Equity Shares: The Coveted Asset Class

Equity Shares: A prestigious asset class

Equity investing or stock market investing is the holy grail of active investing. Everything related to the initial public offering (IPO) of the company’s equity stake, from the company’s shares to the dividend paid by the company, is discussed with great enthusiasm.

Equity shares are a major asset class and play an important role in asset diversification of an investor’s portfolio.

Of course, if we belong to the younger generation, there are also equity shares that our parents are against when they say – ‘avoid the market’ on parental investment advice.

But we rarely read about the meaning of equity shares or stock, its different types, its nuances. Through this blog, we hope to cover everything there is to know about equity shares.

What are equity shares?

An equity share represents part-ownership. In investment, it is the ownership of the company. The extent of ownership is determined by the number of shares (or ownership split) held by the company. 

When a company wants to raise money, it issues shares to the general public, including us. If it is issuing shares for the first time, it tells us about its business in detail in the IPO, before the prospectus. 

In effect, when the initial owners or promoters of a company raise new capital through an IPO, they dilute their ownership control to allow the general public to share in it.

The economic value of owning or the value of a stock is determined by the market value of the company, as it is divided by the total number of shares which gives us the value of one share of stock. 

Other awards include when a company divides and distributes its profits to shareholders, such as dividends.

We offer equity shares either in the primary market, through IPO, or in the secondary market, with share-trading.

An equity shareholder is equipped with many rights. After all, every shareholder in a public limited company is a part-owner of the company (having contributed financially by buying the end).

Meaning: equity and share

Equity  means the quality of being fair and equal. And informally, it has also become petty ownership, especially in terms of sharing future profits and value appreciation. This is, no doubt, a result of the investing world’s use of the word.

A share  is a part of a larger entity. The shape may change but it is part of one. Like a piece cut out of a pie.

In investment, a share refers to the right to own equity, often marked by a required paper or electronic document.

Although an equity share gives us a fraction of the company’s cost value, it guarantees us several rights to ensure that we are not overwritten by larger shareholders (founders, institutional investors). 

Buying equity shares offers an unfettered opportunity to share in the rewards of the company’s growth. On the other hand, the instruments of those companies, if any, promise a fixed return on investment. A debt instrument does not qualify for reward in shareholding.

There are many advantages of buying equity shares of a company. We list the top four benefits of being a shareholder:-

Annual General Meeting (AGM)  – Companies Act, 2013 requires all listed companies to convene AGM. Shareholders can attend meetings.

We have seen shareholders make all shades of comments, even those upset that management is squirming in their seats, venting their anger at ineptitude, praising the companies and pursuing their quest for maximum returns in unison, and of course, voting on resolutions and decisions. AGM

An AGM empowers an informed shareholder to confront the company’s management and act, as they say, ‘like a boss’. Because, an equity shareholder is, in fact, within their rights to get all the answers related to the company’s performance and profitability. 

Voting rights  — used at AGMs, equity shareholders enjoy one vote for each share they hold. One share-one vote. 

Voting rights add more teeth to the role of shareholder and give them an executive role.

Equity shareholders have the right to vote on every resolution proposed at the meeting, including, but not limited to:-

  • Any change in the Articles of Association (or the AOA, defining all rules and regulations for the Company’s operations, financial records, purposes, transactions)
  • Appointment of Auditors
  • New management proposals

Voting can also be by show of hands, by ballot or by mail. The Companies Act, 2013, mandates even companies with more than 1,000 shareholders to arrange e-voting facilities.

Dividend  – This is the portion of profit a company (its board of directors with the approval of shareholders) decides to share with equity shareholders. All or part of this profit is redistributed. 

If few or none are paid that year, the company typically plows the profits, if any, into growing the business further. But of course, the call is taken after the opinion of the stakeholders on what to do.

Dividends can be paid as a cash prize, more units of stock, or other forms to shareholders.

Dividends are a source of income or return on our investment in equity shares without trading our shares. We don’t need to sell units to make a profit on our purchase price but still get a return in a dividend year (when the company pays dividends).

