What is the Equity asset class? Why invest in common shares? How does your life cycle phase, personal circumstances, and risk tolerance impact your target asset allocation to equity investments?
Then we drill down into the diversification and risk-return characteristics of various equity subclasses.
For example, investing by style. Value versus growth investing. Maybe your focus is on generating dividend income rather than capital gains. Perhaps you want to invest based on market capitalization. Mega companies like Apple, Nestle, and Toyota. Or down to small, micro, or nano capitalized companies.
I discuss differences between domestic and international equities. How the risk-return profile and asset correlations differ between developed, emerging, and frontier capital markets. There may also be differences between developed markets, such as EAFE (Europe, Australasia, Far-East) and the US. As well as between individual emerging markets. India and China are much different than Colombia or Qatar.
Not all equities are equal. Two investors may have the same percent allocated to equities. But the characteristics of that allocation may be vastly different.
Note the difference between “global” and “international”. Domestic equities are from your home market. International equities are from around the world, excluding your domestic market. Global include both domestic and international securities. Useful to remember when assessing investment products.
Next we move back into how your life cycle phase affects your equity asset allocation.
“How should Accumulators utilize equities in portfolios?”
Because Accumulators tend to be young, they have a very long time horizon for investing. At least, for the major goal of retirement. The time horizon means Accumulators can handle enhanced portfolio volatility and expect higher returns over time. This suggests heavy exposure to equities.
For many Accumulators, “heavy exposure” means a 100% equity allocation in their early years. However, as discussed with cash and fixed income, there are other factors that recommend some allocation to the other classes. Diversification benefits and short term objectives are two good reasons.
“What about those in the Consolidation phase?”
Consolidators still have a relatively long time frame until retirement. That suggests equities.
However, Consolidators may have more near term objectives and may now decide to focus on diversification as they have more wealth accumulated.
Because Consolidators do have some capital built up, they have the critical mass to better diversify into niche equities than do Accumulators. An Accumulator be may smart to invest in a cost-effective global equity fund as they build an investment foundation. A Consolidator may look for specific investments to improve diversification or try and take advantage of current trends.
Consolidators may have similar equity allocations as Accumulators, but the breakdown within the equities may differ.
“And for those in their Spending phase?”
As you might guess, being at, or near, retirement age means some shift to safer, more liquid assets. Such as fixed income. So the equity allocation is usually lowered when people become Spenders.
But there can still be a long time period to live. With people often living into their 90s, investors might have 30 years to live off their wealth. With inflation and low returns on fixed income, that means Spenders may still need a decent equity allocation.
But the allocation with equities may change. Instead of higher risk frontier markets or micro-cap investments, there may be a shift into more Blue-Chip investments. Or value stocks that generate dividend income, but still have upside capital gain potential.
“How does an investor’s risk tolerance factor in to the target allocation?”
In two key ways, as we saw above in the examples.
One is in the overall equity target allocation. A person’s circumstances or risk tolerance will drive the overall equity allocation.
If you are young, with a long time horizon, accepted investment theory might suggest 80-90% in equities. Whereas, for retirees, maybe a general level should be 50-60%, then adjusted down as years pass.
Also, what is the overall level of wealth. If you have $10 million in assets and only need $50,000 a year to live on, then you can take a low risk allocation with little allocated in equities. If you have $500,000 saved and require $50,000 annually, then you will need to take on more risk.
That is more the unemotional, rational approach to risk and an equity allocation.
However, your emotional view of risk may adjust the equity allocation further.
For some retirees, 50% in common shares may be too high for their comfort. And ability to sleep at night. They may prefer the safety and stability of cash or fixed income over the higher volatility of shares. Likely, these same investors had relatively low equity allocations even in their younger years. Some people are simply more risk averse than others.
Two is the equity investments within the equity allocation itself.
Do you prefer relatively lower risk equities? Blue-Chip companies. Value stocks. Dividend producers.
Do you gravitate towards higher risk investments? Micro-cap stocks. Growth. Frontier markets.
What about the investment itself? A well-diversified global equity fund. Versus individual companies. Maybe with a focus on small-cap mining companies operating in Africa.
