Equity, a word that is one of the most prevalent ones, when it comes to stock market investments. Majority of the investors placing their feet for the first time in the stock market generally start with Equities. However, very few of such beginner level investors and traders actually understand the meaning of Equities as an investment class.
Well, in this tutorial, we will go at length and talk about specifics of Equity as an investment class, what kind of risks it carries, how much returns you can expect over a period of time and so on.
Let’s start with a real-life example to under the basics of this concept.
Understand this – Equity is basically ownership in the company, a stake!
Let’s say you choose to buy 100shares of a company that has a total of 10000 shares listed on the exchange.
In that particular case, you now own 1% of the complete company’s ownership. In a sense with 1% equity, you are now one of the stakeholders in the company and based on its performance, your profit or loss will get impacted.
In other words, in case the performance of the company is in the positive direction, then your equity value will also increase and vice versa.
Another way to understand the concept is:
Let’s say you have ₹1 Lakh as a disposable that you are looking to invest.
Either you can invest the money into a business that you yourself are looking to start. Although, there could be future potential in that idea, however, there is some sort of uncertainty as well.
You may also choose to open a Demat account and invest in a business that has a proven revenue model and is listed on the stock market.
Yes, there is some risk in this idea as well but most of the times, in a stable share market, the blue-chip or highly established companies can be trusted.
For any business to flourish, in which you have invested your money or yourself, there are specific aspects that need to be taken care of:
Business solves a sizable problem faced by a consumer group
Business has specific USPs (Unique Selling Propositions) that differentiate it from the competition
The business has a long-term growth plan
Thus, if you are buying equity or stake in a company that has gone through such phases, then yes, it certainly makes sense to invest in such a company.
In India, if you are looking to invest in Equity, you can invest in shares through NSE (National Stock Exchange) or BSE (Bombay Stock Exchange) which are registered exchanges of SEBI (Securities & Exchange Board of India).
There are few other stock market exchanges as well, but primarily traders invest through the exchanges listed above.
There are a couple of ways in which you can invest in Equity:
Either through the primary market where the company files an IPO and traders bid for the subscription. There are different ways to apply for an IPO where IPO through ASBA is one of the most prominent ways.
Once the company gets listed on the exchange, you can buy or sell shares in the secondary market as well. The price of these shares is then decided based on the concept of demand and supply.
This needs to be understood that it is a matter of chance that you actually end up getting an allocation of funds if you apply for an IPO, you can trade easily through the secondary market for the kind of shares you are interested to buy.
When you are into equity delivery form of trading, then you are buying the stock in a trading session and then selling it off in some other trading session.
Remember, the buying and selling of stocks are not happening within the same trading session.
At the same time, equity delivery format of trading provides you delivery of the bought stocks into your demat account. Furthermore, when you sell them off, those shares are then transferred to the buyer’s demat account.
It generally takes T+2 days for this transfer to take place.
In terms of risk, it is fairly lesser compared to other forms of trading since you have time at your hand and based on the market trend, volatility and other related factors, you may choose to exit the position when you prefer to.
However, the exposure provided by different stockbrokers in this segment is not so high (around 2-5 times on average). The reason for that is simply that investors stay invested in their position for a long time and the stockbroker won’t prefer somebody else holding its money for such a long duration.
If you are looking to buy and sell the stocks (or vice versa) within the same trading session, then you are performing intraday trading or are dealing in the Equity intraday segment.
In this form, the trader enters the trade and exits it within a few hours, minutes and sometimes seconds.
Primarily, the focus in this segment is the technical analysis of stocks where the trader is looking to make some quick money in each trader and may choose to trade in quantum. That is, the number of traders is higher with smaller chunks of profits (or losses) in each trade.
The margin provided in this segment is generally high (around 20 to 60 times on average) as compared to the delivery segment as the exit of the position is happening on the same trading day.
If you entered an intraday trade in a session, you are supposed to exit your position the same day, else it is automatically squared off by the trading platform.
When you talk about equity derivatives, well, it is seen as one of the derivatives classes which gets its value, at least partly, from the underlying equity security. Some of the most commonly used equity derivatives are Futures and Options.
To provide you with a quick idea on some of the latest numbers of contracts running on the stock market:
Index Futures: 2,01,667
Index Options: 94,57,609
Stock Futures: 6,89,492
Stock Options: 7,61,005
The overall valuation of these contracts is in the range of ₹7,72,268.07. Huge, right?
This is an interesting segment of trading, however, it brings along a relatively higher amount of risk and of course, opportunities to make larger profits.
When you are trading in Equity futures, you are not trading directly in a particular financial product. However, the whole trade is based on a contract over a specific underlying asset of a trading product such as equity stock, currency pair, index, commodity etc.
