What Is Equity?

Equity is a company’s net assets minus its liabilities. Equity may also be referred to as shareholders’ equity or stockholders' equity. It stands for the residual claim of a company owner after debts have been paid.

Here’s an example to explain what is equity:

Take a look at the total assets and liabilities of ABC Corporation on 30 September 2019. Its total assets on that date stood at Rs 1 lakh. Meanwhile, its total liabilities—including loans and taxes—amounted to Rs 75,000. So, the equity of ABC Corporation on 30 September 2019 is Rs 25,000 (i.e. Rs 1 lakh – Rs 75,000).

How Companies Raise Capital

All companies need capital to start or expand their operations. They can raise capital in three main ways:

1. Initial Investment In The Company

Say, Alok plans to start a company, and Bindu, Christina, and Dilshad chip in with Rs 10 lakh each, as Alok does. Then all four of them have equity investments in the company.

Some years later, they may decide to raise more capital to expand the operations of the company. This brings up the question of the next source of equity for the company: whether to borrow from private investors or list on the stock exchange.

2. Borrowing From Private Investors

Private investors may include individuals as well as institutions like pension funds, university endowments, and insurance companies. In return for the investment, the company founders pledge to give away a share of the company ownership. The ownership share of each investor is proportionate to their investment.

However, private equity investors must have a comprehensive understanding of the business scenario. They must also meet a minimum net worth threshold to be eligible to invest.

3. Listing On The Stock Exchange

When a company lists on the stock exchange, it aims to raise capital from the public. Most companies start private and relatively small. Some of them become large and eventually go public. Here’s a look at the IPO process:

• A company that wishes to go public and list on the stock exchange has to launch an initial public offering (IPO).
• For this, it must hire an underwriter. This is usually an investment bank that works on behalf of the company. The underwriter carries out all the necessary procedures for launching an IPO. They also evaluate the company’s worth and fix the initial share price accordingly.
• An initial round of shares is issued to the public through an IPO. The shares are issued at either the book price or the price fixed by the underwriter.
• Once the IPO shares are allotted, the company can list on a stock exchange like the National Stock Exchange (NSE) or the Bombay Stock Exchange (BSE).
• The company’s shares can now be traded by buyers and sellers.
• Going forward, the company’s worth will be calculated based on the market price of the shares. The market price is the rate at which the shares are trading on the exchange.

Investing in public equity is relatively simple. Even retail investors with low net worth can invest in public equity through IPOs or the open market. Read up on how to apply for IPO investment, know the advantages and disadvantages, and explore the different IPO types.

Why Invest In Equity?

To understand why equity is a good avenue for investment, it helps to compare other investment instruments in the market. In India, some popular non-equity investment instruments are bank fixed deposits (FDs) and post office saving schemes.

• Returns Potential:

Traditionally, all non-equity instruments are believed to be low-risk or safe investments. But they generate wealth at a lower rate of return. For example, a fixed deposit attracts interest earnings of around 6–7%. In contrast, the cumulative annual growth rate (CAGR) for the Sensex has been above 16% over the last 40 years between 1979 and 2019, according to a Live Mint article dated 3rd April 2019.

• Taxation Factor:

One needs to pay income tax on fixed deposit interest earnings. The tax rate is as per the investor’s tax bracket. So, if you are in the 30% tax bracket, the same rate will apply to your fixed deposit interest income. Gains from equity investments are taxed differently. Say, you sell off (redeem) your equity holdings after more than one year. Your profits will be treated as long-term capital gains (LTCG) since you stayed invested for over 12 months. As per current taxation rules, 10% LTCG tax applies when such gains exceed Rs 1 lakh. Use this income tax guide to calculate your tax liability for the year.

• Security:

The so-called safe investments are not that safe after all. Bank deposits of only up to Rs 5 lakh per investor are insured. The Deposit Insurance and Credit Guarantee Corporation (DICGC), a subsidiary of the Reserve Bank of India, provides the insurance coverage. Should things go south, deposits exceeding Rs 5 lakh even in public-sector banks could be forfeited.

The equity advantage: Taken together, the above reasons make equity one of the best investment instruments available to a retail investor. Such investments are subject to market risk, of course. But one could potentially earn higher returns with a lower tax liability by investing in the stock market.

Learn all about the share market, how it works, and the advantages of equity shares. Get answers to all your equity trading questions here.

Who Should Invest In Equity?

One must factor in the following aspects before investing in equity:

• Time Horizon

Investment is essentially a game for the long term. So, anyone with a considerably long investment horizon should invest in equity.

• Age

As you age, the time horizon for investment shortens. As a thumb rule, allocate (100 – Age)% of your portfolio to equity. For example, a 40-year old could allocate at least (100 – 40)%—that is, 60%—of their portfolio to equity.

• Risk Appetite

Equity investments are subject to market risks. If you have a moderate risk appetite, you could consider investing in blue-chip or large-cap stocks. These are considered to be less risky than other stock types. Learn all about small, mid, and large-cap stocks.

Types Of Equity Investments

There are several ways to invest in equity in India. Outlined below are some of the most popular avenues:

• Shares

Shares are units of partial ownership of a company. Anyone who invests in shares is called a shareholder of the company. Your extent of ownership is in proportion to the amount you have invested in the company.

