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The risks and rewards of investing in equity are clearly apparent from the Bombay Stock Exchange Sensitive Index (BSE Sensex), which is a popular stock market index. This index reflects the movement of the share prices on the stock markets. The Sensex rises and/or falls continuously during trading hours. Rises indicate gains and falls indicate losses. True equity money is unsecured and directly reflects the faith of the investor in the business, its management and the commitment of its principals to it.

Equity remains in perpetual existence
The perpetual existence of a company implies that the death, disability, retirement or termination of a shareholder, director or officer, will not affect the existence of the company. For an equity shareholder, this is convenient since he does not need to renew/renegotiate the terms of his investment (like in the case of a fixed tenure debt investment). He also has the option to sell his equity holding through the stock exchange if he no longer wants to remain invested in the company.

Limited liability
Another extremely important feature of equity is its limited liability, which means that, as a part-owner of the company, you are not personally liable if the company is not able to pay its debts. In case of other entities such as partnerships, if the partnership goes bankrupt, the partners are personally liable towards the creditors/lenders and they may have to sell off their personal assets like their house, car, furniture, etc., to make good the loss. In case of holding equity shares, the maximum value you can lose is the value of your investment. Even if a company of which you are a shareholder goes bankrupt, you can never lose your personal assets. 

About Equity

Equity is a share in the ownership of a company. It represents a claim on the company's assets and earnings. As you acquire more stock, your ownership stake in the company increases. The terms share, equity and stock mean the same thing and can be used interchangeably. Holding a company's stock means that you are one of the many owners (shareholders) of a company, and, as such, you have a claim (to the extent of your holding) to everything the company owns. Yes, this means that technically, you own a portion of every piece of furniture; every trademark; every contract, etc. of the company. As an owner, you are entitled to your share of the company's earnings as well as any voting rights attached to the stock 

Income from equity investing

Capital appreciation
Equity shares of companies are listed and traded on a stock exchange (the Bombay Stock Exchange or the National Stock Exchange). The market prices of these shares are continuously moving up or down depending on the interest in the company’s stock, it’s business potential, etc. As an equity shareholder, you can profit/lose from the market price rise/fall. For instance, if you have purchased the equity shares of Company ABC at Rs 25 per share and the market price of the share rises to Rs 30, you can sell the shares at this price to make a profit. This is called ‘capital appreciation’. However, if the market price falls to below Rs 25, you would lose. This loss would be notional till you actually sell at this price and book the loss.

Bonus shares
When you purchase shares of a company, you become a shareholder of the company. When the company is doing well, it may declare a ‘bonus issue’. This means that the company will issue fresh equity shares to its existing shareholders, for free. As a shareholder, you will be entitled to receive bonus shares in proportion to your holding in the company. For instance, if the company declares a bonus in the ratio of 1:2 (this means it will issue one share for every two shares you hold) and if you hold 100 shares, you will be entitled to 50 shares as a bonus. When you sell your bonus shares in the stock market, the market price at which you sell your bonus, minus brokerage charges and necessary taxes (Service Tax, Securities Transaction Tax, etc.), will be your profit i.e. capital appreciation. In this case, there will be no cost of purchase since you have received the bonus for free.  For instance, if the company declares a ‘bonus issue’ in the ratio of 1:2 (this means it will issue one bonus share for every two shares you hold) and if you hold 100 shares, you will be entitled to 50 shares as a ‘bonus shares’. The cost of these shares will be nil. In this case, if you sell your bonus shares in the market at say, Rs 35, your capital appreciation will be the entire Rs 35 per share minus brokerage, taxes, etc.

