Welcome to the World of Equity!
Hello there! Welcome to your study session on the Overview of Equity Securities. If you’ve ever dreamt of owning a piece of a giant company like Apple or Disney, you’re thinking about equity. In this chapter, we’ll explore what it means to be a shareholder, the different "flavors" of stock, and how these investments behave in the real world.
Equity can seem a bit intimidating because of the jargon, but don't worry! Think of equity simply as ownership. By the end of these notes, you’ll see how all the pieces fit together. Let’s dive in!
1. Common Shares: The Ultimate Stakeholder
Common shares represent the most basic form of ownership in a company. When you own common stock, you are a "residual claimant." This means you are last in line to get paid, but you have the most to gain if the company becomes a superstar!
Key Characteristics of Common Shares:
- Voting Rights: Usually, one share equals one vote. You get to vote on the Board of Directors and major corporate changes.
- Dividends: These are NOT guaranteed. The company pays them only if they have profit and the board decides to share it.
- Residual Claim: If a company goes bankrupt, the order of payment is: 1. Bondholders (Lenders), 2. Preferred Shareholders, and 3. Common Shareholders. You get what’s left over (the "residue").
Voting Variations: Statutory vs. Cumulative
This is a common exam topic! Let’s say you have 100 shares and there are 3 board seats open.
- Statutory Voting: You can cast a maximum of 100 votes for each seat. You can't put all 300 votes on one person.
- Cumulative Voting: You can take your total votes (100 shares x 3 seats = 300) and dump them all on one candidate. This helps small shareholders have a better chance of getting someone they like onto the board.
Quick Review: Common shareholders have the highest risk but the highest potential for gain. They are the "owners" in the truest sense.
2. Preference Shares (Preferred Stock)
Think of Preference Shares as a "hybrid" between a bond and a common stock. They behave a bit like both!
Why are they called "Preferred"?
They get "preference" over common shareholders in two ways: 1. They get their dividends first, and 2. They get paid before common shareholders if the company liquidates.
Important Types of Preferred Stock:
- Cumulative Preferred: If the company skips a dividend this year, they must pay it to you later before they can give a single penny to common shareholders. (Memory Aid: Think of "Cumulative" as "Counting up" what they owe you!)
- Non-Cumulative Preferred: If they skip a dividend, it’s gone forever. You don't get "back pay."
- Participating Preferred: If the company has an amazing year and makes huge profits, you might get an extra "bonus" dividend on top of your fixed one.
- Convertible Preferred: You have the option to turn your preferred shares into common shares. This is great if the company’s stock price skyrockets!
Key Takeaway: Preferred stock is generally less risky than common stock because of the fixed dividend and priority in liquidation, but it usually doesn't offer the same "infinite" upside or voting rights.
3. Private vs. Public Equity
Public Equity (like stocks on the NYSE) is easy to buy and sell. Private Equity is a bit more "exclusive."
Three Common Types of Private Equity:
1. Venture Capital (VC): Investing in "the next big thing" (startups). High risk, but potentially huge rewards.
2. Leveraged Buyouts (LBO): An investor group buys an entire company, usually using a lot of borrowed money (leverage), to take it private.
3. Private Investment in Public Equity (PIPE): A public company needs cash fast, so they sell a large block of shares privately to an investor at a discount.
Did you know? Private equity is often "illiquid," meaning you can't just click a button and sell your shares. You might be locked in for years!
4. Investing in Foreign Markets
Investors often want to buy stocks in other countries to diversify. There are a few ways to do this, but the most important for the CFA exam are Depository Receipts (DRs).
What is a Depository Receipt?
Imagine you want to buy a Japanese company, but you don't want to deal with Japanese exchanges or currency. A bank buys the shares in Japan, puts them in a vault, and issues a "receipt" that trades on your local exchange (like the New York Stock Exchange) in your currency. That "receipt" is a DR.
- ADR (American Depository Receipt): A foreign stock trading in the U.S. in dollars.
- GDR (Global Depository Receipt): Traded outside the company’s home country and outside the U.S. (often in London or Luxembourg).
- Sponsored vs. Unsponsored: If the company is involved in setting up the DR, it’s Sponsored (gives you voting rights). If they aren't involved, it's Unsponsored (the bank keeps the voting rights).
Common Mistake: Don't assume DRs eliminate currency risk! Even if the DR is priced in dollars, if the foreign currency crashes, the value of the underlying shares (and thus your DR) will likely drop too.
5. Risk and Return of Equity
Let's look at why people put their hard-earned money into these assets.
Total Return
The return you get from a stock comes from two places: 1. Dividends and 2. Price Appreciation (the stock price going up).
\( \text{Total Return} = \frac{(P_{end} - P_{start}) + \text{Dividends}}{P_{start}} \)
Risk Hierarchy (Low to High)
1. Bonds (Debt): Safest. You are a lender.
2. Preferred Stock: Middle ground.
3. Common Stock: Riskiest. You are the last to get paid.
Analogy: Think of a house. The Bank (Lender/Bondholder) must get their mortgage payment every month regardless of what happens. The Owner (Equity holder) only keeps what’s left after the mortgage and taxes are paid. If the house value doubles, the owner gets all that gain, while the bank still just gets their fixed interest.
6. Book Value vs. Market Value
This is a crucial distinction for valuation.
- Book Value of Equity: This is an accounting measure. It is essentially Assets minus Liabilities on the balance sheet. It’s what the company is worth "on paper."
- Market Value of Equity (Market Cap): This is what the stock market says the company is worth.
\( \text{Market Cap} = \text{Price per Share} \times \text{Total Shares Outstanding} \)
Note: Market Value is almost always different from Book Value because the market looks forward at future growth, while the book value looks backward at historical costs.
Return on Equity (ROE)
ROE measures how efficiently a company uses the owners' money to generate profit.
\( \text{ROE} = \frac{\text{Net Income}}{\text{Average Shareholders' Equity}} \)
Don't worry if this seems tricky! Just remember: ROE is "Profit per dollar of ownership."
7. The Role of Equity in a Portfolio
Why do we keep equity in a portfolio? Two main reasons:
1. Capital Appreciation: To grow the value of the portfolio over the long term.
2. Inflation Hedge: Historically, stock prices and dividends tend to rise with inflation, helping you maintain your purchasing power.
Quick Summary Key Takeaways:
- Common shares have voting rights but are last in line for payment.
- Preferred shares have fixed dividends and priority over common shares.
- Cumulative voting helps minority shareholders.
- ADRs allow you to buy foreign stocks easily.
- ROE is a measure of management efficiency.
- Market Value reflects future expectations, while Book Value reflects historical accounting.
Great job! You’ve just mastered the fundamentals of equity securities. Keep this structure in mind, and you'll be well-prepared for the more advanced valuation topics coming up next!