Capital Gain or Price Appreciation  – This is the gain if we sell our shares at a profit. We are required to trade shares at a price above our purchase price. 

For publicly-listed companies, the share price is tracked on the stock exchange on which it is listed (since the companies’ IPO). Even without selling ourselves, we can check the current value of our equity share investments by tracking them on stock exchanges.

A little thought on the rights and benefits of shareholders makes the advantages of such ownership clear. But how often do we wonder why the founders or promoters of a company want to reveal their ownership to the public? Ultimately, it opens them up to scrutiny, adds more pressure to perform well, and removes their status as full owners.

That’s why:-

1. Going public helps a company to raise a large amount of funds, which can be used for capital expenditure, operating expenses, expansion etc.

2. Offering shares of the company to the public lowers the cost of capital for the company.

3. Listing on a stock exchange is associated with increased credibility because of the attendant compliance the company is expected to maintain. It enhances the brand image of the company, which is an intangible asset for the company.

However, equity shares are not the only type of shares offered in the Indian market. 

Here are the other types of shares issued in India apart from common equity:-

Preference shares

Preference shares are a type of equity shares but different from the regular equity shares we have discussed so far. 

Moreover, preference shares pay dividends to the holder at a fixed rate every year even when the company is making losses. 

Preference shareholders are above common equity shareholders when it comes to dividend distribution, 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, paying us an annual dividend, paid at a fixed rate, for a predetermined period. Once the shares mature, the principal amount is redeemed ie. Returned to shareholder. The Companies Act, 2013, mandates that a company cannot issue preference shares which cannot be redeemed.

Some preference shares may also be convertible, ie. At the end of tenure, they can be converted into regular equity shares, turning them into tradable liquid assets.

Non-convertible preference shares (since 2013) are allowed to be listed on exchanges, making them liquid, as a shareholder can sell them without waiting for the expiry of the tenure.

Preference equity shares can also be cumulative or non-cumulative. In the earlier period, dividends from a loss-making year were withheld and carried forward to the next year and accumulated for each such year, paid in the next profitable year or on maturity. With non-cumulative preference shares, dividends in loss years are written off due to lack of profit and not carried forward.

A participating preference share entitles the holder to enjoy the profits available to common equity shareholders, while a non-participating preference share does not.

Differential Voting Rights (DVR) Shares

Shares with DVR allow either more or less voting rights than ordinary equity shares. 

For a long time, India (i.e. SEBI’s regulatory body) allowed DVRs which gave less voting rights than regular shareholders. Instead of one vote on the equity share, the holder was entitled to a predetermined fraction of the vote on the equity share (referred to as Fractional Rights or FR) as part of their ownership rights.

FR shares allow promoters to raise capital without greatly diluting existing owners because fractional voting rights reduce DVR shareholder’s legal voice in company resolutions.

Companies such as Tata Motors own DVR shares in addition to the market’s common shares, instead offering a one-tenth vote on the equity share with the promise of higher dividends.

Another type of DVR, which is allowed multiples of one vote on an equity share, with super rights (SR), has been allowed recently (early this year). It is prevalent in other markets such as 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 two to 10 times the voting shares of the equity share, which gives the promoters more control when seeking funds from the public through an IPO.

Considering that SR shares demand strict corporate governance to protect the interests of common shareholders, SEBI has allowed certain sectors to launch SR shares. For example, companies using clearly defined technologies or intellectual property. 

Their operations are difficult to replicate and hence, have a competitive edge by ensuring better returns to their investors. 

We must remember that it is still early days for SR Equity shares and the outcome is yet to be determined.

For a retail investor, this means that we can participate in the growth of such companies if we do not suffer too much from our voting rights. 

DVR shares, especially including SR, cannot be converted into common equity shares before the lock-in period. 

DVR (both FR and SR) shares are geared towards vesting certain owners with more control than the rest. The Ministry of Corporate Affairs in August this year increased the amount of such shares a company can issue from 26 per cent to 74 per cent (of paid-up capital). Companies do not have to generate distributable profits for three consecutive years, which was previously required, to issue such shares.

