We discussed debt instruments in our last article - this is for those who want to invest to receive a fixed income every month without undertaking any risk of the issuer. In this article, we will discuss equity instruments that have their own characteristics in terms of income and responsibilities.
We will explore three aspects of equity instruments:
An equity instrument is an investment for people who want to own an asset or a part of an asset while receiving an income on it. Investors receive shares or certificates to prove the ownership. A company gathers capital through equity financing by issuing these shares to investors (or shareholders) to gather capital to fund their business. On the side of the business, it is known as equity financing. Equity instruments may or may not pay their investors a monthly income because such income relies on the profit/loss of the business. When they do, it is a dividend. To fully understand the equity instrument, we need to answer two questions:
According to the International Financial Reporting Standards, an equity instrument is a financial asset. Their value is measured on the profit and loss of the company, and anyone who invests in them not only becomes a part-owner of the company, but also a risk bearer. Owners can hold these instruments indefinitely or sell them to other investors.
For the issuer - they are both a form of financing their business. For the investor, investing in equity instruments would make him a co-owner and a shareholder, whereas investing in debt instruments would make him a bondholder, lender, or just an investor who receives fixed monthly income. Investing in equity instruments gives the investor the decision-making power within the company. In debt instruments, investors get no such authority. Investors must also carry the company's risks since they have an incentive to receive higher dividends. In debt instruments, investors have no such incentive other than receiving their monthly fixed interests without shouldering any risk of the issuer.
The most common types of equity-based financial instruments are:
Stocks are the most commonly used equity instrument by both issuers and investors. It is one way for companies to raise capital from the public.
There are two types of stocks:
Investing in common/ordinary stocks come with various benefits, such as:
Common/ordinary stocks, however, do not guarantee dividends, nor are they the priority when the company makes any profits. Common stockholders also undertake a massive amount of business risk should the company face a loss. Of course, when the company makes a profit, they do receive a higher dividend. However, they are paid in the end - after paying creditors and other priority shareholders.
Preferred stockholders also have ownership of the business with an extra priority in paying dividends. They will be the second to receive payment after bondholders. They will receive payments regardless if the company is liquidated, and their dividends will increase if the company makes a profit. However, they do not have any voting rights like common stockholders. Hence they do not have to carry many risks like ordinary shareholders.
A convertible debenture is a hybrid financial instrument that has features of both equity and debt instruments. It is similar to a common bond, but an investor can convert it into common stock after a period of a specified time. It is a popular form of equity instrument investment because the interest rates are higher than bonds.
Convertible debentures are usually unsecured bonds that may not have collateral as a backup. The conversion to common stocks hedges against that risk by allowing the investor to become a co-owner.
A warrant is a form of an equity instrument that allows you to buy or sell shares at a certain price and date. A warrant carries an expiration date - meaning you have to trade it by a certain date. The company itself issues it. Options, likewise, are also an equity instrument but offered on the stock exchange. Options also allow you to trade in the stock exchange at a certain price and date but investors can refuse to trade within the period.
In general, equity instruments carry the risk of volatility in the market and are prone to fluctuations in price. Since the investor is so close to the issuer, any disruption faced or caused (mismanagement of the company) by the issuer will also affect the investor. Illiquidity is also a factor in equities, like those which are not traded in the Stock Exchange. Those that are - Options - still has selling limitation on volumes by the exchanges.
For stocks, a common risk of investing is the decline in the price of the share. It could be for various reasons - the general risk of investing, or it could be the specific market of the instrument itself (technology-based equity instrument, for example). It could also be the bankruptcy of the issuer itself, which would lead you to lose all of your investments.
For instruments like convertible debentures, a hybrid of debt and equity carries the risks of both instruments, for example:
Not only investors have risk in equity instruments - issuers carry them too, in terms of relying on equity to fund their operations. Since they have to pay dividends, equities can get expensive for businesses. Hence, issuers need to have backup capital to compensate for any gaps and losses.
Equity instruments are crucial for many businesses and investors. Unlike fixed income-based debt instruments, equities aim for growth and innovation. It may not have the flexibility like debt instruments, but the rewards are a lot higher than debt instruments.
Last update: 05/08/2021