What is an Equity Investment? Find out how to own a company

What Does Equity Mean and What is an Equity Investment?

What is an Equity Investment? There are two main categories of investments (securities) in the financial world, Equity and Debt investments. Our focus will be on equity securities, but first let’s define equity. Equity in this case means ownership of something. When you build equity in your house by paying your mortgage each month you are building your equity in it (ownership of it).

What is an equity security? An equity security provides an opportunity to participate in the companies prosperity. This can be in either capital appreciation, sharing in company earnings, or both! The most well known equity securities are stocks. There are two types of stocks: Common Stock and Preferred Stock. We will discover the benefits and risks to both of these types of equity investments below.

Quick Recap:

What is an Equity Investment: Common Stock

What is Common Stock

Common Stock is what many refer to when they say stocks or the stock market. Common stocks are the most popular answer to what is an equity investment. With Common stocks, a company will issue common stock to raise money. An investor will buy these shares and as a result are part owners of the company. The investor/owner of each share of stock is entitled to a portion of the companies earnings and dividends and a proportionate vote in major decisions.

Most companies are organized so that a Board of Directors represents the stockholders in all of it’s day to day operations. The Board of Directors is elected from the stockholders on a regular basis. This way the stockholders have a say in the company management. This is why is important to know not just the technical analysis but the fundamentals and ethics of a company before you purchase their stock. In purchasing a stock you are becoming part of that company and you should believe in it and that they will grow. Otherwise find another stock, there are plenty available! Let’s go over the benefits and risks of common stock.

What is an Equity Investment: Benefits and Risks of Owning Common Stock

Benefits

Growth from Capital Gains: When the price of the stock increases this is known as capital appreciation. This is the most popular reason investors choose common stocks.

Hedge Against Inflation: Historically common stock owners have returns in excess of inflation.

Income from Dividends: Many companies pay quarterly cash dividends and investors use this as a source of income.

Limited Liability: One of the most important features of stocks is the limited liability. If a company files for bankruptcy and cannot pay all of its debts, stock holders personal assets are not at risk. The max loss for an investor is the investment itself.

Rights to Vote: Using a proxy vote shareholders can have a say in company decisions and corporate directors.

Preemptive Rights: If a company decides to issue additional common stock shares, the current common stockholders are asked first if they want to purchase more shares. This way investors can keep their same percentage of ownership in the company.

Risks

Market Risk: The stock price of a company fluctuates daily from the actions of buyers and sellers based on the perception of the company. The chance that the price of the stock will decline is one of the main risks. Sometimes the company remains unchanged but the market is dragged down by uncontrollable events (e.g. coronavirus).

Decreased or No Dividend: There is no guarantee that dividends will be paid out. If the company looses money or becomes unprofitable the Board of Directors may decide to forgo dividend payments.

Low Priority at Dissolution: Common Stockholders are paid out last if a company enters bankruptcy. There is a risk that there could be nothing left to pay the common stockholders. First, all debt securities like bonds are paid, then all preferred stock is paid and finally common stockholders get what is left.

The key takeaways from common stocks are the following. You would want to invest in common stocks for Capital Appreciation, as a Hedge Against Inflation, and for Income from Dividends. However, when you invest with common stocks you are accepting Market Risk and Business Risk. For instance, if the company performs poorly they may not pay dividends and could file for bankruptcy where you can lose the principal you invested. Now it’s time to learn about Preferred Stock.

What is an Equity Investment: Preferred Stock

What is Preferred Stock

Preferred stock in an equity security because it represents a type of ownership in the issuing company. However, preferred stockholders have no voting rights, a key difference from common stockholders. Although it is classified as an equity security it behaves very similarly to a debt security. Unlike a common stock, the rate of return of a Preferred Stock is fixed. A preferred stock’s annual dividend represents its fixed rate of return. Similarly, debt securities have a fixed rate of return.

The fixed rate of return is a key attraction to income investors. Typically the preferred stock is identified by its annual dividend as a percentage of its par value. Additionally, the par value is always assumed to be $100. The price of preferred stock fluctuates from interest rates and the companies ability to pay dividends, similar to debt securities. Additionally, there are a number of different types of preferred stocks tailored to different investors. Let’s take a look at the benefits and risks of preferred stock.

What is an Equity Investment: Benefits and Risks of Owning Preferred Stock

Benefits

Dividend Preference: When a company declares it will pay dividends all preferred stockholders are paid before any common.

Priority at Dissolution Over Common Stock: If a company goes bankrupt, preferred stockholders are paid fully before common stockholders.

Income from Dividends: The Preferred stock typically offers a fixed income for its investors.

Risks

Purchasing Power Risk: Increases in inflation can reduce purchasing power of the preferred stock investment.

Interest Rate Sensitivity: When interest rates rise the value of preferred stocks declines. This is because there are probably higher fixed interest rate investments available than your preferred stock rate. This leads to less demand and drives the price down.

Decreased or No Dividend Income: Similar to common stock, there is no guarantee that dividends will be paid out. If the company looses money or becomes unprofitable the Board of Directors may decide to forgo dividend payments.

Priority at Dissolution: Although preferred stockholders are paid before common stockholders, they are only paid after all creditors (e.g. Bonds).

In summary, the main reasons someone would invest in preferred stock are for Fixed Income and Higher Payment Priority over common stock. However, the risks with preferred stock are Loss of Purchasing Power, Interest Rate Risk, and Business Difficulty. Similar to common stock, if the companies business is suffering they may not be able to pay any dividends.

What is an Equity Investment: Knowledge is Power

We hope we provided an acceptable answer to “what is an equity investment?” Above all, YP Investors aims to educate and help to grow your wealth. Make sure to look at the benefits and risks of both common stock and preferred and select which suits your goals better. Additionally, be sure you are investing in sound fundamental and technical stocks whether they are common or preferred. We have the stock analysis tools and market condition alerts for our members. Try them out risk-free with a 3-Week Free Trial membership. Use your knowledge to grow your wealth, good luck on your investments!