This contract is between two parties i.e. buyer and seller where both of them trade in a collection of stocks (also called a lot).
When both the parties enter the contract, price of the stock and the corresponding exercise date is also finalized. Depending on how the stock unfolds on that date, the corresponding profit/loss is measured.
Equity options are another form of derivatives where the trader does not need to buy or sell any specific security or stock. Here again, a contract is set up and the overall transaction happens over the underlying asset.
When you don’t actually buy the stocks, it becomes a cheaper option as you don’t need to pay for the stocks but just the contract.
You have the option to go long or short depending on your analysis and then find a corresponding buyer or seller for you to get ahead with a contract. Although, the trading platform that you use gives you the provision to find such a party with an opposite interest on the same asset.
Well, we have been using the term ‘exposure’ a lot in this review and in other sections of different articles of this website.
It’s meaning is pretty simple though!
It is a form of a loan that is provided by your stockbroker based on the demat account holdings’ valuation you have in your demat account. This exposure can be used in order to place trades above and beyond the trading account capital that you have in your trading account balance.
A broker provides this loan at a specific interest rate (12% to 18% generally) and the values of exposure vary with the trading segment.
Although, different stockbrokers offer different exposure values, here is a quick idea on the range of exposure that you can expect in the equity segment:
Equity is the sum of the shareholder's equity and reserve & surplus.
Shares are derived from total shareholder's equity only.
Equity, in itself, is not a tradeable product.
Shares are the forms of equity that get traded in the share market.
When we say the term Equity Valuation, it implicitly means Company equity valuation.
During this valuation process, multiple factors are considered including industry size, the position of the company against its peers, business model, the impact of different factors on the company’s financials etc.
The companies with strong fundamentals demand higher valuation while weak fundamentals of the business have limited say.
There is a specific process in place as far as the calculation of the valuation of the business is concerned:
Learn different macro and micro factors that impact the business directly or indirectly
Look at business financials over the past few years in terms of revenue, profit after tax, yearly growth etc and make a calculative forecast of the company’s future performance
Choose any of the valuation methodologies as per the business model of the company
Calculate the valuation based on the analysis done in the earlier steps
Although, we have tried to put the whole mechanism of valuation in a few steps above, however, the overall process is relatively complication and needs a deeper study of the concept.
Debt To Equity Ratio
Each business takes debt for its business expansion, growth or for even managing operations at times. At the same time, the business has own funds as well in order to cater to specific needs.
Debt is part of the company’s liabilities and when you divide it with overall equity, you get the debt to equity ratio.
This particular number, when calculated, will tell you the level to which the business is managing its cash flow through the taken debts as compared to the own-held cash of the company.
This also gives an indication of how much capacity the business has in order to repay its taken debts.
Lower the number, better it is for the business. For calculation, you can take these numbers directly from the balance sheet.
In order to understand the equity formula, you need to understand the other parameters (apart from Equity) in the equation.
Equity Formula, in general, is:
Equity = Assets – Liabilities
This formula has a deeper meaning. That is – if the assets of a company are more than its liabilities, then the equity will be positive implying the company’s business is doing well.
At the same time, if the assets of a company are less than its overall liabilities, then it implies the business is not so great and the equity stays in the negative direction.
Thus, using the formula, you can conclude about the company’s health!
Equity examples are of multiple kinds. Some of those are listed below for your reference:
Additional Paid-in Capital
Each of these equity examples mentioned above has its own set relevance in stock market investments.
Equity Vs Commodity
Beginner level traders generally get confused with different kinds of investment products. One of those confusions is around Equity and Commodity.
However, both these investment products differ in the following ways:
Where equity corresponds to ownership in a company or a business, a commodity in itself is a basic financial product which investors can take positions in.
Equity product is traded with the help of exchanges in the form of future or option contracts generally through delivery but the commodity is limited as a derivative product mostly.
Liquidity in equity products is higher than in the case of commodities.
Debt Vs Equity
Moving ahead with the comparisons, equity and debt funds are completely different financial products too. Here are some quick differences between the two:
The nature of the invested funds is different. In Equity, you invest in specific company stocks buying a stake in the business while doing so. However, in the case of Debt funds, money is invested in a pool of government bonds, corporate bonds etc.
Equity funds are seen to be relatively riskier as compared to debt funds.
Short-term equity investments (less than a year) draw a tax of 15% while long-term investments (more than a year) have no taxes levied. Debt funds, on the other hand, the taxes are in the range of 20% for a 3-year holding period.
Equity, generally, brings higher returns as compared to debt funds.
Equity Vs Mutual Funds
One of the most looked-forward comparisons is Equity vs mutual funds. Well, there are differences, quite a few actually. Some of those are discussed here:
You can individually select stocks in equity investments but not in mutual funds.
