Equities Explained

03/02/2010

Capital Markets

Vinay Dwivedi
vinay.dwivedi@tcs.com
 The World of Equities

Abstract
This document explains the concept of equities followed by its types, issuance process,
trading mechanism, key terms and market participants associated with same. It touches
the basics of every topic mentioned above to allow the reader to have a overall
understanding of the concept and does not dive into the very minute details of every term
or process explained.

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CONTENTS

INTRODUCTION AND DEFINITION ..................................................................................................... 4

TYPES OF STOCKS ................................................................................................................................... 6
EQUITY ISSUANCE PROCESS................................................................................................................ 7
ROLE OF STOCK EXCHANGES ........................................................................................................... 11
KEY TERMS .............................................................................................................................................. 13
CORPORATE ACTIONS ......................................................................................................................... 15
CONCLUSION........................................................................................................................................... 17
REFERENCES ........................................................................................................................................... 19

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Introduction and Definition

The terms equity, stocks, shares are very commonly used today. It is one of the financing
methodologies used in today’s capital markets world. Equities are issued by companies to
meet their funding requirements. When a company needs finances to expand their
business/support existing or for any other reason, they can approach the market via two
routes, one via debt financing and other via equity financing.
Debt Financing:
In debt financing, company can either borrow funds from a bank or issue bonds1 . In
either case the company has to pay back the borrowed amount as well as the interest to
the bank or bond holders irrespective of the company’s performance.
Equity Financing:
The second option is equity financing wherein the company issues equity and gives a
share of ownership in the company to the investors who hold the equity. Normally, the
long term capital needs are met by issue of shares. The capital raised by a company by issue
of shares (preference and equity) is called as Share Capital.
There is no fixed return on equity shares. The company does not commit any fixed return to
the investor but as the company does well, the value of the stock appreciates in the
market and the investors can sell them off to reap profits. Additionally the company
declares periodic dividends to share the profits of the company with investors.

ADVANTAGES OF EQUITY SHARE CAPITAL

To the Company:
• It represents permanent capital. There is no liability for repayment during the
lifetime of the company. Only on the winding up of the company, the equity
shareholders are paid and that too after payment to creditors and preference
shareholders.

• There is no fixed obligation for payment of dividend.

• It enhances creditworthiness of the company. Banks and others may trust a
company with a sound equity base.

• It does not create any charge on the assets of the company.

• Equity share capital with a higher promoter’s contribution reduces the chances of
hostile take-over.

1
Bonds are financial instruments in which the issuing company pays the buyer interest amount at fixed
intervals during the tenure of bond and the principal amount at maturity.

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To the Shareholders:
• Equity shareholders enjoy control over the company's management. As one acquires
more stock, his ownership stake in the company becomes greater. Being a
shareholder of a public company does not mean that one has a say in the day-to-
day running of the business. Instead, the investor’s say in the company is
represented by a vote per share to elect the board of directors at annual meetings
and other corporate decisions
• The dividend can be very high, especially in the case of highly profitable companies.
• The existing shareholders are eligible for bonus shares, and rights issue of shares.
• The shareholders wealth increases due to regular payment of dividend and bonus shares.

Origin of Stocks/Shares
The origin of the concept of stocks/shares can be traced back to the Roman times wherein
the empire contracted out many of its services to private groups called publicani. Shares
in publicani were called "socii" (for large cooperatives) and "particulae" which were
analogous to today's Over-The-Counter shares of small companies
After the Middle ages, the Dutch East India Company in Netherlands which was
established in 1602 was the first multinational corporation in the world and the first
company to issue stock in 1606.

Source:Wikipedia.org

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Types of stocks
The stocks are broadly classified into the following two types.

Common Stock
• The generally talked about stocks are usually referring to this type. Also majority
of stock is issued in this form.
• Common shares represent ownership in a company and a claim (dividends) on a
portion of profits. Investors get one vote per share to elect the board members,
who oversee the major decisions made by management.
• In long term, common stock, by means of capital growth, yields higher returns
than almost every other investment.
• This higher return comes at a cost since common stocks entail the most risk. If a
company goes bankrupt and liquidates, the common shareholders will not receive
money until the creditors, bondholders and preferred shareholders are paid.

Preferred Stock
• Preferred stock represents some degree of ownership in a company but usually
doesn't come with the same voting rights. (This may vary depending on the
company.)
• With preferred shares, investors are usually guaranteed a fixed dividend forever.
This factor differentiates it from common stock, which has variable dividends that
are never guaranteed.
• Another advantage is that in the event of liquidation, preferred shareholders are
paid off before the common shareholder (but still after debt holders).

