“Mr. Ajit Palekar was thrilled to receive his fat bonus followed by a promotion to the position of vice president in a boutique IT services company. He spent approximately 20% of his bonus on a vacation with family that was long overdue. After returning to work, he was thinking about how to invest his extra earnings in the stock market. Ajit decided to meet Mr. Rajesh Jain, his classmate who works at a leading brokerage and wealth management company.
Ajit started asking pointed questions, such as “tell me a good stock that can give me solid return in the next six months,” which took Rajesh by surprise. Ajit wanted a few stock tips and mantras that could provide him with super returns, and Rajesh was not pleased with the conversation. After a few discussions and debates, they decided to meet leisurely on a weekend.
When they met, Rajesh said, “I will explain the basics of equities and how they work.” Rajesh also insisted that they meet regularly to enable him to explain the process gradually. Let’s review the advice provided by Wealth Guru Mr. Rajesh and what we can learn from it.”
What are Equities?
The word “equity” refers to part ownership in an entity. Anyone who holds equity, or shares of the stock, of an entity is a part owner of that entity. The business entity could be a sole proprietor (as in kirana stores) or a partnership (agreement among two or more people) or a private limited company. As private companies expand, they might be listed on the public markets to raise funds for expansion and growth. For example, companies such as HDFC Bank and ITC are publicly listed companies traded on stock exchanges.
Shares of their stocks can be bought and sold by investors through stock exchanges or stock markets (e.g., National Stock Exchange, Bombay Stock Exchange).
Stock Market Framework
The Stock Market framework is a platform that enables companies to raise capital from public investors, including individuals, mutual funds, foreign institutions, domestic institutions, and others. This is true for companies listed for the first time through an initial public offering (IPO), an activity typically known to comprise the “primary market.” For example, Multi Commodity Exchange of India Limited was listed on March 9, 2012.
Once a stock is listed, people may buy or sell it, activities that occur on the “secondary market” (e.g., NSE, BSE, NASDAQ, New York Stock Exchange).
Benefits for an Equity Holder
An equity holder is a part owner of a company to the extent that he or she owns shares of that company. For example, Mr. Palekar holds 10 shares in a company with total capital of 100 shares. Therefore, Mr. Palekar holds a 10% stake (10 out of 100) in the company. Such an example is hypothetical; in the real world, individuals often hold a very small fraction of the total share capital of a company.
I know that you are asking, “What do I get in return for being an equity holder?” Well, an equity holder invests capital in a company and he receives compensation in the form of a share in the profits. A portion of the profits distributed to shareholders (equity holders) is known as dividends.
In a nutshell, an equity holder may receive one or more of the following benefits:
1. Dividends ( as previously dicussed);
2. Capital appreciation;
3. Bonuses (a company issues additional free shares when it achieves extraordinary performance or certain targets); and,
4. Others (e.g., splits, rights shares) that can be discussed at a later stage (these are not necessarily benefits but may have similar implications).
Capital Appreciation: In simple terms, capital appreciation is the increase in the price of an asset (or stock) purchased. For example, assume that Mr. Ramesh bought 100 shares of ITC stock last year at Rs.220 per share. Currently, if ITC’s stock price is at Rs.260, what happens to Ramesh’s investment? The investment now reflects a profit of Rs.40 per share, or a total of Rs.4,000 (40 x 100). In technical terms, the profit that results from differential prices is called capital appreciation.
Taking the ITC example further, if the company declares a dividend of Rs.4.5 per share, the total dividend earned is Rs.450 (4.5 x 100).
Therefore, investing gurus hold stocks even during market downturns because the dividend income is a continuous stream of earning that flows regularly for several years. Along with a basket of investment assets, if one invests regularly in equities, he/she can build a sizable portfolio to generate sizable income during retirement.
If you want to build a sizable portfolio, you need to start investing early to give yourself adequate time to accumulate more savings and earnings. Second, you need to generate consistent returns, which means that you need to pick the right stocks.
We will further discuss this topic in Lesson 3. Have a nice day and welcome to the world of equities!
You can also learn more about investing concepts at: http://www.nseindia.com/invest/content/intrstn_invst_cncpts.htm