsible towards the stocks they hold.
However, unlike Silicon Valley, US’ tech hub and Infosys closer home which have seen success with such programmes, newer Indian companies have found it a little difficult to structure their Esops well, resulting in dashed hopes of employees, at times. We may say, it is still early days for Esops to make sound sense for employees.
Sweat equity refers to an option similar to Esop. Sweat equity shares are given to internal stakeholders of a company to make them part-owners and enjoy profits, apart from drawing a salary. However, there are significant differences between Esops and sweat equity shares.
Sweat equity shares, can be given to promoters and directors, apart from employees, often by way of appreciation. The decision to issue them is taken at general meetings involving the existing shareholders of the company.
Both Esop and sweat equity are meant to retain talent because they are often realised after a certain time, after an IPO or a lock-in period. If we leave the company early, they become redundant.
Shareholder’s pecking order
There is a flipside to everything. For an equity shareholder, the status of being part-owner can weigh heavily if the company is liquidated. Owners, afterall, just like the crew of a sinking ship that leaves last, are the last to be compensated when assets are distributed during liquidation.
The pecking order is stated below:-
Different kinds of shares issued by companies explained, let us delve a little more into ways of acquiring equity shares in the Indian market.
There are two kinds of markets for buying shares for the retail investor — primary and secondary.
Primary market for stocks
A primary market is where in the company raises money from the public for the first time, through an IPO.
For an IPO, the company appoints a merchant banker to prepare the Draft Red Herring and Red Herring prospectus and run the book (assess the financials of the company and its potential to determine its market value before launch, estimate the number of shares to be issued). The company then comes out with a price-band for us to apply for, in order to buy/subscribe to those shares. Both of the major stock exchanges in India — NSE (National Stock Exchange) and BSE (Bombay Stock Exchange) — list upcoming IPOs on their websites.
At our end, we should appraise ourselves of the prospectus published before the IPO by the company to understand the growth prospects and claims.
Here are the steps to invest in an IPO:-
Step 1 – Open a trading and demat account.
It is the trading account in which the shares, if allotted, will be stored in an electronic or dematerialised form. We may open one with any broker, if we do not already have one.
Step 2 – Fill up the IPO application form.
It can be done online or offline (available with the IPO bank or our broker). Going online is the easier way, where we can directly fill the application form from the trading terminal of the broker. It has the advantage of most of the data required of us being pre-filled, saving us time needed for such clerical tasks.
As part of the online application process, there is a facility by Sebi called Asba (Application supported by blocked amount). It lets the bank block the amount mentioned in our application and subsequently debit it if the shares get allotted to us. Else the amount is released back to us.
Offline application would require us to submit a cheque for the amount, which gets debited once the allotment is done.
A secondary market is one where the shares first issued in the primary market exchange hands.
The major stock exchanges are secondary markets. These facilitate the buying and selling of existing securities or stocks, in case of equity shares. This platform to trade provides liquidity to the equity shares.
Of course, there are other kinds of exchanges besides stock exchanges such as commodity exchanges. But equity shares are traded on stock exchanges such as the NSE and BSE in India.
The prices of the stocks in the secondary market are determined by demand and supply. Of course, demand and supply is further determined by macro- and micro-economics and the company’s financial health and prospects.
We lay out the steps of acquiring equity shares on the secondary market:-
Step 1 – Open a trading and demat account with any stock broker
Step 2 – Add funds to the trading account
Step 3 – Log into the platform or trading terminal provided by the broker
Step 4 – Place the order, comprising the amount or volume of shares, at the terminal
Albeit, choosing the stocks to trade in is the crux of equity share investing than the actual act of trading, which can be covered by just the four steps mentioned above.
We elaborate on the research needed to make a good selection of stocks below. However, there are a few mistakes to avoid in investing, applicable to equity shares as well.
Taxation of equity shares
The participants in an equity market are many. From institutional investors, trusts, government bodies to individual retail investors. Taxation varies accordingly. For this blog, we will look at taxes the individual retail investor in equity shares has to pay.
There are two major taxes for the retail investor. Here is a brief primer:-
Securities transaction tax
The securities transaction tax or STT is a tax levied by the Central government while buying or selling a security, listed on the stock exchange. For equity shares, the STT is paid both by the buyer and the seller of the shares, at a rate of 0.1 percent of the traded price. STT is levied only on delivery-based buying and selling of shares (ie. not on futures and options)
Capital gains tax
Capital gain refers to our earnings from the sale of a capital asset. It would only be a gain if we sold at a higher price than what we had paid.
‘Capital gain = selling price – buying price’
The tax is levied when we make a profit from selling our shares.
Short-term capital gains tax (STCG) — If we sell our shares within a year of buying for a profit, we are taxed a blanket 15 percent of the value, irrespective of our tax bracket.
If our taxable income is less than Rs 25,000, excluding the short-term capital gain, we can add to our income upto Rs 25,000 from the capital gain, and then pay the tax on the remainder of the profit at 15 percent.
Long-term capital gains tax (LTCG) — If we sell our shares for a profit after a year of buying them, LTCG is applied in the following manner:-
1. If the capital gain is less than Rs 1 lakh, then it is tax- exempt.
2. If the capital gain is more than Rs 1 lakh then LTCG at the rate of 10 percent will be charged on the amount that is over and above Rs 1 lakh, provided STT has been paid by both the parties.
However, profits made on sale of equity shares invested in before January 31, 2018, will be grandfathered, a legal term to say, they will be LTCG-tax-exempt. The cut-off signifies the time when LTCG tax was applied to equity share gains in the Union budget.
Short-term capital loss — Short-term capital losses can be offset by short- or long-term capital gain. If the losses are not completely adjusted in the financial year, then the remaining loss can be carried forward for eight years for tax purposes (STCG and LTCG taxes computed after figuring in losses), provided ITR (income tax return) is filed every year.
Long-term capital loss — Long-term capital losses, arising after April 1, 2018, can be set off against long-term capital gains in the same financial year. If the loss cannot be entirely compensated, the remainder can be carried forward for eight years, if ITR is regularly filed.
As we have mentioned before, the key is selecting which equity share or company stock to buy. Reams can be written on the selection process and star investors are born from their savvy in stock selection.
An IPO has a lot still up in the air, but there is a prospectus and the buzz around a company to guide us.
But most equity shares can be found on the secondary market, with company results and news to guide us, besides expert advice.
To pick stocks that suit our investing, we may need two kinds of analysis — fundamental and technical.
Mastering such analyses takes time but it is never too late to start. Here is a brief on both:-
Fundamentals analysis — We assess the fundamentals of the company. Fundamentals would include the sturdiness of the business, future growth potential, profit and loss statements, debt, and other features. The company’s prospects are studied to estimate a valuation of the company using the annual reports and quarterly results published by the company. Existing shareholders, too, go by the same.
The valuation done, we would need to buy those companies whose current market price is less than their intrinsic (or expected) value. The process of valuation of this underlying worth is what differentiates the best brokers from the rest.
Of course, we may not undertake this for every stock. It could help if we chose a few promising or popular industries and picked out companies to study.
Technical analysis — The core is trends in stock prices for this kind of analysis. Most often, recent price trends are charted with the help of algorithms, indicators and tools to help a trader take a call on buying or selling. By itself, technical analysis helps one profit from short-term price divergence.
Below is a convenient table enumerating the key features of the two kinds of studies informing equity share traders:-
Retail investors can turn to business news reportage, broker advice, expert views, star investor insights to make an informed choice on which equity shares to pick up or sell off.
If we find this overwhelming, there are other ways of investing in the secondary market, ie the stock exchanges.