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Equity Issuance Process

Companies are broadly classified into two types public and private. A private company is
one in which the number of shareholders (effectively means the owners) are less than 50,
company is not listed on a recognized exchange and has minimum regulatory disclosure
requirements whereas a public company is one in which there can be thousands of
shareholders, company is listed on a recognized exchange and has certain mandatory
regulatory disclosure requirements

The first time when a company issues stock in the market i.e. direct sale of stock by the
company to the investors, the process is called as Initial Public Offering (IPO). When a
company issues equity it goes public from private and gets listed on a recognized
exchange. Once the equity is issued and ownership of equities lies with the investors, the
equity is traded on a recognized stock exchange via registered brokers. If a company is
already public and raises equity to further meet it’s requirements, the process is called
Follow on public offer (FPO).

The following diagram depicts the IPO process.

Pre-Issue Procees

Appointment of
Filing the Promotion of
Lead Managers Due Diligence
Prospectus the Issue.
and other process
with SEBI Road shows
intermediaries

Distribution and
Listing on Allotment of Price Discovery
Processing of
Stock shares and in case of Book
Investor
Exchange Refund Building Issues
Applications

Post Issue Process

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The process starts with the appointment of Lead manager who should be a SEBI
registered merchant banker and other intermediaries to the issue.

SEBI
SEBI is Security and Exchange Board of India. It plays the role of regulator in the
securities market in India. Its role can be considered at par with SEC (Securities and
Exchange Commission) in USA. Its primary functions being to protect the interests of
investors in securities and promote the development of, and to regulate the securities
market.

The lead manager carries out the due-diligence process which involves detailed study of
the company’s business, operations discussions with the management, auditors, legal
advisors etc and examination of company records, prepares a draft offer document or
draft prospectus. The lead manager has to verify and certify the facts stated in the draft
prospectus and ensure that the company is not making any false claims.

The draft prospectus is then filed with SEBI for its review. After review comments by the
SEBI, the company makes changes to the draft prospectus if required. The comments
from SEBI do not mean it has approved the contents of the prospectus. SEBI only ensures
the sufficiency of information and disclosures. The company and the lead manager are
responsible for the contents of the prospectus .The lead managers and syndicate
members 2 have to underwrite the whole issue, which means they have to bail out the
issuer by buying the shares offered if there are not enough bidders hence the Lead
manager also has to act as a market maker for the issue and organizes for road shows
which imply marketing of the issue so that there are enough subscribers for the same.

Till few years back, companies used to issue shares at a fixed price. But today flexible
pricing or book building process is used quite often and fixed price issues have
disappeared. Book building allows investors to bid at a price they are comfortable at,
within a price band specified by the company. It is widely accepted as a system which
enables better price discovery through competitive bidding. The final issue price is
discovered based on the bid demands received at various price levels

The next step is to prepare an offer document or a prospectus from the draft document.
As per company law, a prospectus should contain all details regarding the issue including
the price and this document has to be filed with the concerned Registrar of Companies.
But in a book built issue, the price will be known only after the bidding process is over.
Hence, ironically, an issuing company cannot prepare the offer document till the issue is
practically completed.

2
Syndicate members are commercial or investment banks responsible for underwriting IPO's and Book
Building process. Syndicate members are usually registered with SEBI or registered as brokers with BSE /
NSE Stock Exchanges. They work as intermediaries between the Issuer Company and the potential buyers
of the IPO stocks. Investors submit their bids for IPO shares through Syndicate Members appointed by the
Issuer Company. Hence they are responsible for accepting the bids, payments and application forms for the
public issue.

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To overcome this, the issuer company prepares what is known as a Red Herring
Prospectus. A Red Herring Prospectus does not mention the price per share or the total
value of shares to be issued. It mentions a price band at which prospective investors can
bid and the total number of shares to be issued. This document is filed with the stock
exchanges and the Registrar of Companies.

Investors can apply for shares in an IPO in following categories:

Retail Individual Investor (RII)

In retail individual investor category, investors can apply for a maximum of Rs1 lakh in
an IPO. If retail investor applies for more than Rs 1 lakh, they are considered as High
Net worth Individual (HNI).
Non-institutional bidders
Individual investors, NRIs, companies, trusts etc who bid for more than Rs 1 lakh are
known as Non-institutional bidders.
Qualified Institutional Bidders (QIB's)
Financial Institutions, Banks, FII’s (Foreign Institutional Investor) and Mutual Funds
who are registered with SEBI are called QIB's. They usually apply in very high
quantities.