The risk-return profile can vary wildly within an asset class. Your personal risk tolerance will dictate the way you invest within that class. And that can create much different risk levels for the overall portfolio.
A relatively short, but good overview of equity considerations in your target asset allocation. Very useful to compare the life cycle phases between cash, fixed income, and equities. Also, how both your personal financial situation and risk appetite will impact your equity allocation. As a percentage of the entire asset allocation. As well as the riskiness inherent in the equities themselves.
The final core asset class is equity. Cash and fixed income the other two core classes.
Technically, equity includes preferred shares. However, I normally include preferred shares in fixed income. In fact, many offered preferred features look very much like fixed income. And investors normally buy preferred shares for the income stream, not capital gains. As such, we will equate common shares with equity for now.
We can utilize percentage target asset allocations for common share equities.
Once again, the “right” allocation is determined by your own comprehensive investor profile. It will be unique to your needs, desires, and circumstances. Keys include your current financial situation, phase in the life cycle, and risk tolerance.
Here are a few thoughts from my side.
Common Shares
Common shares traditionally have the highest risk and expected return of the three core asset classes. Though, as we saw earlier, within any asset class itself, there may be a wide variance in expected risk and return scenarios.
Some common shares distribute dividends and may be purchased for an income stream. But most common shares are acquired for capital appreciation potential, rather than pure income generation.
Common shares are more suitable for investors who can handle higher volatility in their investments. This may include investors with long time horizons, those that do not require immediate liquidity, and those with more aggressive levels of risk tolerance.
Equity for Accumulators
Common shares are well suited for Accumulators.
Accumulators generally have the longest time horizon of any investor group, so they can more readily ride out the fluctuations of higher risk assets. At times, liquidity may be an issue for Accumulators owning common shares. But if they properly plan their cash reserves, that should not be a major concern.
With the highest expected returns and the fact that Accumulators can handle the higher risk, it should make sense that Accumulators invest 100% of their wealth (less any cash reserves) in common shares.
Too Much of a Good Thing
It may seem to make sense, but probably not the best strategy in actuality.
That is because of the risk reduction benefits in diversifying one’s investment portfolio across multiple asset classes.
The Magic Number
As an Accumulator, wealth allocated to cash equivalents may be proportionately high. Say 20%. If you allocate another 5-25% in fixed income, that leaves between 55-75% available for common shares.
Probably a good range for most Accumulators.
Of course, your risk tolerance may lead you to increase or decrease the amount you allocate to common shares.
Further, as you consider investing in alternative asset classes, that will also impact your allocation to common shares.
Equity for Consolidators
Common shares are also very good investments for Consolidators.
The same rationale applies to Consolidators as to Accumulators. Those with relatively long time horizons should focus on higher risk investments.
The Magic Number
Consolidators have already accrued some wealth. Cash reserves, as a percentage of accumulated capital, will be less than in the Accumulation phase. Say 5% in cash equivalents. I suggested 10-30% in fixed income for the generic Consolidator in a previous post. That would leave 65-85% for common shares.
That seems to me a decent range for a Consolidator with a moderate risk tolerance. If your personal risk level differs, you should adjust the percentage accordingly.
While this is a good starting point, I would offer a couple of potential amendments.
First, as you age within the Consolidation stage of life, you may want to slowly lower your risk tolerance over time. This reflects your ever reducing time horizon and the desire to begin generating a fixed income stream for retirement. One that also improves portfolio stability and liquidity.
Second, as you increase your wealth and investment expertise, you probably will want to consider alternative asset classes. Real estate is common for investors. There are many other classes as well. The extent that you allocate a portion of your capital to alternative assets will also impact the percentage allocated to common shares.
Common Shares May Provide Alternative Asset Class Exposure
I will note though, that most investors never need to consider alternate asset classes. A well-diversified portfolio of common shares tends to cover many other classes.
For example, you own a passive index fund covering Canadian common shares. How about iShares Core S&P/TSX Capped Composite Index ETF (XIC)? Yes, this is part of your equity asset allocation. But the fund itself provides nice exposure to alternative asset classes. A top 10 fund holding, Brookfield Asset Management’s business involves real estate, renewable power, and private equity. Barrick Gold is another significant member of the index. As is Nutrien. There are multiple Real Estate Investment Trusts (REITs) within the index, providing real estate exposure. And so on.