Rights shares
Another way a company offers benefits to its shareholders is by offering ‘rights shares’. This means that the company will offer fresh equity shares to its existing shareholders at a price, which is lower than the current market price of the share. For instance, if the current market price of the company’s share is Rs 35, it will offer shares at below this price, say Rs 25. As a shareholder, you will be entitled to receive ‘rights shares’ in proportion to your holding in the company. For instance, if the company declares a ‘rights issue’ in the ratio of 1:2 (this means it will issue one share for every two shares you hold) and if you hold 100 shares, you will be entitled to 50 shares as a ‘rights shares’. This implies that to obtain the ‘rights shares’, you will have to pay Rs 1,250 (50 shares you are entitled to x Rs 25 per share). In this case, if you sell your rights shares in the market at say, Rs 35, your capital appreciation will be Rs 10 per share minus incidental selling costs.

However, if you don’t want to subscribe to the rights offered to you, you can sell your rights entitlements. The price that you receive to sell your rights entitlements will depend on the rights offer price, the current market price and the demand for the company’s shares. For instance, taking the above example forward, if you decide to sell your rights entitlements of 50 shares and you receive Rs 2.50 per share, you will get a total of Rs 125. This will be your profit after deducting incidental selling expenses.

Dividend income
Companies report their profits earned on a quarterly basis. Based on the quantum of profits, companies declare dividends to distribute a portion of these profits to their shareholders. Dividends are declared as a percentage of the share’s face value. For instance, if a company declares a dividend of 10 per cent and its share has a face value of Rs 10, it implies that it will pay Re 1 per share as dividend (Rs 10 x 10 per cent). As a shareholder, you will be entitled to dividend to the extent of your share holding. For instance, in this case if you hold 500 shares, you will get a dividend of Rs 500 (500 shares x Re 1 per share). However, dividend income is uncertain. Companies don’t declare dividends regularly. Dividends are declared only when there are profits available for distribution.

Reasons for issuing equity

To expand its business, a company, at some point, needs to raise money. To do this, it can either borrow by taking a loan or raise funds by offering prospective investors a stake in the company --- which is known as issuing stock. A company usually borrows from banks and/or financial institutions. This is called ‘debt financing’.

On the other hand, issuing stock is called ‘equity financing’. While raising loans is used for temporary cash requirements (such as borrowing to fund a project), issuing stock is used to raise funds of a permanent nature. While a lender gets interest for the loan given to the company, an equity shareholder gets a share in the

5 STOCK SELECTION GUIDELINES

There are more than 6,000 companies listed on our stock exchanges. Selecting companies whose equity shares you should invest in, becomes difficult due to this wide choice. To narrow down your choice, follow these 5 stock selection guidelines: 

Know the business

Warren Buffett, one of the world’s most successful investors, follows the philosophy of buying stocks of only those businesses that he understands. Select companies in businesses that you already have an idea of and find interesting. One of the businesses that could be of interest to you would be the one, which you are affiliated to because of your employment. For instance, if you are working in a pharma company, you may understand this business well. 

 Assess the past performance

All companies present details of their financial performance in their Annual Reports[A1] [A1]. In case of a company having its Initial Public Offering – IPO (when a company offers its shares to the public for the first time, it is called Initial Public Offering), it is required to publish its past performance in its IPO offer document[A2] [A2]. There are also a vast number of research reports published by research and brokerage houses, and company analysis done by the media, which is worth reading, to assess a company’s past performance and future potential. ‘Ratio Analysis’ is widely used to assess a company’s past performance.

Know the promoters

The promoters and management team of a company are the key people who drive its business. Their integrity dictates whether the business benefits or they benefit personally. Also, their experience and business competence is crucial for business growth. Evaluate the company’s promoters and management on the basis of four Cs: Competence, Credibility, Corporate governance and Concern for shareholders. 

