Risk/ReturnCharacteristics of Equity Securities

An investor receives three types of returns from an equity investment:

• Dividends

• Price appreciation/depreciation (Capital gain/loss)

• Gains/losses from currency fluctuations (in case of holding equities denominated in foreign currency)

The risk of equity securities is measured in terms of the standard deviation of returns.

Between common shares and preferred shares, common shares are considered more risky. This is because preferred shares pay fixed dividends and have priority claim over the net assets of the firm in case of liquidation. Because of higher risk, common shares also have higher average returns than preferred shares.

Within preference shares, cumulative shares are less risky compared to non-cumulative shares because the dividend is accumulated if not paid in a given year.

Within common shares, callable common shares are more risky than vanilla common shares and puttable shares are less risk than vanilla common shares. Callable shares are more risk because if the market price of the shares rises, they can be called by the issuer and limit the upside potential for the investors. For this reason, callable shares pay higher dividend yields. Puttable shares are less risky because if the market price of shares falls, investors can sell the shares back to the issuer at a better price. For this reason, puttable shares pay lower dividend yields.

Using Equity Securities to Finance Assets

A company raises capital by issuing equity securities in the primary markets. The main purpose of raising capital is to finance the core activities of business. The company may use the capital to finance long-lived assets, R&D, finance capital intensive projects, or to even launch new products or enter new geographic regions. It may also use it as a currency to make acquisitions or offer it as incentives to employees (stock options).

Market Value Vs. Book Value of Equity

The Book Value of Equity is the net value of the company after all the assets have been used to pay off the liabilities. It is equal to the firm’s total assets minus total liabilities. It is equal to the capital contributed by the owners (also known as shareholders) plus any retained earnings or losses. If a company has positive retained earnings, the book value increases, however, if the company has losses, the book value decreases. Market value of equity is another term for market capitalization. It is calculated by multiplying the current stock price by the total shares outstanding. The market value reflects the expectations of investors about the future performance of the company. Book value and market value of equity are usually different as the book value does not reflect investor expectations and perceptions.