Do not believe you require adding specialized alternative asset class products to get exposure in those sectors.
Equity for Spenders
During retirement, there will probably be little income from employment or business. Spenders will normally need to live off their savings and pensions. As such, Spenders desire liquid, low risk investments, that provide a constant stream of cash flow. This suggests a shift from higher risk equities into lower risk fixed income assets.
And many Spenders do lower their component of common shares to a minimal amount.
But I do not think this is prudent for most investors.
An Ever Lengthening Time Horizon
Despite the natural inclination to lower your risk tolerance and seek safe investments, you should not completely succumb to this approach. The main reason is today’s life expectancy.
Traditionally, people worked until 65 and then retired and lived off pensions. That was not a problem previously. According to U.S. National Center for Health Statistics, National Vital Statistics Reports, in 1950 the U.S. life expectancy was only 68.1 years of age. Three years from retirement to (average) death did not require significant savings.
But by 1970, life expectancy had risen to 70.8 years. By 1990, it was 75.4. For 2010, 78.3 years. And for 2020, life expectancy is projected at 79.5 (81.9 if you are female).
If you retire with same assumptions that they used in 1970, you may fall 9 years short in your ability to live.
That means you may need to work longer than 65, start saving much earlier to accumulate more wealth, and/or increase the level of risk in your retirement portfolio to compensate for a longer life.
The Magic Number
For the generic Spender, by retirement you may have about 10% allocated to cash equivalents and another 30-40% in fixed income. That leaves about 50-60% for common shares and alternative asset classes.
As the generic spender moves through the Spending phase, the percentage allocated to higher risk equities should decrease over time. A gradual reduction to 20-30% in common shares may be appropriate for the average Spender.
How fast you adjust your allocation depends on your financial situation, risk tolerance, and personal circumstances.
Perhaps you retire at 65 with $100,000 in capital and plan to live another 20 years. At a 5% return, an annuity would pay you $657.22 monthly Not great.
But if you had accumulated $500,000 in capital, that same annuity would provide $3286.09 monthly. Much better.
And if you had saved $2,000,000, your annuity would pay $13,144.35.
If you have accumulated closer to $100,000 than $2,000,0000, you may need to take on additional risk comfortably live through retirement.
If you could earn 10%, rather than 5%, your $100,000 annuity would pay $957.05 monthly. And at a 15% return, your annuity would pay $1300.53 monthly. Both are an improvement over $657.22 at 5%.
Personal circumstances also play a role in your allocation decision.
If your family all lives to 100, you may want to plan on a longer life than the average.
If you live in a location with a high cost of living, you may need to generate greater returns to keep up with inflation and higher expenses. For example, retiring in the Cayman Islands is a more expensive prospect than living out your days in Saskatchewan, Canada.
Conclusion
Those are my thoughts on target asset allocation considerations for common shares, fixed income, and cash equivalents.
Some general asset allocation principles that make sense for most investors.
Invest in higher risk and return assets when you have long time horizons. Shift into more liquid investments that provide a fixed income stream as you age and require safety. Diversify across asset classes to lower portfolio risk.
However, your personal circumstances will play a huge role in the right allocation for you.
Your current financial situation, investment objectives and constraints.
Your investment time horizon, phase of life cycle, and risk tolerance.
These variables are unique for each investor. They do not easily fit into a generic asset allocation calculator. They must be considered both separately as well as in their entirety.
That is why attention to your comprehensive investor profile is crucial.
Most readers have traded common shares of individual companies.
The main method is to buy and sell shares on the open market through a brokerage account.
However, you can invest in public companies using other means. Many investors acquire common shares through public offerings, direct stock purchase plans, dividend reinvestment plans, employee stock purchase plans, and warrants. Often, these methods can be excellent ways to save costs, while building your investment portfolio.
Public Offerings
Investors may acquire shares through a “Direct Public Offering” or “public offering”.
Companies that go public for the first time have an “Initial Public Offering” (IPO) for its shares.
Existing public companies may have “Subsequent Public Offerings” or “Follow-On Public Offerings” when issuing additional shares to the public. You may also see other derivations of these terms.
In my experience, public offerings have mixed results for small investors.