Assess the future prospects of the company

Although a company may have performed well in the past, it is not necessary that it will continue performing well in the future. All companies go through business cycles of ups and downs. It is important that you form a view on the future trends of the business the company is a player in. This can be done by reading views of experts in that business/industry and forming your own view by reading and understanding economic trends and the impact of these trends on the company’s business 

Assess the stock price

As mentioned earlier, the share price of all companies continuously fluctuate on the stock markets with investors buying and selling the shares. The price at which an investor is willing to buy or sell a share of a company is the perceived value of the share of the company taking into consideration the company’s present business and future business growth. In addition to this, investor sentiment plays a large role in pricing of stocks. It is important that before you buy a company’s share, you assess whether the price of the share at which it is available for purchase, is adequately valued i.e. it is not over-priced. Similarly, when you sell, you need to make sure that you are not selling too cheap. To help you assess this, you could use a popular stock market ratio called the Price/Earning ratio (P/E ratio). The P/E ratio is based on the following formula:
 

P/E ratio = Market price of the share
                 Earning per share (EPS)*

*EPS  = Profit After Tax (PAT)
               Total number of shares issued by the company

You can obtain information on the EPS, PAT and total number of shares issued by the company from its annual report.

Let’s understand how the P/E ratio is used with an example:

Company XYZ Ltd. has issued a total of 10 lakh equity shares and has earned a net profit of Rs 10 lakh. The EPS of the company is Re 1. The current market price of the company is Rs 15 per share. The P/E ratio of Company XYZ Ltd will be 15 (Rs 15 / Re 1).

The P/E ratio helps judge by how many times the company’s share is traded based on its earnings. In this case, the company’s stock is available at a multiple of 15 times its earnings. The higher the P/E ratio, the higher is the stock’s valuation. Usually market prices of well-established companies with a good past track record and reputed promoters command a high P/E ratio.

To use the P/E ratio correctly, keep the following aspects in perspective:

• Compare the P/E ratio of a company with that of other companies in the same business.
• Compare it with P/E ratios of the benchmark indices such as the P/E ratio of the BSE Sensex, the NSE Nifty, etc.
• Compare the P/E ratio with the growth potential of the company and the industry it is a part of. There could be a situation that even if the P/E ratio of a company is high, it would be worthwhile to buy the stock if the growth potential is significant.

To conclude, just because a company’s P/E ratio is high, it does not mean that it is over-priced. Consider this ratio along with other factors such as past performance, business potential, promoters, the company’s order book position, etc.

SOURCES OF STOCK INFORMATION

Any financial educator will tell you about the importance of the well-informed investor. Investment in equity needs proper study and research before putting your money on the line. Use the following sources of information to undertake your research 

Corporate Filings

Companies listed on the stock exchanges (whose shares you can purchase/sell) have to compulsorily submit all information and updates such as submission of their quarterly results, announcements of bonuses/dividends/rights, changes in key personnel, mergers, etc. to the stock exchange. All this information is available on the website of the stock exchanges (Bombay Stock Exchange’s website is www.bseindia.com and National Stock Exchange’s website is www.nseindia.com).

Research Reports
 

If you don't have the time to do all the research by yourself, you can obtain research reports published by various research houses. Research houses usually distribute these reports to their customers, their associates, the media, etc. They also vend these reports at an affordable cost. These reports are very useful since they are created by professional equity research analysts who usually meet with the management of the company, visit the company’s factories/workplaces, etc., study the past performance, make an assessment of the future trends, etc. based on which they give a ‘buy’, ‘sell’ or ‘hold’ recommendation. The initial reports (i.e. reports which cover all aspects of a company) are then followed up by updation reports, which are usually published every quarter after the company announces its quarterly results.

Research houses also offer a lot of useful information at no cost on their websites. Often, research reports are archived on their websites helping you get a comprehensive picture of how the company has evolved over time.

