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Understanding Equity Investments

10 Mins 21 Dec 2022 0 COMMENT

Suppose you find out about a startup business and are impressed by it in terms of growth, revenue, profits, etc. You also dreamt of having such a business but don't have enough capital to start a business. But how can you own that business without investing much money? The easy answer is to purchase a share of that company. What is this investment called, and how does it work? Let's find out in this article.

Equity is basically the ownership of a business. A business is divided into pieces called shares, and these shares are subscribed by people in exchange for money or sometimes non-monetary consideration. For example, if you have 1000 shares of ABC company, which means you are the owner of those 1000 shares and if these shares represent 1% of the company's capital, you are the owner of 1% business of ABC company.

For better understanding, we'll see another example. You have four people, each one of you brings 25 crores to start a business. Therefore, the total capital is 100 crores. At the time of registration this capital of 100 crores is divided into 10 crore shares of Rs. 10 each. Hence, each one of you holds 2.5 crore shares, which represent 25% of the capital or 25% ownership or equity.

Let's take the story further. You and your friends now decide to sell 20% shares of your company to the public for raising the money needed for expansion. 20% shares of your company mean 2 crore shares with a face value of Rs. 10 each. In case these shares sell for Rs. 100 each, which is the market value, your company earns a premium of Rs. 90 per share. But the ownership or equity will still be represented in multiples of face value, Rs. 10.

Simply put, if an investor buys 1 crore shares, he is now the owner of 10% of the business. Therefore, an investor purchasing a stake in the company or shares of the company is said to make an equity investment.

A company can also issue new shares instead of offloading existing shares.

Now, how important are Equity Investments? If your financial goal is long-term investment, experts may advise you to go for equity. Also, if you want to save taxes and beat inflation, equity is the best avenue.

Let's understand this with an example. You have Rs. 1 lakh in my hand and two options for investments: one is equity and another is a fixed deposit. The rate of interest in a fixed deposit is say 6%, and suppose you fall in the tax bracket of 30%.

Post-tax return in this case would be 6% multiplied by 1 minus 0.3, which equals to 4.2%. Therefore, after 20 years, I'll have an amount of Rs. 2.28 lakhs in my hand.

Now if you had invested the same amount in equity with the assumed rate of return of around 12 % (which is generally the return of a stock index like Nifty or Sensex over a longer period), we have seen that Sensex has given a return of 12.58% per annum from 2001 to 2021.

If you had to pay a long-term capital gain tax of 10%, my post-tax return would be 12 multiplied by 1 minus 0.1, which equals to 10.8%. After 20 years this 1 lakh would become Rs. 7.78 lakhs, which is almost more than three times the amount you received in a fixed deposit.

Here you can see how your equity investment value is more than triple the return of the FD investment.

Are you wondering how your equity investments will pay you well? There are two ways you can receive returns from equity Investments:

  1. As a shareholder you may receive a periodic payment made from the company's profits as dividends
  2. When the price of a stock appreciates due to the growth posted by the company resulting in capital appreciation.

Now you must be wondering to put all that you have in equity? Wait before you proceed. There is a thumb rule here that may help you find the right composition of debt and equity in your portfolio.

This rule helps in asset allocation which differs from person to person depending on their risk appetite, financial goals, income, age, etc.

The rule is: "100 minus your age should be the weightage of equity in your portfolio." So, if you are 35 years old, the weightage of equity in your portfolio should be "100 minus 35", which is equal to "65%."

Hence if you have Rs. 1 lakh for investing put Rs.65,000 into equity and allocate Rs.35 into debt securities.

Do remember that this is a general thumb rule and basis your risk appetite you may choose to put a higher or lower allocation to equities.

Here again some of you might be wondering how much returns will you earn from equity investments?

Returns from equity are uncertain though proper research and analysis of various factors involved may help you evaluate the returns you may earn from your equity investments.

And what are these factors? These factors include domestic and global factors like rate of inflation, interest rates, political, economic, environmental, and fiscal policy and more.

Therefore, ideally before investing in company shares your goal should be to find the right value; you need to do thorough research, review the company's fundamentals, look into its historical performance, and conduct proper analysis before investing.

Also, you should look for long-term stability and strength of the company against its competitors.

Now that you know equity yields a better return than other forms of investments and how you should proceed it is important here to mention that there are risks associated with equity too. Yes, equity investments are not totally risk-free, but in the case of equities with greater risk there is a possibility of Greater profits and this is the reason for equities being preferred for growing an investor's investment into wealth.

When it comes to equities there are two types of risk associated: Market risk and Company or sector-specific risk.

Simply put risks that affect the entire market and all stocks are market risks whereas risks that are particular to a company or industry and can be controlled through diversification are company-specific risks. For example, when the rate of inflation in the country rises it affects all sectors and companies and you cannot save yourself from this risk. This is an example of market risk also known as systematic risk. But if a company faces shortage funds due to any reason that can be controlled by seeking help from other sources this financial risk is particular to that company and hence it is company-specific risk and you can reduce it with proper diversification of funds. This risk is also known as unsystematic risk. Systematic risk can't be reduced with diversification within equity, but you can always reduce their impact by diversifying your investment into different asset classes like equities, bonds, gold etc.

You can mitigate such risks by allocating assets based on your investment goal, time horizon, and risk tolerance.

Let's talk about three golden rules that can save your Equity portfolio from risks:

  1. Invest for long term
  2. Diversify your portfolio
  3. Take advantage of systematic investment plans (SIP) and systematic equity plans (SEP)

SIP and SEP are periodic investments in your favourite funds or stocks to average out the purchase price.

Now that you have a clear picture of what to expect from equity investments let's look at how you can start investing in them?

There are two ways of doing this:

  1. Through direct investment in shares of companies where you need in-depth knowledge of the company investors have complete control over these stocks remember you need Demat account and trading account to start with.

Investment through equity-oriented mutual funds where fund managers will do it all for you. They will invest in stocks of multiple companies through a single investment you just need to open an account with a stock broker to start investing in mutual funds.

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