Stock offerings have a maximum number of shares issued. If the offering is popular, there is a good chance that it will be fully or over-subscribed (more investors want shares than are being offered).
In the investing realm, large investors (mutual funds, pensions, wealthy individuals, etc.) are usually accommodated to a greater extent than small. For popular offerings, you may not be able to get any or all of the shares you desire.
If there is greater demand than supply, investors that cannot purchase all their shares in an IPO may do so on the open market once the shares begin trading.
Use caution if you follow this strategy. As with everything, when there is excess demand, prices rise. The greater the excess, the higher the price shoots until equilibrium is reached.
For very popular issues, the share price may rise simply on the excess demand and not on the company’s fundamentals. When this occurs, it is common to see the share price increase rapidly above the issue price in the initial few days of trading. It is also typical in these circumstances to look at the share price a year later and see that it has fallen significantly to reflect reality, rather than hysteria.
For example, The Blackstone Group (symbol: BX) issued an IPO in June of 2007 at $31 per share. Shares traded between $34.25 and $38.00 and closed at $35.06 on June 22, the initial day of trading. If you had been part of the IPO at $31, you could have earned between 10.5% and 22.5% (before transaction costs) in one day. A very nice return.
However, if you were one of the investors who had scrambled to buy this stock in the open market on June 22, your returns might have been a little different. One week later, at the end of June, your shares were only worth $29.27. At the end of July 2007, $24.01. The end of August 2007, $23.13. And so on.
After an initial frenzy, the shares settled back to where the fundamentals indicated they should trade. As for fundamentals, we shall look at this topic when reviewing how to analyze stock.
Over time, Blackstone shares have had ups and downs. As low as $4.51 in January 2009. As high as $43.80 in April 2015. In December 2016, Blackstone traded just under $30.00. Had you bought in the IPO or on the initial trading date, you would hold an unrealized capital loss after all this time. Not as nice as flipping the IPO immediately.
Yes, there are many examples where the IPO kept going up in price. This further complicates the issue of small investors buying IPOs once they begin to trade.
When investors bought Blackstone on the initial trading day, every one of them believed they were buying the next Alphabet Inc. Better known as Google (symbol: GOOGL). Google issued its IPO in 2004 at $85 and closed its opening day at $100. Over the next 52 weeks, Google never traded below $100. It traded at $280 a year later, and sat in December 2016 at $808. That also does not factor in the 2014 stock split which brought shareholders substantially more value.
But it does not work out this way very often.
When buying an IPO or shares in the open market, do not pay for the excess demand. Always buy based on facts, not hype. You may miss out on a few Googles, but you will also avoid purchasing the many Blackstones.
As an aside, Blackstone is a decent company. A reason I chose it here. Easy to take a fly by night company selling vapour-ware and see why it fell from favour. But plenty of real and profitable companies whose shares still suffer from IPO over-enthusiasm. Every stock looks very promising at IPO time. Be careful.
Open Market Purchases
Most investors buy and sell shares on the “open market”. Also known as the “secondary market” or “aftermarket”.
The open market may be a formal stock exchange (e.g., New York Stock Exchange [NYSE]) or “over the counter” (OTC).
OTC shares trade via a dealer network and not on a formal exchange. OTC stocks may also be called “unlisted” shares.
To purchase shares on the open market, you require a brokerage account. Further, you need to ensure that the brokerage house where you have your account is entitled to trade shares on the markets you desire.
For example, I use one on-line broker that allows me access to all major Canadian and US stock exchanges. But they do not have access to exchanges outside North America. I must use another broker to trade equities in Europe and Asia.
I believe most investors should trade via low-cost, on-line accounts. I see little value, for most investors, in using premium, full-service brokers. Your bank likely offers relatively easy to use on-line brokerage accounts.
Online brokers tend to offer adequate products and services to meet most investors’ needs. It is not difficult to trade on your own via your own bank. Just be wary if they try to “help” you purchase their own in-house products.
Direct Stock Purchase Plan (DSPP)
DSPPs allow individuals to purchase shares directly from a company (or transfer agent).
The benefit of DSPPs is that investors can acquire shares without paying a commission on the transaction. In today’s low cost on-line broker world this is less important, but every penny saved is useful in compounding returns for future growth.
