What Are Equities?
Equities are shares of a corporation that investors can buy as part of their portfolio. Equities provide investors with partial ownership in a corporation, which entitles investors to the corporation’s net assets and profits but also exposes them to any risks or losses incurred by the corporation.
All corporations need money to start up or grow their business. One of the ways corporations can raise money is to divide their ownership into smaller units and sell the units to the public.
Each unit of a company is called a share or equity because it represents an ownership share in the corporation, which entitles investors to the corporation’s net assets and profits. But as part-owners, investors will also be affected by any risks and losses experienced by the corporation.
A company’s shares are first made available through an initial public offering (IPO). A company will hire an investment dealer to help them bring their shares to the market.
After the IPO, shares are traded in a secondary market through a centralized exchange such as the Toronto Stock Exchange (TSX). Investors who purchase the shares become shareholders of the company, and as such gain proportionate ownership of the company according to the number of shares they hold. As shareholders, they are entitled to certain rights and benefits.
Common and Preferred Shares
When corporations issue shares, they fall into two general types: common shares and preferred shares. Both types of shares represent ownership in the corporation that entitles investors to the corporation’s earnings and assets. However, common and preferred shares have different entitlements and rights.
Common shares entitle shareholders to a share of a corporation’s profit and net asset value, as well as a share in the control of the corporation through voting rights on certain matters regarding the company’s operations. Some of the matters on which shareholders are entitled to vote to include electing the members of the Board of Directors, the people who chose to control the activities of the corporation. Common shareholders are typically given one vote per share.
The price of common shares reflects expectations of a company’s future profitability, and the demand for the shares. Shareholders benefit from common shares that appreciate at price and can realize a capital gain when the shares are sold. However, share prices can also fall and incur capital losses if shares are sold.
Investors purchase common shares with the anticipation that they will get a return in the form of capital gains.
Preferred shares are considered a hybrid of equity and fixed income securities. Like bonds, they are issued at par value, e.g. $25, and typically provide a regular income stream.
Common and Preferred Shares Entitlements
Preferred shareholders are entitled to receive a portion of the corporation’s profits in the form of dividends. The dividends are typically fixed and paid regularly. However, a company has no contractual obligation to pay dividends. If dividends are paid, preferred shareholders will receive their dividends before common shareholders.
Preferred shares are considered to be lower risk than common shares because preferred shareholders rank before common shareholders for the company’s assets in the event of bankruptcy.
In exchange for the priority they have over common shareholders, preferred shares typically do not come with voting rights. Therefore, preferred shareholders do not have control over the corporation.
The table below highlights the characteristics of common and preferred shares.
Benefits and Risks of Common Shares
Compared with other investment assets such as bonds, common shares produce higher average long-term returns.
If the common shares are in a profitable corporation, the price of the common share can appreciate over time. Eventually, shareholders may sell the common shares for a higher price than the purchase price and realize a profit.
As common shareholders are part owners of the corporation, whatever affects the corporation’s earnings will eventually have an impact on the shareholders. If a business is not doing well for any number of reasons such as poor management decisions, slow economic growth, or competitor products, dividend payments may be reduced or cut.
Shareholders also face the risk that a company may go bankrupt, in which case they may also lose some or all of their investment money. However, shareholders are not liable for the debts incurred by a company, nor are they personally liable for any actions undertaken by the corporation.
Prices of common shares reflect the company’s profitability as well as investors’ demand for the shares. Common shares involve more risk than preferred shares because of their price volatility and the uncertainty of the future share price.
Example: Shi-woo purchases 400 shares of Treatwell Medical Devices Inc. at a price of $40 per share. Her original investment is $16,000, calculated as (400 x $40). The company announces that it has plans to aggressively expand into Asia where there are enormous opportunities. The share price rises to $55 based on this news and Shi-woo’s investment is now worth $22,000, calculated as (400 x $55). A few months later, the expansion plan stalls because Treatwell is unable to obtain the necessary regulatory approvals to operate in the target countries. The share price falls to $26 and Shi-woo’s investment drops to $10,400, calculated as (400 x $26). The following year, the company begins to experience financial difficulties as a result of an economic slowdown and its failure to move into the Asian market. By the end of the year, Treatwell files for bankruptcy. Shi-woo has lost her entire investment of $16,000.
Benefits and Risks of Preferred Shares
Since preferred shares can be redeemed back to the issuer for par value, they usually trade around that price. This offers relative price stability. They also provide fixed dividends on an ongoing basis.
Similar to common shareholders, preferred shareholders are affected by the performance of the corporation. If a company performs badly, it may miss dividend payments. Preferred shareholders are also subject to loss of their original investment if the company declares bankruptcy.
Preferred shares are typically redeemable. The issuer may exercise its right to call the preferred share at an inopportune time for the preferred shareholder. In a low-interest-rate environment, existing preferred shares might be paying a higher yield than the market. This is good for the investor but expensive for the dividend-paying company. Most would prefer to pay the expense of calling in the shares, rather than pay a high fixed dividend yield on them.
In the fall of 1997, the Bank of Nova Scotia had an outstanding issue of preferred shares that were callable on October 29, 1997, at their par value of $25 per share. Just prior to the call date the shares were trading at $26.85, a $1.85 per share premium to their par value, calculated as ($26.85 – $25.00).
At the time, the Prime rate in Canada was 6.25%. From the Bank of Nova Scotia’s perspective, letting the preferred shares remain outstanding and paying the fixed dividend of 9.25% for any longer than necessary would not have made good business sense. Consequently, the company redeemed the shares on the October 29th call date. The Bank of Nova Scotia preferred shares were trading at $25 on October 29th. The $1.85 premium on the shares disappeared once the shares were called.
After a corporation sells its products and deducts its costs, it is left with either a profit or a loss.
When there is a profit, the corporation can reinvest the money in their business. Some corporations will use the profits to grow their business and invest the profits in research and development. Others may use the money to buy machinery or invest in technology to increase production.
A company may also allocate a portion of the profits to be shared with common and preferred shareholders in the form of dividends. Dividends are the portion of the corporation’s profit that is not reinvested in the business and is instead distributed to shareholders.
The decision about how profit is to be used rests with the Board of Directors. If the Board believes a portion of the profits should be distributed to the shareholders, then the corporation will make a public announcement that it will distribute dividends. The date on which the dividend is authorized and announced to the public is called the declaration date. The announcement will include details about the dividend amount that will be allocated to each share.
The date of record will also be indicated. Investors who own the shares as of the date of record are entitled to dividends.
The following are some of the different features that can be added to preferred shares.
Types of Common and Preferred
To attract investors, corporations can add different features to their common and preferred shares.
With regard to common shares, some corporations may issue two types of common shares which are denoted as Class A and Class B shares. The differences between the two shares usually have to do with voting rights and dividend entitlements. Typically, Class A shares offer more votes per share.
Preferred shares may also come with different features that appeal to the different needs of investors and the corporation.
Investment Profile of Common and Preferred Shares
Equities and Mutual Funds
Portfolio managers consider investing in equities to provide potential growth in their portfolios.
Since common shares can provide unlimited price appreciation, more aggressive mutual funds tend to hold equities that do not pay dividends but rather retain their earnings to reinvest in the business. The primary objective of these mutual funds is capital gains.
Mutual funds where the objective is moderate growth may select common shares from large, stable companies. These companies provide more price stability and perhaps dividend income.
Portfolio managers consider investing in preferred shares primarily for the dividend income since the opportunity for price appreciation is limited. Since dividends provide a tax-efficiency income stream for investors, this type of mutual fund is appropriate for non-registered accounts.
Investment Risk and Return
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