Chapter 10: Equity

Question 1

What is ordinary shares?

Answer 1

Securities held by owners of an organisation, have the right to profit after debt holders and preference shareholders. They can attend and vote in company meetings

Question 2

Explain the cashflow from equity

Answer 2

Income

• Regular dividends to shareholders. Dividends depend on the profit of the company
• Expectation to increase over time, but not guaranteed
• Companies hold back profit to fund investments or smooth dividends
• Profit can be held until perpetuity
• Companies can buy back their shares

Capital

• No guarantee to shares can be sold at a higher price than initially paid
• Shareholder rank behind other creditors on wind-up

Question 3

Explain the characteristics on equities

Answer 3

S - Security

• Depend on the security of issuing company
• Security can be asses using credit rating, company accounts and accounting ratios (dividend cover, gearing)

Y - Yield

• Real return
• Riskier than bonds so expected to give a higher return

S - Spread

• Volatile prices
• Price and dividend affected by economic cycle (cyclical industries are more sensitive)

T - Term
* Can be held into perpetuity

E - Expenses

• Dealing cost + margin between buying and selling price
• Higher expenses than bonds

E - Exchange rate
* Currency risk

M - Marketability

• Varies by company.
• Larger more marketable than smaller companies
• Listed more marketable - have to comply with stock exchange requirements

T - Tax

• Income and capital gains tax differently
• Capital gains are taxed when the equity is realised

Question 4

How can equities be categorised?

Answer 4

• Size of the company
• Expected profit growth
• Industrial sector

Question 5

What are the practical reasons to categorise equities?

Answer 5

• Factors affecting one company will also affect other companies in the same industry
• Relevant information will come from the same source and is presented similarly
• Cannot be an expert in everything
• Give structure to management and decisions, e.g., the fund manager can allocate RX to a specific industry

Question 6

What are the correlations reasons to categorise equities?

Answer 6

• Companies’ share prices in the same industry move in a similar manner
• Companies in the same sector:
• use the same resources
• supply to the same markets
• have similar financial structures

Question 7

What are the problems with industry groupings?

Answer 7

• Companies operating within different sectors in the same industry
• Companies operating in different markets
• Heterogeinty of companies within a single sector can differ by:
• Size
• Operations (niece)