A potential downside of DSPPs is that usually there is a minimum purchase amount. This may be higher on the initial purchase and then lower for subsequent acquisitions.
Employee Stock Purchase Plan (ESPP)
If you work for a public company, you may encounter an ESPP.
ESPPs allow eligible employees to acquire company shares with no transaction costs. Even better, the shares are normally offered at a discounted price to market value. This can be a very nice perk for staff.
The discounted share price incentivizes employees to invest in their company versus other investment options.
In return, the company has shareholder employees with a vested interest in the firm’s performance. As such, staff will work harder to ensure that the company does well financially and that its share price increases. Well, that is the idea.
Some ESPPs have restrictions on selling shares (e.g., an initial period of time where shares cannot be sold), but often there are no restrictions on trading. Also, depending on the discount value, there may be tax implications at purchase.
Dividend Reinvestment Plan (DRIP)
DRIPs are also helpful in avoiding commissions. One of my favourite investing recommendations.
DRIPs allow investors to reinvest any cash dividends, they are eligible to receive, into additional shares of the company. Often this results in the purchase of fractional shares based on the dividend amount.
DRIPs are nice as they help investors (hopefully) compound investment returns by adding to their existing shares in the company. The additional shares, in turn, result in their own future stock dividends, and so on throughout the future.
DRIPs are an easy way to invest. Without thinking or acting, you automatically acquire additional shares of the company.
One problem with DRIPs is that, in most countries, you are taxed on the dividend as if you received the cash.
For example, you are entitled to receive a dividend of $1000 that is reinvested in additional shares of the company. You receive shares and not cash. However the tax man usually still wants his share of your earnings. If you have a 30% marginal tax rate, you must find $300 to pay for tax on income you did not actually receive.
Another thing to watch with DRIPs (and other investing methods that make automatic purchases) is the lack of thinking required. When using DRIPs you need to still assess the investment potential of the dividend.
Perhaps you are entitled to a $5000 dividend from Omega corporation. You have the option of a cash dividend or stock dividend. Omega shares are expected to return 10% over the next year and carry a risk of 5%.
If you take the DRIP, you may earn 10% on your shares (and the stock that you received in lieu of a cash dividend). But perhaps you analyzed other investments and found Alpha company with the same 5% risk, but an expected return of 20%. If you received a cash dividend from Omega, you could have bought Alpha shares instead.
DRIP programs can be useful, but do not fall into the trap of blindly reinvesting in underperforming shares. Always look at where your income is being invested. Ensure it is the best investment for you, not simply the most convenient.
Note that with Omega, you could sell shares equal to the stock dividend and then use the proceeds to buy Alpha shares. But then you will incur transaction costs and possibly capital gains tax payable.
Warrants
Warrants are issued by companies, usually as a sweetener to an offering.
Warrants give holders the right to purchase shares from the company at a certain price for a specified period of time.
Warrants are much like call options. Both can be traded separately in the secondary market.
Also, options and warrants fluctuate in price based on the value of the underlying shares relative to the exercise price of the warrant/option and the time remaining until expiration.
However, options are not issued by companies. They are exchange traded instruments created by other investors.
As well, most options expire in under one year, whereas warrants may not expire for years.
I include warrants in this section as warrants are often exercised and company shares received by the warrant holder.
I do not include options here as almost all common share option contracts are closed out for financial consideration (assuming they are “in the money”) prior to expiration. There is no actual exchange of shares between the counterparties.
Many investors go their entire lives without purchasing individual bonds, preferred shares, or even cash equivalents. Instead, they utilize funds for these asset classes, if investing at all.
Most investors though, do buy and sell common shares of individual companies.
I am not sure buying individual stocks is the best investment strategy, but almost all of you will trade specific stocks during your life. So we will spend some time reviewing common stock.
Today a look at key characteristics of common shares.
Ownership in the Company
As we discussed in my last post, investing in common shares means owning a (very small) piece of a company.
Ownership is important as it allows the investor to benefit from growth in the company.
Participation in Corporate Success
As a common shareholder of a public company, you may directly and indirectly share in the profits of the company.