Investing in dividend yield stocks 

Dividend yield is a ratio, which divides the dividend paid out by a company with the current market price. For instance, if a company pays out Rs 5 per share as dividend and its current market price is Rs 55, its dividend yield is about 9 per cent (Rs 5 / Rs 55 x 100). Companies, which offer high dividend yields, are usually ‘value’ companies, which ‘value investors’ look for. These companies have strong fundamentals and good potential, which the market has yet to recognize. When the market recognizes the worth of these companies, their dividend yields fall because of rise in their market prices. They, then offer a significant amount of capital appreciation 

Diversification

Diversification means spreading your money over a number of investments. In other words, you don’t concentrate your money over just one or two, or only over a few investments. For instance, if you have an investible surplus of Rs 1 lakh, you can diversify into two ways. Firstly, don’t invest the entire Rs 1 lakh in just one asset class. Allocate the amount among 2-3 asset classes. For example, instead of investing the entire Rs 1 lakh in say, equity, invest a portion in equity, another portion in mutual funds and the balance in debt. Secondly, within each asset class you are investing in, don’t invest all the amount allocated to that asset class in only one or two investments. For instance, if out of Rs 1 lakh, you have decided to invest Rs 35,000 in equity, don’t invest the entire Rs 35,000 in shares of just one company. Allocate this amount between 2-3 companies at least.

 Diversification - benefit and pitfall. Diversification is a well-established risk management investment strategy. It helps spread your risks over investment options offering different risk-return levels. Diversification especially helps when one invests in investment options with complementary risk-return profiles. For instance, it has been historically proven that when the equity markets are on a bull-run, the debt markets are usually sluggish. Now, if you invest in a combination of equity and debt, you are protecting your investments from a significant fall. In other words, if you had only invested in equity and the equity markets were in a bearish situation, you would have made significant losses on your investments. However, by investing in both, debt and equity, a portion of your portfolio, which is invested in debt, will offer profits during this time to reduce the losses on your equity investments, resulting in either an overall lower loss, or even a marginal gain depending on the level of investment in debt. The reverse will hold true if the equity markets are moving upwards and the debt markets are stagnant.

However, diversification also results in lower profits. For instance, if you had invested only a portion of your portfolio in equity, and the equity markets are in a bull-run phase, you would make profits on only the portion of your investments made in equity. The portion invested in debt would not offer the same level of profits, or may even result in losses. Having said this, diversification helps cap losses, which is important, especially for risk-averse investors.

Diversification methods: Diversification can be done across different asset classes (equity, debt, mutual funds, gold, property, etc.) as well as across different investment options (say, in case of equity – investment in companies with different market capitalisations, in different sectors, etc.). The amount of investment made in each asset class and investment option will depend on your investment risk profile and expected investment returns

Growth investing

Growth investing means investing in companies, whose turnover and profits are expected to grow significantly, which will result in appreciation in their share prices. These companies are in a phase of rapid growth and expansion of their businesses.

Rupee cost averaging / value averaging

To buy ‘low’ and sell ‘high’ is very difficult to do, especially in volatile markets (where prices rise and fall significantly over very short periods of time). One investment strategy that helps overcome this volatility and take advantage of it by averaging out cost of investment, is ‘Rupee cost averaging’ (RCA) or ‘Value averaging’. Under RCA, you decide how much you want to increase your investment by at fixed periodical intervals of time, say on a monthly basis. If the markets rise, you will need to invest a lesser amount or book profits. However, if the markets fall, you will need to invest more to achieve your target investment amount. Let’s understand this with an example. You plan to increase your equity portfolio by Rs 15,000 every month. In the first month, you invest Rs 15,000. In the next month, due to a market fall, your portfolio value falls to Rs 12,000. You will need to invest Rs 18,000 in this month to make up the loss of Rs 3,000 and add fresh investments of Rs 15,000. If in the following month, the market is bullish and your portfolio rises by Rs 13,000, you will invest only Rs 2,000 to bring up your portfolio value by Rs 15,000. Similarly, if the market is very bullish and your equity portfolio value shoots up by Rs 17,000, instead of investing that month, you will book profits to the extent of Rs 2,000. RCA helps you undertake disciplined investing. You need to set a target and use the market movement to achieve it. It also helps you decide when and to what extent to exit from the market. However, in a long bull or bear phase, this strategy becomes difficult to implement. 