In a book built issue allocation to Retail, Non Institutional Investors and Qualified
Institutional Buyers is in the ratio of 35:15:50 respectively.

Source www.sebi.gov.in

The IPO then becomes available for subscription in the market and interested parties can
apply to the same. In case of fixed price, the investors have to mention the no of shares
they wish to apply for whereas in case of book building issue mention the price at which
they apply and the number of shares In any case the investor has to arrange for the
corresponding applicable funds i.e. either issue a cheque/Demand draft/Pay order in case
of paper application or make money available in the bank account in case of online
application.

The Registrar appointed to the issue is responsible for authentication of applications,

finalizes the list of eligible allotters after deleting the invalid applications. It also ensures
that the corporate action for crediting of shares to the demat accounts of the applicants is
done and the dispatch of refund orders to those applicable are sent. The Lead manager
coordinates with the Registrar to ensure follow up so that the flow of applications from
collecting syndicate members, processing of the applications and other matters till the
basis of allotment is finalized. It ensures that the refund orders are completed and issue is
listed.

At this level, the lead manager assumes a second role of book running and is called the
book running lead manager. Book running involves receiving bids from investors and
overall management of the process till the issue is completed. Other intermediaries called
syndicate members, who are members of stock exchanges who receive the bids on behalf
of the book running manger, are also involved in the bidding process. There can be more

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than one book running lead manager in which case the duties and responsibilities of each
will be mentioned in the prospectus.

Based on the number of applications received for an IPO, the issue can be oversubscribed
or undersubscribed. If the applications received for the number of shares is more than that
offered, the issue is said to be oversubscribed else undersubscribed. If an issue is
oversubscribed then a specific number of shares are allotted for every bid amount and
allotment is made on a lottery basis.

Commercial banks managing all activities relating to collection of funds from bidders are
designated as bankers to the issue. A bidder, at the time of placing the bid, makes the
payment to an escrow account with one of the bankers to the issue. An escrow account is
a designated account, the funds in which can be utilized only for a specified purpose. In
other words, the bankers to the issue keep the funds in the escrow account on behalf of
the bidders. These funds are not available to the company till the issue is completed and
allocation is made. After the allocation is completed, only the amount due to the company
will go to the company's account and the amount to be refunded will go to a separate
refund account.

Once the equity is listed on the exchange it becomes available for trading in stock
exchange and can be traded via registered brokers.

Types of markets.
The IPO market in which the companies issue shares to the public is referred to as the
primary market whereas the buying/selling of stocks among traders/investors via brokers
on a recognized exchange is referred to as secondary market.

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Role of Stock Exchanges
Stock exchanges provide a platform to the retail investors and other market participants
to deal in equities. They assist, monitor and control the business of buying, selling and
dealing in equities. They establish a set of rules for fair trading and make sure all market
participants comply with that ensuring that no entity gets an unfair advantage in the
dealing of equities.

In the primary market, they liaise with merchant bankers and issuing company that are
trying to raise money by issuing equity. In the secondary market they provide a platform
to deal in the already listed equities. All the buy/sell orders placed by the investors via the
brokers are routed to the stock exchange for execution which matches the orders between
buyers and sellers. The order gets executed at the exchange depending upon the type of
order. If the order is a market order it gets executed immediately. If it is a limit order it is
stored in the order book and matched against the other limit orders. Once the order is
matched a trade is said to be executed. As soon as a trade is executed the trade
confirmation message will be informed to the brokerage firm which in turn informs the
investor through a message on the trading terminal.

The order matching in an exchange is done based on price-time priority. The best price
orders are matched first. If more than one order arrives at the same price they are
arranged in ascending time order. Best buy price is the highest buy price amongst all
orders and similarly best sell price is the lowest price of all sell orders.
Let us take an example to illustrate this.

Assume following are the limit orders available at the exchange for a scrip ABC.
Buy Quantity Buy Price Sell Quantity Sell price
100 320.20 300 321.50
250 320.40 200 321.70
350 320.70 500 322.10
600 320.70 75 322.2

Now at this moment

• If a market order to buy 50 shares of ABC is placed it gets executed at 321.5 since
it is the best sell price available and the sell quantity is reduced to 250.
• If a market order to sell 150 shares is placed, then it will get executed at a price of
320.7.Now since there are two matching orders present at the price of 320.7, the
order which was received first by the exchange will be executed.
• If a limit order to buy 200 shares at 321.50 is placed, then it will get executed at a
price of 321.50 and the sell quantity available at the price of 321.50 will become
100.