Employee Stock Option Plan or ESOP

An ESOP (also known as an Employee Stock Ownership Plan), is a plan offered by a company to its employees, which gives them the right to buy company shares at a discount at a later date (often after a lock-in period). (or sometimes, even free), compared to the stock’s potentially high market price. Such rights are called stock options.

ESOPs are offered as part of employee compensation. Start-ups, for example, work around paying high salaries initially with no turnover of funds and instead offer a stake in the company’s potential future prosperity. For unlisted companies and their employees, Esops generate revenue only after listing. 

These schemes help instill a sense of ownership and inclusiveness among employees, who are considered the main internal stakeholders of the company, just as equity shares make external investors feel responsible for the shares they hold.

However, unlike Silicon Valley, the tech hub of the US, and Infosys closing home, which have seen success with such programs, new Indian companies have found it a bit difficult to structure their Esops well, resulting in employee hopes being dashed at times. We can say that it is still early days for Esops to make sense for employees.

Gham Equity

Sweat equity refers to an option like an ESOP. In addition to drawing salary, sweat equity shares are issued to internal shareholders of the company to make them part-owners and earn profits. However, there are significant differences between ESOP and sweat equity shares. 

Sweat equity shares can often be given by way of appreciation to promoters and directors in addition to employees. The decision to issue it is taken in a general meeting consisting of the existing shareholders of the company. 

Both ESOPs and sweat equity are meant to retain talent because they often materialize after a certain period of time, such as an IPO or lock-in period. If we leave the company early, they become redundant. 

Pecking order of shareholders

Everything has a flip side. For an equity shareholder, being a part-owner can carry a lot of weight if the company is liquidated. Finally, like the crew of a sinking ship, the owners are the last to leave, compensated when the assets are distributed during liquidation. 

Primary market for stocks

A primary market is one in which a company raises money from the public for the first time through an IPO. 

For an IPO, the company hires a merchant banker to prepare a draft red herring and a red herring prospectus and to run the book (assess the financial position of the company and its potential to determine its market value prior to launch, estimate the number of shares to be issued. ). The company then comes up with a price-band for us to apply for, to purchase/subscribe those shares. Both major stock exchanges in India — (National Stock Exchange) and BSE (Bombay Stock Exchange) — list upcoming IPOs on their websites.

Finally, we should self-assess the prospectus published by the company before the IPO to understand the growth prospects and claims. 

Here are the steps to invest in IPO:-

Step 1 – Open a trading and demat account. 

It is a trading account in which the shares, if allotted, will be stored in electronic or dematerial form. If we don’t already have a broker we can open it with any broker.

Step 2 – Fill the IPO application form.

This can be done online or offline (available with IPO Bank or our broker). The easiest way is to go online, where we can fill the application directly from the broker’s trading terminal. We have the advantage of pre-filling most of the required data, which saves time on such clerical tasks. 

As part of the online application process, a facility called ASBA (Application Supported by Blocked Amount) is available by SEBI. This allows the bank to block the amount mentioned in our application and then debit it if we are allotted shares. Otherwise the amount will be refunded to us. 

Offline application requires us to submit a check for the amount, which gets debited after allotment. 

secondary market

The secondary market is where shares are issued in exchange for the primary primary market.

Major stock exchanges are secondary markets. These facilitate the purchase and sale of existing securities or stocks, in the case of equity shares. This platform for trading provides liquidity to equity shares.

Of course, apart from stock exchanges there are other types of exchanges such as commodity exchanges. But equity shares are traded on stock exchanges like NSE and BSE in India.

Stock prices in the secondary market are determined by supply and demand. Of course, supply and demand are determined by macro- and micro-economics and the company’s financial health and prospects.