RISKS ASSOCIATED WITH EQUITY INVESTING

There are broadly two kinds of risks associated with investing in equity: Systemic risks & Non-systemic risks

Articles 

Systemic risk

This implies ‘risk in the system’. This risk applies to the entire market and includes risks such as interest rate risk, inflation risk, exchange rate risk, political risk, etc. Some of the important

Non-systematic Risk

This is risk that is very specific to a particular stock or an industry. Some of the important non-systemic risks are indicated below:

Coping with Risks

While systemic risks are not in one’s control, non-systemic risks can be assessed for each company before one makes an investment decision.

MONITORING YOUR EQUITY INVESTMENTS

Once you have made your investment in shares of the companies you have selected, you cannot afford to simply forget about your investments

Cant afford to forget your Investments

Once you have made your investment in shares of the companies you have selected, you cannot afford to simply forget about your investments and hope that someday, when you need the money and you check on your investments, they would have significantly risen in value. As stated earlier, companies go through business cycles of ups and downs, which affect their share prices. Not only this, companies also go through mergers, acquisitions, changes in managements, new business developments, etc., all of which affect their stock prices for the better or worse. You need to periodically monitor your company’s performance. The periodicity could be quarterly since companies report their results on a quarterly basis. Use ‘Ratio Analysis’ to study the company’s quarterly performance.

In addition to assessing the company’s performance, you need to keep track of developments in the economy since this affects the businesses of all corporates. For instance, in a year when the monsoons are good, companies’ businesses show a positive impact, especially those, which are directly affected by the monsoons. Similarly, a high growth in the country’s Gross Domestic Product – GDP (the total market value of all the goods and services produced within the country during a specified period) indicates prosperity and high purchasing power in the hands of the consumers, which means good overall business prospects.

With India becoming an integral part of the global economy, most companies’ are impacted with global developments. For instance, if the US raises or lowers the Fed rates, the impact is felt in our country, too. A hike in Fed rates will result in money moving out of our country towards the US, which will adversely affect our capital markets and the business environment. The situation will reverse in case of a fall in Fed rates. Similarly, if countries lower or increase their import quotas, our exporting companies are impacted. This implies the need to keep track of global market developments.

Information on the economy and news on the global markets are available in daily business publications and websites of foreign business publications.

 INVESTING IN EQUITY --- THE PROCEDURE

The Procedure

In the past, investing in equity involved a high cost (high brokerage charges of about 2 per cent of the transaction value) and a number of hassles (shares were traded in the physical form, which involved a lot of paperwork and often resulted in bad deliveries due to signature mis-matches, forgery, etc.).

Today, the entire scenario of equity investing has changed for the better. Shares are now traded in the electronic (dematerialized) form and costs of investing have reduced dramatically.

Another significant improvement has been the increase in the number of mediums through which an investor can transact in equity. From just personal visits to a broker’s office and the basic telephone used in the past for equity transactions, today, an investor can use his cell phone, the Internet, call centres and kiosks for his equity trades. 

Another radical convenience, that is available to an investor today, is the seamless linkage between his demat account (which holds his equity shares in dematerialized format), his bank account and his broking account). For instance, if an investor purchases shares through the Internet, once his trade is executed by the broker, the shares purchased by him will be transferred to his demat account and his bank account will be debited for cost of shares and relevant expenses. All this will be done without the investor having to make efforts at every stage for the necessary actions.

3-step process of investing in equity

Step 1: Open the necessary accounts

Before you start investing in equity, you need to open the following accounts:

Broking account

This is an account you open with a broker. You will need to fill in an application form, which will require you to submit details such as your full name, address, Permanent Account Number (PAN), etc. Once your application has been processed, you will receive a broking account number.

Demat account.