Shares are usually classified by the market capitalisation (market cap) of the company. The term refers to the total market value of a company’s outstanding shares of stock. It is calculated using a simple formula:

Total number of a company’s outstanding shares x Current market price of one share

For example, say, ABC Corporation has 100 outstanding shares. If the market price of each share is Rs 10, then the market cap of ABC Corporation is Rs 1,000.

Based on the market cap of the company, shares may be classified as large-cap, mid-cap, and small-cap. You can read more about these here.

• Mutual Funds

Mutual funds are a convenient way to invest in equity. They are suitable for investors who lack stock market experience or the time to carry out market research. A mutual fund accumulates investments from retail investors and then allocates the capital to different assets.

Such funds are offered and managed by asset management companies (AMCs). An AMC may pool investments from various investors for different mutual fund portfolios. Each such portfolio has a fund manager working on behalf of the AMC. The fund manager invests the accumulated capital of a mutual fund in various assets such as equities and bonds. For example, equity mutual funds are funds that invest mainly in equity shares.

Mutual funds offer a host of benefits to the investor:

1. As the investment decisions are taken by expert fund managers, the investor’s money is in safe hands.

2. Mutual funds offer the benefit of diversification. This means they reduce your risk exposure by spreading the investment across multiple assets. With mutual funds, you get the diversification advantage even in case of pure equity funds. Equity mutual funds invest in the stocks of several companies. This reduces the impact of an individual stock on the fund’s net asset value (NAV), which is simply the per unit market value of the fund.

3. An investor can invest in a mutual fund by either paying a lump-sum amount or investing in small amounts through a Systematic Investment Plan (SIP). SIP is a mode of investing where a fixed amount is invested in a pre-selected mutual fund scheme on a fixed date every month. Kotak Securities offers the SIP feature for stocks too with AutoInvest. Through this, you can invest a fixed amount in a single stock on a fixed date every month.

Learn more about Mutual Funds at Kotak University here.

• Options And Futures

While shares and mutual funds represent the cash market, options and futures help investors buy or sell equity stocks/indices in the future. Both are contracts for buying or selling a particular stock/index on a particular future date at a predetermined price. But there is a critical difference between options and futures: - An options contract gives an investor the right, but not the obligation, to buy (or sell) shares at a specific price at any time during the contract term. - On the other hand, a futures contract requires a buyer to purchase shares (or the seller to sell them) on a specific future date, unless the holder’s position is closed before the expiry date.

Consider an example of an options contract: An investor opens a call option to buy stock of ABC Corporation at Rs 50 per share on 30 April 2020. This is called the strike price. The share is currently trading at Rs 30. At the time of opening the call option, the investor pays an amount which is called the premium. If the buyer does not buy the shares of ABC Corporation before 30 April 2020, the contract expires and the investor loses the premium. On the other hand, if the stock price jumps to Rs 60, the investor can buy the shares at Rs 50. They can then sell the shares from the option in the cash market and book a profit of Rs 10 per share.

A futures contract, on the other hand, is obligatory. Say, you enter a futures contract to purchase a particular stock on a specific date at a specific time. You will be obliged to complete the transaction on that date unless the contract is closed beforehand.

Options and futures contracts can be used by seasoned investors. They could use the instruments to speculate on price movements of the underlying stock or hedge current investments. One advantage is that investors can execute large trades by depositing just a small amount of margin money. You can learn more about Derivatives Trading at Kotak University here.

• Arbitrage Funds

An arbitrage fund is a mutual fund that takes advantage of market volatility. It aims to generate returns based on price fluctuations in the cash and derivatives markets. For example, an arbitrage fund might buy and sell the same stock at the same time but on different exchanges. Or, it might purchase stock in the cash market and simultaneously sell it in the futures market. This allows the fund to benefit from price movements resulting from market inefficiencies and ensure profits for investors.

Risks Of Equity Investment

All investments are potentially risky. Here is an overview of the risks associated with equity investments:

• Macroeconomic Risk

An economic slowdown, for example, may affect the stock market in different ways. Though such macroeconomic factors broadly affect all sectors, they may not have the same impact across sectors. In fact, a company in an otherwise stable sector might suffer due to management issues or run into regulatory trouble. So, investors should diversify their portfolio to minimise their exposure to any particular stock or sector.

• Political And Legislative Risks

Businesses are affected by the policies of the ruling government. A new legislation could adversely affect the prospects of a particular company or a sector. For example, a stricter environmental law could make it difficult for mining companies to clock profits at the earlier rate. Again, suppose the government decides to liberalise a previously protected sector. In such a case, indigenous companies with lower efficiency may lose out to foreign competition.

• Exchange Rate Risks

Companies that depend heavily on the import of raw materials are hit adversely when the rupee depreciates. Meanwhile, exporters may see their profit falling when the rupee appreciates. A depreciating rupee affects the economy as a whole because the price of crude oil increases in rupee terms.

Final Word

Adding equity to your investment kitty could help you beat the impact of inflation. Inflation is said to be wealth’s worst enemy—it reduces the purchasing power of your money over time. But equity, unlike many other investment vehicles, can potentially provide inflation-adjusted returns in the long term. While seasoned players can invest or trade in equity directly in the stock markets, those with less experience could always take the mutual fund route. Just remember to factor in your financial goals and needs. That will help you put together an effective equity investment strategy.