Dividends
Dividends the company declares and pay come from its accumulated earnings. If the company does well, you can directly benefit by receiving dividends. Normally, there is no right to a dividend for common shareholders (unlike preferred shareholders). But if the company deems it prudent, excess earnings are often paid out to common shareholders.
We will look at dividends a little more later, as they are integral to some investors’ strategies.
Capital Gains
You may indirectly share in the company’s success by the value of your stock increasing.
A change in the share value has many causes. Earnings – current, but more importantly the expected future earnings – is a major determinant of share price. If the earnings outlook appears rosy relative to competitors, other companies, other asset classes, etc., the share price should increase.
We will review the factors that impact share valuations later.
Limited Liability
A corporation is an individual legal entity, separate from its shareholders.
Think of companies the same as you would a person. A corporation, as represented by its officers and Board of Directors, may enter into business contracts, buy or sell assets, borrow or issue debt, develop new products, and so on.
The corporation itself is responsible for its actions. And, in today’s business world, the company’s officers, Board of Directors, key insiders, or substantial shareholders, may also be found liable for the company’s actions in a court of law.
But as a general, minority investor, you will not assume legal responsibility for the company’s actions.
This is “limited liability”. Your liability, or potential loss, is limited to the amount you invested in the company’s shares.
For example, you invested $10,000 in common shares of ToxicWasteco, a public company on the New York Stock Exchange. The company was extremely profitable and your shares grew to a value of $50,000.
Then ToxicWasteco was discovered to have deliberately discarded radioactive refuse in landfills that were later used for housing communities. The company declares bankruptcy after losing a class action lawsuit. In addition, three senior executives that approved the plan to use landfills were each sentenced to 10 years in jail and fined $1 million.
The company’s officers were found liable for their actions on behalf of the company.
However, as a mere investor, you did not play a part in ToxicWasteco’s operational decisions. Your liability is limited to the $10,000 in initial capital invested in the company. And yes, to you, the loss will feel like the unrealized $50,000.
Voting Rights
While common shareholders do not have a direct say in the company’s operations, they do have some influence through their voting rights. Technically, yes. Practically, you have zero influence.
Most common share issues (and possibly other classes of shares if they include voting right features) give shareholders the right to vote at Annual General Meetings (AGM) and on other occasions where votes are required.
Note that some common shares may only have partial or no voting rights. These shares are called “restricted shares” (not to be confused with “restricted stock” that cannot be traded by shareholders for a given period).
There may also be “subordinate voting shares” which rank behind another class of voting shares. Usually the ranking is based on the number of voting rights per share.
For example, ABCco requires 10 Class B shares to equal 1 vote as opposed to 1 Class A share equalling 1 vote. That makes Class B shares subordinate to Class A in terms of voting rights.
Shareholders vote to elect the directors of the company. The directors are charged with overseeing the company’s actions on behalf of all shareholders.
Shareholders may also vote on material transactions that affect the company. These include: purchase or sale of significant assets or business operations; corporate acquisitions, mergers, consolidations, or liquidations; approval of the appointment of auditors; approval of dividend declarations by the Board of Directors.
It may seem impressive, but in actuality shareholder votes amount to no power. The vast majority of outstanding shares are held by large institutions (e.g. pensions, mutual funds, etc.) and corporate insiders. This ensures their priorities override those of minority shareholders.
For example, you own 100 common shares of Microsoft worth USD 7500. Windows 10 is installed on your computer and it has some very annoying features. You plan to speak up at the next AGM and would like a vote to force Microsoft to fix the bugs in their operating system. With your 100 shares, you receive 100 votes. That should make an impact.
Unfortunately, Microsoft has approximately 7.6 billion shares outstanding versus your 100. Of those 7.6 billion shares, corporate insiders own 2% and institutions and mutual funds hold another 75%. Bill Gates himself controls about 167 million shares. Unless Mr. Gates agrees with you on Windows 10, there is no chance that your proposal will get a vote.
While having a vote sounds good, unless you are an institutional investor or insider, it has no relevance.
And yes, these corporate insiders and institutions essentially alone choose the Board of Directors. Which may explain why the Directors often seem to act contrary to the best interests of minority shareholders. Or perhaps it is a coincidence.
Determining Your Rights
Those are the key characteristics of common shares.
