Overview of Equity Securities

Equity securities play a fundamental role in investment analysis and portfolio management. The importance of this asset class continues to grow on a global scale because of the need for equity capital in developed and emerging markets, technological innovation, and the growing sophistication of electronic information exchange. Given their absolute return potential and ability to impact the risk and return characteristics of portfolios, equity securities are of importance to both individual and institutional investors.

This reading introduces equity securities and provides an overview of global equity markets. A detailed analysis of their historical performance shows that equity securities have offered average real annual returns superior to government bills and bonds, which have provided average real annual returns that have only kept pace with inflation. The different types and characteristics of common and preference equity securities are examined, and the primary differences between public and private equity securities are outlined. An overview of the various types of equity securities listed and traded in global markets is provided, including a discussion of their risk and return characteristics. Finally, the role of equity securities in creating company value is examined as well as the relationship between a company’s cost of equity, its accounting return on equity, investors’ required rate of return, and the company’s intrinsic value.

We conclude with a summary of the key components of this reading:

• Common shares represent an ownership interest in a company and give investors a claim on its operating performance, the opportunity to participate in the corporate decision-making process, and a claim on the company’s net assets in the case of liquidation.

• Callable common shares give the issuer the right to buy back the shares from shareholders at a price determined when the shares are originally issued.

• Putable common shares give shareholders the right to sell the shares back to the issuer at a price specified when the shares are originally issued.

• Preference shares are a form of equity in which payments made to preference shareholders take precedence over any payments made to common stockholders.

• Cumulative preference shares are preference shares on which dividend payments are accrued so that any payments omitted by the company must be paid before another dividend can be paid to common shareholders. Non-cumulative preference shares have no such provisions, implying that the dividend payments are at the company’s discretion and are thus similar to payments made to common shareholders.

• Participating preference shares allow investors to receive the standard preferred dividend plus the opportunity to receive a share of corporate profits above a pre-specified amount. Non-participating preference shares allow investors to simply receive the initial investment plus any accrued dividends in the event of liquidation.

• Callable and putable preference shares provide issuers and investors with the same rights and obligations as their common share counterparts.

• Private equity securities are issued primarily to institutional investors in private placements and do not trade in secondary equity markets. There are three types of private equity investments: venture capital, leveraged buyouts, and private investments in public equity (PIPE).

• The objective of private equity investing is to increase the ability of the company’s management to focus on its operating activities for long-term value creation. The strategy is to take the “private” company “public” after certain profit and other benchmarks have been met.

• Depository receipts are securities that trade like ordinary shares on a local exchange but which represent an economic interest in a foreign company. They allow the publicly listed shares of foreign companies to be traded on an exchange outside their domestic market.

• American depository receipts are US dollar-denominated securities trading much like standard US securities on US markets. Global depository receipts are similar to ADRs but contain certain restrictions in terms of their ability to be resold among investors.

• Underlying characteristics of equity securities can greatly affect their risk and return.

• A company’s accounting return on equity is the total return that it earns on shareholders’ book equity.

• A company’s cost of equity is the minimum rate of return that stockholders require the company to pay them for investing in its equity.