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IFT Notes for Level I CFA® Program

R39 Overview of Equity Securities

Part 1


 

1.  Introduction

In this reading, we look at the different types of equity securities, how private equity securities differ from public equity securities, the risk involved in investing in equities, and the relationship between a company’s cost of equity, its return on equity, and investors’ required rate of return.

2.  Equity Securities in Global Financial Markets

In 2008, the U.S. contributed about 21% to the global GDP, but its contribution to the total capitalization of global equity markets was around 43%.

Historically, equity markets have offered high returns relative to government bonds and T-bills but at higher risk. The volatility in equity markets was high during key crises such as World War I, World War II, the Tech Crash of 2000-2002, the Wall Street Crash, and the most recent credit crash of 2007-2008. In the recent crash, while the world markets fell by 53%, Ireland was the worst hit incurring losses of over 70%.

An important point to note is that equity securities are a key asset class for global investors.

3.  Types and Characteristics of Equity Securities

3.1.     Common Shares

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

Statutory voting versus cumulative voting

In statutory voting each share is entitled for one vote. In cumulative voting, a shareholder can cumulate his total votes and choose one particular candidate. For example, let’s say that a shareholder holds 100 shares and is supposed to vote for the election of three board members’ position. In statutory voting, he can vote 100 votes for each position while in cumulative voting, he can vote all the 300 votes to a single candidate thereby increasing his likelihood of winning. Cumulative voting is beneficial to minority shareholders.

Different classes (Class A and Class B)

A firm can have different classes of equity shares which may have different voting rights and priority in liquidation. For example: Class A shares would have more votes than Class B shares.

3.2.     Preference Shares

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

Cumulative and non-cumulative preference shares

  • Cumulative: If dividends are not paid out for year one and two, year three dividends would be sum of the third year’s dividends plus the non-paid out dividend of years one and two.
  • Non-cumulative: If dividends are not paid out for year one and two, and the firm decides to pay dividends in the third year, it would only have to pay third year dividends.

Participating and non-participating preference shares

  • Participating: As the name implies, preferred shareholders participate in the firm’s profit. Shareholders receive extra dividends than the pre-specified rate in case of higher profits. The shareholders also receive a higher proportion of firm’s asset than the par value in case of liquidation.
  • Non-participating: Shareholders receive only the pre-specified rate even if the firm earns higher profits. The shareholders only receive the par value in case of liquidation.

Convertible preference shares

  • Convertible preference shares are those that can be converted to common stock and hence have lower risk and the inherent option to gain from a firm’s future profits.

4.  Private versus Public Equity Securities

Private equity refers to the sale of equity capital to institutional investors via private placement. The key characteristics of private equity are:

  • Less liquidity as shares are not publicly traded.
  • Price discovery can be biased as the security is not available for valuation by a broad base of public participants.
  • Management can focus on long-term value creation as it doesn’t have to worry about reporting results to market.
  • Lower reporting costs due to lesser regulatory requirements.
  • Weaker corporate governance due to lesser regulatory requirements.
  • Potential for generating high returns when investment is exited.

The types of private equity are:

Venture capital:

  • Refers to capital provided to firms in early stages of development.
  • The three stages of funding include: seed/startup capital, early stage, and mezzanine financing.

Leveraged buyout:

  • Large amount of debt relative to equity is used to buy out a firm.
  • The large proportion of debt amplifies returns if the buyout turns out to be successful.
  • Leveraged buyout performed by management is termed as Management Buyout (MBO).
  • The firm acquired either has to generate the adequate cash flows or sell assets to service the debt.

Private investment in public equity: A public company, which needs additional capital immediately, sells equity to private investors.


Equity Overview of Equity Securities Part 1