If you wish to determine the rights of common shares that you own, or intend to purchase, the details will be disclosed in the company’s and/or share issue’s documentation.
The key documents are usually the Memorandum and Articles of Association (Mem and Arts). But share details should also be disclosed in annual reports, prospectuses, and corporate filings with regulators and stock exchanges.
Equity is the final major investment category, along with cash equivalents and fixed income.
Today we will review the concept of equity, in general, and in relation to companies.
Equity in General
Equity is anything that represents an ownership interest.
If you own a home (or possibly even a vehicle), you likely borrowed money from a bank (or similar) upon purchase. But you also contributed a portion of the cash yourself. This percentage is your equity interest in the house (or car). Over time, as you pay off the debt, your level of equity increases proportionately in the asset.
Your equity at any point in time equals the current market value of the asset less any outstanding debt and accumulated interest owing on the asset.
Equity and Margin Accounts
Some readers may have, now or in the future, brokerage accounts that allow margin trading.
A margin account allows investors to leverage by borrowing funds from the brokerage house using their investment portfolio as collateral. The amount that may be borrowed is dictated by the type of assets and market value of the investments within the account.
The equity portion is the value of the total investment portfolio minus the amount that has been borrowed.
While this may seem the same as a mortgage or a car loan, it is not. Asset values within a portfolio fluctuate daily. If prices fall, even in the very short term, you may be required to make additional contributions to the account (margin calls) to cover shortfalls. If you cannot, your assets will be sold to meet your minimum margin levels.
For most investors, margin accounts are a risky proposition. Take care if you ever decide to set up a margin account.
Debt is Not Equity
Creditors, like a bank that loans you money, are not equity holders in your home or vehicle.
Creditors may have a lien, or claim, to your overall assets (general) or specific assets (mortgage), but they do not have any right to participate in your affairs (unless incorporated into the the debt agreement or via court order).
The debt holder is simply entitled to the principal outstanding and all agreed upon interest payments.
Owning an equity interest gives the holder the right to participate in the company’s performance. As results may vary over time and circumstances, equity is riskier than debt.
The debt holder is only concerned about seeing the debt serviced in a timely manner. The equity holder wants to see an appreciation in the asset value or other performance factor that increases the value of the equity interest.
Corporate Equity
Within a company, equity refers to the funds contributed by all shareholders. While there may be a variety of share classes issued, the main form is common stock. And, as we saw previously, some companies issue preferred shares.
Equity includes more than just the capital contributed by shareholders. It also includes the company’s retained earnings.
Retained earnings are a company’s accumulated earnings over its life less dividends that have been paid to shareholders.
Combined, retained earnings plus contributed share capital, equal a company’s shareholder equity on its balance sheet.
Companies issue shares to raise capital. The proceeds are used to finance current operations, pay down pre-existing long term debt, or allow for expansion of the company.
Authorized Versus Outstanding Capital
Each class of stock has a maximum number of shares that may be issued. This maximum is known as the company’s “authorized capital” and is stated in the corporation’s “articles of incorporation”.
The number of shares actually issued to date is known as the “outstanding shares”. It is also referred to as the “float”.
For example, ABC has an authorized limit of 10 million, Class A common shares, according to its articles of incorporation. As at December 31, 2016, ABC has 1 million, Class A common shares outstanding.
The number of outstanding shares includes any “restricted stock” that may exist. Restricted shares are those that have restrictions on their ability to trade.
Perhaps corporate insiders (e.g. officers of the company) own shares that cannot be sold for a 5 year period from issue. Often this is used as an incentive for senior employees to stay tied to a company for long periods. Also, by having a vested interest in the long term growth of the shares, the employees personal objectives are in line with other shareholders.
Shares that have been repurchased by a company through open market transactions or “share buy-back programs” are not considered outstanding stock.
Note that if there are no repurchased shares in existence, or those that previously were purchased by the company have been retired, the outstanding shares may be referred to as “issued and outstanding”.
Knowing the number of shares outstanding is important when analyzing a company’s value. This may include “earnings per share” (EPS) or “market capitalization” calculations.
Knowing the number of shares authorized is also important. It allows you to assess the potential dilution effect on existing shareholders if new shares are issued.