We present the steps for buying equity shares in the secondary market:-

Step 1 – Open a trading and demat account with any stock broker

Step 2 – Add funds to trading account

Step 3 – Log in to the platform or trading terminal provided by the broker

Step 4 – Place an order with the amount or volume of shares on the terminal

However, selecting stocks for trading is the main part of equity share investing rather than the actual transaction itself, which can be covered by just the four steps mentioned above. 

Below we outline the research needed to make good stock picks. However, there are some investment mistakes to avoid, which also apply to equity shares.

Taxation on equity shares

There are many participants in the equity market. From institutional investors, trusts, government bodies to individual retail investors. Taxation varies accordingly. For this blog, we will look at the taxes payable by an individual retail investor in equity shares. 

There are two major taxes for retail investors. Here is a brief primer:-

dealing with securities

Securities Transaction Tax or STT is a tax levied by the Central Government on the purchase or sale of securities listed on stock exchanges. For equity shares, STT is paid by both the buyer and the seller of the shares, at the rate of 0.1 percent of the traded price. STT is levied only on delivery-based purchase and sale of shares (ie not on futures and options).

Capital Gains Tax

Capital gains are our earnings from the sale of capital assets. We will only make a profit if we sell for more than what we paid.

‘Capital Gain = Selling Price – Buying Price’

A tax is levied when we sell our shares and make a profit.

Short Term Capital Gains Tax (STCG)  – If we sell our shares within one year of purchase for a profit, we are taxed at 15 percent of the value, irrespective of our tax bracket. 

Excluding short-term capital gains, our taxable income is Rs. If less than 25,000, we will deduct from capital gains Rs. 25,000 can add to our income and then pay 15 percent tax on the remaining profit.

Long Term Capital Gains Tax (LTCG) –  If we sell our shares for a profit after one year of purchase, is levied as follows:-

1.        Capital gain is tax free if it is less than Rs 1 lakh.

2.        Capital gain Rs. If above 1 lakh, LTCG will be levied at the rate of 10 per cent on the amount above Rs 1 lakh and above, provided STT is paid by both the parties.

However, profits on sale of equity shares invested before January 31, 2018 will be grandfathered, a legal term, they will be LTCG-tax-free. The cut-off indicates the timing of implementation of LTCG tax on equity share gains in the Union Budget.       

Short-term capital loss –  Short-term capital loss can be offset by short-term or long-term capital gains. If the loss is not fully adjusted during the financial year, the remaining loss is carried forward for eight years for tax purposes (calculated after deducting loss for STCG and LTCG taxes), filed in ITR (Income Tax Return) every year.

Long Term Capital Losses – Long term capital losses  arising after 1st April 2018 can be set off against long term capital gains of the same financial year. If the loss is not fully recoverable, the ITR can be carried forward for the remaining eight years if filed regularly.

As we mentioned earlier, the key is choosing which equity share or company stock to buy. Reams can be written on the selection process and star investors are born from their savvy stock selection.

The IPO is still very much up in the air, but there is a prospectus and discussions around the company to guide us. 

But most equity shares can be found in the secondary market, with company results and news to guide us without expert advice.

To select stocks that suit our investment, we may need two types of analysis – fundamental and technical.

Mastering such analytics takes time but it’s never too late to start. Here is a brief about both:-

Fundamentals Analysis –  We evaluate the company’s fundamentals. The basics will include the strength of the business, future growth potential, profit and loss statement, debt and other characteristics. A company’s prospects are studied to estimate the company’s valuation using annual reports and quarterly results published by the company. Existing shareholders also go the same way.

Here’s an interesting read on the performance of some stocks that have turned out to be multi-baggers. 5 Important Lessons to Know Before Investing in Equity Stocks

Once the valuation is done, we need to buy those companies whose current market price is less than their intrinsic (or expected) value. This inherent value assessment process is what sets the best brokers apart from the rest.

Of course, we can’t do this for every stock. It may help if we choose some promising or popular industries and companies to study.

Technical Analysis –  Key to this type of analysis is the trend in stock prices. Often, recent price trends are created with the help of algorithms, indicators and tools that help the trader make buy or sell calls. By itself, technical analysis helps to profit from short-term price deviations.

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