Investment - Focus : Smart Insight from Alliance Trust

Please remember that investments can go down as well as up and investors may get back less than they originally invested.

Getting informed

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Guide to equities

What are equities?

An equity is the term used to describe a share in a company. The term derives from the ownership being shared equally between investors. The ownership of a company may be split between a few holders, who may be related, or connected to the business. Shares in such companies are often not freely traded on a Stock Exchange and are known as “Private Companies.” Alternatively, shares in a company may be held by a larger number of shareholders, both private and corporate. Shares in such companies will be traded on an exchange, where buyers and sellers “meet” to agree a price, such as the London Stock Exchange. These companies are called “Publicly Listed Companies” or PLCs. By buying a share in a company it means:

  • You own one equal part of that company.
  • You have the right to vote on important company decisions.
  • You are entitled to a share of any post tax profits that may be distributed by the company to its shareholders by way of a dividend.

Why do companies issue shares?

Companies need to fund their operations and developments. In order to do so, they have three primary sources of funding:

  • Borrowing money from banks or investors, either through an overdraft, loan or by issuing debt instruments such as bonds (see our Guide to fixed incomefor further information).
  • Issuing shares to investors, who then take an equity stake in the business.
  • Using the profits from the existing operations, to reinvest in the company.

A company may borrow from a bank or by issuing loan notes, which promise to pay the holder a fixed rate of return over a particular period, at the end of which, the capital will be repaid. In the event of the collapse or closure of a business, the debt holders will have priority over shareholders in being repaid their capital from the assets of the business.

Investors who hold equity are effectively lending their money to a company, but their right to recover the full value of their investment is restricted. However, they are entitled to an equal share of the profits and or rise in the value of the business.

Why invest in equities?

Over the long term, analysis has shown that historically the return on equities is better than other asset classes, this can be seen in the graph below. However, it’s important to note that past performance isn’t a guide to future performance and that equities are one of the more volatile asset classes, so although they can offer good growth potential their value can rise or drop sharply at any time. Investors put their capital at risk when they invest in shares and in extreme cases they can lose their entire investment. Shareholders take an extra risk compared to bond holders; therefore they expect a higher level of return. This could be through capital growth, where the share price rises, or income return, where the profits of the business are distributed to the shareholders as dividends. However, if the business is poorly managed, then the share price may fall and the dividend payments may not be maintained.

Barclays graph

Source: Barclays Equity Guilt Study 2013

Please note that the value of an investment can go down as well as up and that past performance is not a guide to future performance.

Long-term capital growth

Many look at investing in equities for long-term capital growth; this is when you are looking to grow your investment over the long term. Clearly it is in the interests of the company you are invested in, to grow their business, as this provides them with the financial capacity to reward shareholders, employees and to pursue further opportunities.

How do you know the value of a share?

Assuming that you are looking at buying a share in a publicly listed company, the value that the stock market applies to a share is ultimately affected by supply and demand. On a stock exchange, where millions of shares are traded every day, shares should change hands if the highest price that the buyer is prepared to pay, matches the lowest price that the seller is willing to accept.

How can a share in a company such as Tesco PLC be worth a different amount at 10:15am than it is at 10:20am on the same day?

Share prices change constantly and participants in the market will make different assessments of the value of the company. There are lots of different ways of assessing the potential of a company to generate revenue, but ultimately the value of a company is the present value of its future cash flows. This can be complicated but in simple terms we need to forecast how much a company is going to earn in the future and how fast it is going to grow those earnings. Once we have done that, we then need to discount the earnings to take into account the effect of inflation, which will mean that £1 earned next year will not have the purchasing power of £1 earned today.

So you have decided to buy a share. Is that the end of the process?

Investing all of your money in a single company is the financial equivalent of putting all your eggs in one basket. You want to be very careful about how the basket is carried, or the company is managed. If you make a good decision, then your portfolio will grow, but if you had chosen to invest in Lehmans just before it crashed, then you would have lost your entire investment. This is an extreme example, but you also need to try to avoid the companies that are not going to grow as fast as others which are doing the same thing.

One solution is to invest in a range of different companies. This can be done by splitting your capital into a number of different tranches and buying a smaller stake in a greater number of companies. This means that you are less exposed to the collapse of an individual company, but as the risk is lower, then opportunity for large returns is too. To find out more about this, read our article on understanding risk and return. However in order to do this you would need to research and understand each of the companies which you plan to invest in.

The alternative is that you buy shares in a collective investment vehicle such as Investment Trust or an open-ended fund. These vehicles are managed by professional fund managers who invest on behalf of their clients or shareholders in a range of investments that comply with their mandate. The individual investor gains access to the expertise of the manager and is invested into a ready-made portfolio, thus reducing their individual risk. Read our guide to open-ended vs. closed ended funds (Investment Trusts) for further information.

What are the risks? Making sure it’s right for you

Investing in equities is not for everyone and it is important that you understand the risks associated with this asset class. Compared to some asset classes such as bonds and cash, equities are usually considered as higher risk – however depending on what company you invest in, the risk can vary. Things that can affect the price of a share include current economic conditions, financial news and other company specific events, such as a management change. It is therefore important that you consider investing in shares as a long-term exercise.

Risk information

To spread your risk, you should consider investing in different investments and asset classes. This reduces the risk of relying on the performance of a single investment or asset class.

You need to ensure you understand the risks and commitments before investing. If you are unsure you should consult a Financial Adviser before investing.