The National Stock Exchange (NSE) and the Bombay Stock Exchange (BSE) are the two
major stock exchanges in India in addition to the 22 other regional stock exchanges. Both
the exchanges maintain various indices such as the banking index, IT index, metal index,
etc that help investors judge the direction of markets, The primary index of BSE is the
BSE Sensex which contains the top 30 companies from different sectors which are
heavily traded high with a huge market capitalization Similarly the index for NSE is the

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Nifty which contains the top 50 companies on a similar criteria. One can estimate the
market direction or calculate the market appreciation based on the movement of these key
indices.

During the last fifteen years NSE has seen a huge growth in the number of companies
listed on it. The below graph indicates the numbers.

Source:www.nseindia.com

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Key terms
The following are the key terms that are often used with respect to equities.
Face Value
• The nominal Rupees amount assigned to the share by the issuer.
• The face value is usually a very small amount that bears no relationship to its
market price, except that it is used to calculate dividend payments.
Market Value
The market value is the value at which the stock is currently trading in the exchange. The
price that is applicable to buy/sell the equity.

Market capitalization
• The total market value of a company's outstanding shares 3 .
• Market capitalization is calculated by multiplying a company's shares outstanding
by the current market price of one share.
• It is used to estimate a company’s size and generally referred to as market cap.
Based on the market cap, companies in India are classified into following
categories.
o Large-cap companies – market -cap of more than Rs 5,000 crore
o Mid-cap companies, -market-cap between Rs 500 crore and Rs 5,000 crore
o Small cap companies-market-cap of less than Rs 500 crore
Earning per Share (EPS)
• The EPS is used as key parameter to compare the performance of two companies.
The EPS is calculated as
o EPS = Net Earnings/Total number of outstanding shares
• Assume there are two companies A and B each with net earnings of 5,00,000.The
first company have 5,000 number of outstanding shares whereas B has 10,000 of
outstanding shares. So the EPS of A comes to 100 whereas of B comes to 50.So
EPS gives you an estimate how much a company makes per share. So higher the
EPS, better the company.
• Generally EPS is used as a comparison tool between industries that belong to the
same sector. There are times in market wherein certain sectors do very well
whereas other do not hence it makes sense to compare EPS across companies in
the same business.
Price-Earnings Ratio (P/E)
• The P/E ratio is another key parameter used to value stocks.
o P/E = Market value of share/EPS.
• It is the measure of the price paid for a share relative to the annual net income or
profit earned by the firm per share. So a higher P/E ratio means that investors are
paying more for each unit of net income, so the stock is more expensive compared
to one with lower P/E ratio. The P/E ratio is also referred to as the earnings
multiple.

3
The common shares of a company that have been issued and are in the hands of the public are called
outstanding stock.

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Volatility
• It is a measure of the relative rate at which the price of equity moves up and
down.
• If the price of a stock moves up and down rapidly over short time periods, it has
high volatility. If the price does not move a lot, it has low volatility.
• Volatility is found by calculating the annualized standard deviation of daily
change in price.

Liquidity
• Liquidity helps one to assess how readily can one buy and sell the shares in the
market.
• The more liquid the stock the more are the people interested in the stock and
orders within close ranges of market are executed very easily.
• Illiquid stocks carry a trading risk wherein one will not be able to find a
counterparty to deal in the share.

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Corporate Actions
A corporate action is an event initiated by the company. The corporate actions that
influence the equity holders of the company are
Dividend
• For every share one owns, a portion of the company's earnings in the form of
dividends. Dividends are generally paid out quarterly and declared with quarterly
results.
• Dividends are generally declared as a percentage of the face value and have no
link with the market value. So if a company declares a dividend of 200% and has
a face value of Rs 10, the dividend applicable on each share will be Rs 20.

Stock Split
• In Stock Split, the outstanding shares of a company are split into multiple stocks.
This is generally done in cases wherein the stock price has appreciated to a level
that are either too high or are beyond the price levels of similar companies in the
same sector.
• The primary motive is to make shares seem more affordable to small investors
even though the underlying value of the company has not changed. So if a stock
has a face value of 10 and it is split in the ratio of 1:10, for every stock 9
additional will be issued but the face value of each stock will be reduced to 1.
• Also the market value of the stock becomes 1/10 keeping the market
capitalization constant. However post split the stock becomes more attractive to
investors and results in increase in the liquidity of the stock.

Stock Bonus
• In stock bonus, additional stocks are issued to the current stock holders but
without altering the face value of the stock. So if a company declares a stock
bonus of 1:1 bonus, for every 1 stock held an additional stock will be issued.
• In this case as well the market value of the stock comes somewhere half as the no
of shares are doubled. When a bonus issue is made, the company's share capital is
increased with a corresponding decrease in its Reserves and Surplus.
• A stock split does not affect the Balance Sheet of a company while a Bonus issue
affects the balance sheet as the reserves diminish while share capital increases.