You may choose to enter or exit a stock as per your comfort in the case of equity, but it does not work like that in case of mutual fund investments.
Mutual funds are a relatively safer investment product as compared to equity but then bring lesser returns than the latter.
Equity, as a financial product, has its charm and of course differences from other fellow financial products. It all depends on how you, as an investor or a trader, look at this financial class.
Nonetheless, let’s move on and understand different kinds of equities you can invest in.
Types of Equity
On a general basis, there are 3 types of Equity Funds in the Share Market, namely:
Large-Cap Equity Funds
These funds generally belong to mature companies in the business such as Infosys, SBI, HDFC that have proven business models. The return percentage is not that high, but is consistent and certainly be trusted for long-term investments.
Mid-Cap Equity Funds
These funds belong to companies that are mid-scale in size and have shown reasonable progress in their monetary and competitive performance.
Some of these funds include Abbott India, Aditya Birla Fashion etc. The risk factor in these is relatively better than Large-cap equity funds, however, the risk level is relatively high too.
Small-Cap Equity Funds
Equity funds falling in the Small-cap segment come with the highest of the risk percentage as compared to the rest of the fund types.
However, for risk-taking traders, these type of funds are work well while risk savvy investors should generally stay away from small-cap funds.
Some of the examples include 5Paisa, 3i Infotech, Ace Exports etc.
Thus, based on your risk appetite and investment objectives, you can make a corresponding choice with the kind of funds you would like to invest your money in.
When you invest in the share market and specifically in the Equity segment, there are risks of various kinds. Some of those risks can be around the dynamics of the companies you invest in:
Risk of price fall of the stock you have invested in
When you invest in specific stocks expecting regular dividends and the company stops paying it or lowers its value
Risk of any potential fraud found in the company leading to it getting bust or its operations getting stopped
However, there are specific factors on which these equity risks depend upon:
Company management stability
Having said that, this needs to be understood that when you invest in equity, remember equity investment has its positives of high returns along with concerns of relatively higher risks.
This concept comes into play when a company with ‘X’ number of shares issues additional shares to new investors in order to raise extra funding/investment for their business operations.
When this situation arises, then the number of shares increases while the overall stake in the company stays consistent (at 100% at any given point in time), the respective percentage stake of each stakeholder or investor will automatically decrease. This is what is termed as Equity Dilution.
Let’s take a quick example to understand this:
For instance, a company Rabi Solutions has a total of 1000 shares held by its current 10 investors, with each investor holding 100 shares. In simple terms, out of the total 100%, each shareholder holds 10% of the company equity.
Now, in its next funding or fundraising process, the company adds a new investor allocating 100 shares to that person. Now, with 11 investors holding the same amount of shares, the overall equity will be divided among 11 parts.
After this investment, each shareholder will hold 100/11 i.e. 9.09% equity share in the company.
This drop from 10% to 9.09% shareholding is seen as Equity Dilution.
When you invest in the equity segment and make returns from your investments, then the corresponding amount of tax needs to be paid as well.
With GST in place, each trade you place in the stock market across trading segments, you need to pay this form of tax to your stockbroker. Your broker then further pays this tax to the corresponding regulatory body, state government and central government.
This form of tax is applicable when the equity you buy is sold anytime after one year of buying the security.
If you are looking to invest in the equity segment, be for short-term or long-term, you MUST perform the requisite research. If you fail to do so, there are high chances you may end up losing some or most part of your investment.
In order to perform your research, you need to figure out whether you are looking to perform your investment for short term or long term. This is for the reason that you’d require to perform the technical analysis of stocks in case of former and the fundamental analysis of stocks in case of the latter.
While performing technical equity research, you can choose to use different tools such as stock charts, technical indicators, heat maps, stock analytics etc.
Here are some interesting facts related to this trading class that you must be aware of:
In order to invest in Equity, you can use either of the trading platforms including a mobile app, terminal software or web-browser application. You can also choose to use the call and trade facility in order to place your order in the stock market through your stockbroker.
Within Equity class, you can buy and sell the shares on the same day (called Intra-day trading) or choose to buy today and sell later (Delivery based trades). To be relatively safer, you can choose to trade in derivatives (that is, futures and options).
If you are looking to trade just in intraday based trading, then you actually do not need a Demat Account and just a trading account since the shares will not be stored in your account anyway.
In case you buy and sell in delivery based trading, then once you buy the shares, the stocks will be stored into your demat account after T + 2 days where T is the day of the trade.
Mathematically, Equity is basically the difference between the assets and the liabilities of the company i.e. Equity = Assets – Liabilities.