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2022 Curriculum CFA Program Level I Equity Investments

Overview of Equity Securities

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Introduction

Equity securities represent ownership claims on a company’s net assets. As an asset class, equity plays a fundamental role in investment analysis and portfolio management because it represents a significant portion of many individual and institutional investment portfolios.

The study of equity securities is important for many reasons. First, the decision on how much of a client’s portfolio to allocate to equities affects the risk and return characteristics of the entire portfolio. Second, different types of equity securities have different ownership claims on a company’s net assets, which affect their risk and return characteristics in different ways. Finally, variations in the features of equity securities are reflected in their market prices, so it is important to understand the valuation implications of these features.

This reading provides an overview of equity securities and their different features and establishes the background required to analyze and value equity securities in a global context. It addresses the following questions:

  • What distinguishes common shares from preference shares, and what purposes do these securities serve in financing a company’s operations?

  • What are convertible preference shares, and why are they often used to raise equity for unseasoned or highly risky companies?

  • What are private equity securities, and how do they differ from public equity securities?

  • What are depository receipts and their various types, and what is the rationale for investing in them?

  • What are the risk factors involved in investing in equity securities?

  • How do equity securities create company value?

  • What is the relationship between a company’s cost of equity, its return on equity, and investors’ required rate of return?

The remainder of this reading is organized as follows. Section 2 provides an overview of global equity markets and their historical performance. Section 3 examines the different types and characteristics of equity securities, and Section 4 outlines the differences between public and private equity securities. Section 5 provides an overview of the various types of equity securities listed and traded in global markets. Section 6 discusses the risk and return characteristics of equity securities. Section 7 examines the role of equity securities in creating company value and the relationship between a company’s cost of equity, its return on equity, and investors’ required rate of return. The final section summarizes the reading.

Learning Outcomes

The member should be able to:

  1. describe characteristics of types of equity securities;

  2. describe differences in voting rights and other ownership characteristics among different equity classes;

  3. distinguish between public and private equity securities;

  4. describe methods for investing in non-domestic equity securities;

  5. compare the risk and return characteristics of different types of equity securities;

  6. explain the role of equity securities in the financing of a company’s assets;

  7. distinguish between the market value and book value of equity securities;

  8. compare a company’s cost of equity, its (accounting) return on equity, and investors’ required rates of return.

Summary

Equity securities play a fundamental role in investment analysis and portfolio management. The importance of this asset class continues to grow on a global scale because of the need for equity capital in developed and emerging markets, technological innovation, and the growing sophistication of electronic information exchange. Given their absolute return potential and ability to impact the risk and return characteristics of portfolios, equity securities are of importance to both individual and institutional investors.

This reading introduces equity securities and provides an overview of global equity markets. A detailed analysis of their historical performance shows that equity securities have offered average real annual returns superior to government bills and bonds, which have provided average real annual returns that have only kept pace with inflation. The different types and characteristics of common and preference equity securities are examined, and the primary differences between public and private equity securities are outlined. An overview of the various types of equity securities listed and traded in global markets is provided, including a discussion of their risk and return characteristics. Finally, the role of equity securities in creating company value is examined as well as the relationship between a company’s cost of equity, its accounting return on equity, investors’ required rate of return, and the company’s intrinsic value.

We conclude with a summary of the key components of this reading:

  • Common shares represent an ownership interest in a company and give investors a claim on its operating performance, the opportunity to participate in the corporate decision-making process, and a claim on the company’s net assets in the case of liquidation.

  • Callable common shares give the issuer the right to buy back the shares from shareholders at a price determined when the shares are originally issued.

  • Putable common shares give shareholders the right to sell the shares back to the issuer at a price specified when the shares are originally issued.

  • Preference shares are a form of equity in which payments made to preference shareholders take precedence over any payments made to common stockholders.

  • Cumulative preference shares are preference shares on which dividend payments are accrued so that any payments omitted by the company must be paid before another dividend can be paid to common shareholders. Non-cumulative preference shares have no such provisions, implying that the dividend payments are at the company’s discretion and are thus similar to payments made to common shareholders.

  • Participating preference shares allow investors to receive the standard preferred dividend plus the opportunity to receive a share of corporate profits above a pre-specified amount. Non-participating preference shares allow investors to simply receive the initial investment plus any accrued dividends in the event of liquidation.

  • Callable and putable preference shares provide issuers and investors with the same rights and obligations as their common share counterparts.

  • Private equity securities are issued primarily to institutional investors in private placements and do not trade in secondary equity markets. There are three types of private equity investments: venture capital, leveraged buyouts, and private investments in public equity (PIPE).

  • The objective of private equity investing is to increase the ability of the company’s management to focus on its operating activities for long-term value creation. The strategy is to take the “private” company “public” after certain profit and other benchmarks have been met.

  • Depository receipts are securities that trade like ordinary shares on a local exchange but which represent an economic interest in a foreign company. They allow the publicly listed shares of foreign companies to be traded on an exchange outside their domestic market.

  • American depository receipts are US dollar-denominated securities trading much like standard US securities on US markets. Global depository receipts are similar to ADRs but contain certain restrictions in terms of their ability to be resold among investors.

  • Underlying characteristics of equity securities can greatly affect their risk and return.

  • A company’s accounting return on equity is the total return that it earns on shareholders’ book equity.

  • A company’s cost of equity is the minimum rate of return that stockholders require the company to pay them for investing in its equity.