Rights Issue
• In a rights issue a listed company asks its shareholders to dig into their pockets to
provide extra capital. The transaction involves the company giving existing
shareholders the right to subscribe to newly issued shares in proportion to their
existing holdings.
• The price of the newly issued shares is fixed, and is always set below the
prevailing market price

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Buyback
• Buyback is a process in which a company itself buys its outstanding shares from
the market thus reducing the no the outstanding shares.
• This could be done as the company might need more controlling stake in the
company. Also it sends a positive signal to the market as the promoters
themselves increase their stake and generally results in price increase as the no of
shares (supply) has reduced.
• There are two ways in which a company can buyback the shares from the market.
the first way being via a tender offer to existing shareholders to sell off the shares
at a certain premium amount over the market value at a specific future date and
second way is just to buy from open market over a period of time as any other
investor would have done.

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Conclusion
Equities have been popular in the capital markets segments for many years. The
instrument attracts retail as well as institutional investors due to the higher returns it can
offer as compared to the other fixed income instruments such as bonds, treasury bills, etc.
Companies go public as they can access the market for money without increasing their
debt, it also enhances the status and public image of the company as it is tracked by more
people now. The structure of the equity market has something to offer today for all class
of investors. The people who want to play safe generally invest in equities that are
government owned companies and other big bang companies who already have a good
reputation in the market. These companies are associated with steady and consistent
growth in the market. The rewards expected here are not very high but still will be
consistent and chances of facing a loss are very rare. There is another class of investors
who believe in taking high risk invest in companies that are emerging in the market and
yet to make a solid mark for themselves. The risk here is maximum but if it comes off,
the rewards will be much better.

The Infosys Story

Infosys was founded by Narayana Murthy along with some others in 1981. It came with
an IPO in 1993 at the price of Rs. 95. Suppose that a person applied for 100 Shares. It
would cost him Rs. 9500 and assuming that he is holding the same position till today.
What will be the value now? Let us calculate.
Infosys gave 1:1 bonus in 1994. So, our 100 shares will be 200 in 1994. Again they gave
1:1 bonus in 1996. That will take the count to 400 shares. And again in 1998 they offered
bonus of 1:3 shares. That will take our count to 1600 shares. In 2000, they split the stocks
(Rs. 10 Face value to Rs. 5 Face value). This will take our count to 3200 shares. In 2004,
again they announced 1:1 bonus. It will take our count to 6400 shares. Again a bonus
shares in the ratio of 1:1 in 2006. Now, the count of ours would be 12800.
As on 14/08/2009, when we check the CMP of Infosys. Its Rs. 2042. So, what will be the
value of our shares? 12800 x 2042 = Rs. 2, 61,37,600. Yes, it comes to above 2 crores.

Source: www.managementparadise.com

The economic polices set by the government of the country has a key influence on the
performance of the stock. Say for e.g. if the fuel prices are increased, the stocks related to
airlines will take a dip as they have fuel as one of the key costs and will impact their
profits tremendously.Similairly if the interest rates are decreased, the reality sector stocks
will appreciate as more people will be willing to take loans to buy homes. In today’s
market every single such news is being tracked by the market players and it leads to
appreciation/depreciation in the stock price. The traders in today’s market track every
news with respect to the company i.e. the earnings report, mergers and acquisitions, other
corporate announcements, government policies affecting the company and take positions
accordingly to make profits.

A category of small cap stocks, is also available in today’s market, which are only
utilized for speculative trading and follow huge price swings with huge volumes. Pigs are
high-risk investors looking for the one big score in a short period of time. Pigs buy on hot

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tips and invest in companies without doing their due diligence. There is a set of people in
the market that believes in investing in equities and booking profits at regular intervals as
booked profit is yours and unbooked profit is just an illusion. Take the example of
General Motors in US stock market, the stock hit a 50 year low value in recent times of
recession whereas once in the growth days was trading at decent prices till many years.
The people who booked the profits enjoy the gains whereas the ones did not stand at the
same point again with no gains at all. The market generally moves in cycles wherein it
goes up in a bull cycle and goes down in a bear cycle. As per a old saying,
“"Bulls make money, bears make money, but pigs just get slaughtered!"

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References
[1] www.investopedia.com
[2] www.nseindia.com
[3] www.wikipedia.org
[4] www.managementparadise.com
[5] www.sebi.gov.in

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