This is the account, which will hold shares purchased by you, in electronic form. This works like a bank account. In case of a bank account, you deposit and withdraw your money and receive a bank statement periodically, which shows you how much money is remaining in your account. Similarly, in case of a demat account, shares purchased by you are deposited into your account and shares sold by you are withdrawn from your account, and you receive a statement periodically, showing the shares remaining in your account

A demat account can be opened with a depository participant. It is preferable to have your demat account maintained with your broker or an entity affiliated to your broker. This ensures prompt transfers to and from your demat account of shares purchased and sold by you without any effort required to be made by you (you simply need to issue necessary one-time instructions to your broker

Bank account

You can use an existing bank account for your equity investments.

Step 2: Decide your mode of transacting – in cash or with margins

You have two options of investing in equity:

1.       By making purchases in cash and taking delivery of the shares or

2.  By undertaking margin trading (you pay only a portion of the cost for purchases and your broker funds the balance) and squaring off your positions (you don’t take delivery of the shares. You simply book your profit or loss).

If you decide to undertake cash purchases, you need to have sufficient funds in your bank account to make the purchases.

If you decide to undertake margin trading, you need to pay the broker the margin amount and start your trading.

Step 3: Deciding on which mediums to use for transacting

There are a number of mediums you can use to transact in equity. These are:

Visits to the broker’s office/branches

You can simply visit your broker’s office or closest branch and undertake your transaction by interacting with a counter representative

Your telephone

This is the traditional way of transacting. You simply call your broker and place your order. This facility is available in the form of call centres*.

The Internet

Register yourself with your broker’s internet portal and use the equity-trading platform available to conduct your trades.

Kiosks.

Kiosks are like booths or cabins placed at prominent locations across the city. Simply enter a kiosk and execute your trade. A kiosk is used for trading through the internet. The only difference is that instead of using your home computer, you can use the kiosk located outside your home.

Now you are ready to start investing in equity.

COMPUTING RETURNS ON YOUR EQUITY INVESTMENTS

Once you sell your shareholding, you should compute the returns you have earned on your investment

COMPUTING RETURNS

Once you sell your shareholding, you should compute the returns you have earned on your investment. To do so, you should take into consideration the sale value, your cost, dividends received and rights/bonuses 

Also take into consideration the time element of all your inflows and outflows and use the internal rate of

Return formula to compute your returns.IRR is the rate at which your cash outflows and inflows over different  time periods are equal. 

TAX IMPACT ON EQUITY INVESTING (FOR FINANCIAL YEAR 2006-07)

Investing in equity brings with it two streams of cash inflows – dividend income and capital appreciation (sale of shares at a profit). The tax impact on both these cash inflows is indicated below 

Tax impact on your dividend income 

Dividend received on your equity investment is tax-free in your hands. However, companies need to

pay a dividend distribution tax at the rate of 14.025 per cent (12.5 per cent for tax + 2 per cent for education cess + 10 per cent for surcharge) on the dividend declared and paid out to shareholders

 Setting off capital losses

If you have incurred a capital loss, the tax authorities allow you to use this loss to reduce taxable capital gains from another source under certain conditions. Here is a simplistic example for explanation. If you have incurred a loss of Rs 1,000 from sale of shares of Company ABC and you have made a profit of Rs 2,000 from sale of shares of Company XYZ, you can use the loss on sale of shares of Company ABC to reduce the taxable capital gains earned on sale of shares of Company XYZ. In other words, you will pay capital gains tax on only Rs 1,000 (gain of Rs 2,000 earned on sale of shares of Company XYZ – loss of Rs 1,000 incurred on sale of shares of Company ABC).

Long-term capital losses

Since long-term capital gains earned on your equity investment are tax-free, long-term capital losses incurred on your equity investment cannot be used to reduce taxable capital gains.

Short-term capital losses

Short-term capital losses incurred on your equity investment can be set off against any capital gain (long-term or short-term). If in the current year you don’t have any taxable capital gain to set off the loss against, you can carry forward this loss for 8 years and set it off against any future taxable capital gain (long-term or short-term).