Equity and its types

A share is a small piece of ownership in a company. This lesson covers what that ownership gets you, how it differs from lending a company money, and the different kinds of share you will come across.

What equity is

A company raises money in two ways: it borrows, or it sells a piece of itself. Equity is the second. Buy a share and you own a fraction of the company: a fraction of what it owns, of the profit it will make, and of the say in how it is run.

Owners are paid last. A company pays its staff, its suppliers, its taxes and its lenders first, and whatever is left belongs to the shareholders. That can be a great deal or nothing at all, which is exactly why shares carry more risk than lending, and why they can pay more.

Owning against lending

A lender agrees the return in advance: the interest. It is the same whether the company has a brilliant year or a poor one, as long as the company can pay. An owner is promised nothing. In a good year, the owners keep everything above the interest; in a bad year, they absorb the loss.

Figures are before tax, to keep the picture simple. Drag the profit below ₹90 lakh and the interest is still due in full; the owners carry the shortfall.

You earn from a share in two ways: dividends, when the company pays out part of its profit in cash, and a rise in the share price, when the market values the company more highly. Neither is promised. Many companies pay no dividend at all and keep their profit to grow.

The kinds of share

Indian company law recognises two kinds of share capital: equity shares and preference shares. Equity shares come with the ordinary votes, or with different ones.

Ordinary equity shares

The common kind, and what people usually mean by “shares”. Each normally carries one vote at shareholders’ meetings, a claim on whatever profit is left after everyone else is paid, and a place at the very back of the queue if the company is wound up.

Shares with differential voting rights (DVRs)

Equity shares that carry different voting rights from the ordinary ones, usually fewer votes, sometimes with a higher dividend to make up for it. The share of the profit is the same; the say is not. They let founders raise money without giving up as much control, and they tend to trade below the price of the same company’s ordinary shares.

Preference shares

A fixed dividend, paid before ordinary shareholders receive anything, and an earlier claim on the company’s money if it is wound up. In exchange, they usually carry no vote. They come in several varieties:

• Cumulative or non-cumulative. If a dividend is skipped, a cumulative share carries it forward, and it must be paid before ordinary shareholders see anything. A non-cumulative share simply loses it.
• Convertible or non-convertible. Whether they can later be turned into ordinary shares.
• Redeemable. Indian companies cannot issue preference shares that last for ever. They have to be bought back, generally within twenty years.

A preference share sits between a bond and an ordinary share: more certain than equity, less certain than a loan.

Large, mid and small caps

A company’s market capitalisation is what the market says the whole company is worth: its share price multiplied by the number of shares. SEBI groups listed companies by it:

1. Large cap. The 100 largest companies by market capitalisation.
2. Mid cap. The 101st to the 250th.
3. Small cap. The 251st and everything smaller.

AMFI publishes the list every six months. It is a ranking, not a rupee threshold, so a company can move from one group to another without changing at all, simply because others grew past it. Smaller companies tend to swing more in price, because they usually depend on fewer products, customers or people.

New shares: bonus issues, splits and rights

Companies change how many shares exist for different reasons, and the difference between them matters.

• Bonus issue. Existing shareholders receive free extra shares, created out of the company’s reserves. No new money comes in: the same company is simply cut into more pieces.
• Stock split. Each share is divided into several, each with a smaller face value. Again, the same company in more pieces.
• Rights issue. Existing shareholders are offered new shares, usually at a discount, in proportion to what they already hold. Here new money does come in, and a shareholder who does not take up the offer ends up owning a smaller fraction of the company.
• Sweat equity and ESOPs. Shares, or options to buy them, given to employees and directors for their work or know-how rather than for cash.

A bonus issue or a split can make a share look cheaper without making it cheaper. The price adjusts in proportion, and what you hold is worth the same the moment afterwards as the moment before. Anything that happens to the price after that is the market’s doing, not the bonus’s.

Work it out on your own numbers

• Stock average calculatorYour average price across several buys, and where you break even.
• Breakeven calculatorHow much a share has to rise to win back a fall.
• Target return calculatorThe return you need to reach an amount by a date.

This lesson explains ideas. It is not advice about what to buy, sell or hold.