Equity shares: Meaning, Criticisms & Real-World Uses

What Are Equity Shares?

Equity shares, often simply called shares or common stock, represent ownership interests in a company. When an individual or entity purchases equity shares, they become a shareholder in the issuing corporation. This form of ownership falls under the broader category of Investment Fundamentals and is a cornerstone of modern capital markets. Holders of equity shares typically have claims on a portion of the company's assets and earnings, and generally possess voting rights that allow them to influence corporate governance matters, such as electing the board of directors.

History and Origin

The concept of dividing company ownership into transferable shares dates back centuries, evolving with the rise of mercantile adventures and early joint-stock companies. These early forms allowed individuals to pool capital for large-scale, often risky, ventures, such as overseas trade expeditions. The ability to buy and sell these ownership units facilitated investment and risk-sharing. The formalization of equity shares and the establishment of organized stock exchange venues in cities like Amsterdam and London in the 17th century marked significant milestones, providing liquidity and price discovery for these ownership interests. The structure of modern corporations, and the rights afforded to those who hold equity shares, are deeply influenced by principles of corporate governance that have developed over time. The Organisation for Economic Co-operation and Development (OECD), for instance, publishes widely recognized Principles of Corporate Governance that outline rights and equitable treatment of shareholders, contributing to transparent and efficient markets.¹⁰,⁹,⁸,⁷,⁶

Key Takeaways

Equity shares represent fractional ownership in a company, granting shareholders a claim on assets and earnings.
Shareholders typically have voting rights, allowing them to participate in major corporate decisions.
The value of equity shares fluctuates based on market supply and demand, company performance, and economic conditions.
Investors in equity shares aim for capital appreciation and potentially receive dividend payments.
Equity shares are a primary means for companies to raise capital through equity financing.

Formula and Calculation

While there isn't a single "formula" for equity shares themselves, their intrinsic value and market value are often analyzed using various financial metrics. One fundamental calculation often associated with equity shares is Earnings Per Share (EPS), which indicates how much profit a company makes for each outstanding share.

The basic formula for Earnings Per Share is:

\text{EPS} = \frac{\text{Net Income} - \text{Preferred Dividends}}{\text{Number of Common Shares Outstanding}}

Where:

Net Income represents the company's total profit.
Preferred Dividends are dividends paid to preferred shareholders (deducted as they are not available to common shareholders).
Number of Common Shares Outstanding is the total number of equity shares held by investors.

Another important measure is Book Value Per Share, derived from a company's balance sheet:

\text{Book Value Per Share} = \frac{\text{Total Shareholder Equity}}{\text{Number of Common Shares Outstanding}}

Interpreting Equity Shares

Interpreting equity shares involves understanding their dual nature as both an ownership stake and a tradable security. For investors, owning equity shares means participating in the potential growth and profitability of a company. The market value of equity shares can be influenced by a myriad of factors, including economic outlook, industry trends, company-specific news, and investor sentiment.

When evaluating equity shares, investors often look beyond just the current price. They consider the company's financial health, management quality, competitive landscape, and future growth prospects. For instance, a high EPS suggests a company is profitable relative to its share count, while comparing a company's book value per share to its market price can offer insights into how the market values the company relative to its accounting value.

Hypothetical Example

Imagine a fictional technology startup, "InnovateTech Inc.," which decides to become a public company through an initial public offering. Initially, the founders own all the equity shares. To raise capital for expansion, InnovateTech issues 1,000,000 new equity shares to the public at an IPO price of $10 per share.

An investor, Sarah, buys 1,000 shares of InnovateTech at the IPO. She now owns a tiny fraction of the company. As a shareholder, she has the right to vote on certain company matters at the annual general meeting and receives any dividends the company might declare. Two years later, InnovateTech's innovations prove highly successful, and its profits grow significantly. The demand for its equity shares increases, and the share price rises to $25 per share. Sarah's initial investment of $10,000 (1,000 shares * $10) is now worth $25,000 (1,000 shares * $25), representing a capital gain of $15,000.

Practical Applications

Equity shares are central to global financial markets and have numerous practical applications for both companies and investors:

Capital Formation: Companies, whether small startups or large corporations, issue equity shares to raise capital from investors. This allows them to fund operations, expansion, research and development, and other strategic initiatives without incurring debt.
Investment and Wealth Creation: For investors, equity shares offer the potential for capital appreciation and income through dividends, forming a crucial component of many investment portfolios aimed at long-term wealth creation and portfolio diversification. The U.S. Securities and Exchange Commission (SEC) provides guidance to investors on how to hold and manage their securities, including equity shares.⁵
Mergers and Acquisitions: Equity shares are frequently used as currency in mergers and acquisitions, where one company may offer its shares to acquire another.
Employee Incentives: Stock options and restricted stock units (RSUs) involving equity shares are common forms of compensation, aligning employee interests with shareholder interests.
Corporate Governance and Control: The distribution of equity shares determines control over a company. Large shareholders can exert significant influence over management and strategic direction. Regulatory updates often address issues related to the offering and marketing of common stock, as seen in recent SEC actions concerning false or misleading statements in such offerings.⁴

Limitations and Criticisms

While equity shares offer significant opportunities, they also come with inherent limitations and criticisms:

Volatility and Risk: The market value of equity shares can be highly volatile, subject to market fluctuations, economic downturns, industry-specific challenges, and company performance. Investors can lose a significant portion or even all of their investment if a company performs poorly or goes into liquidation. Exaggerated stock market valuations and geopolitical tensions are some factors that can increase risk for investors.³
Lack of Guaranteed Returns: Unlike bonds, equity shares do not offer guaranteed returns or regular income. Dividends are declared at the discretion of the company's board of directors and can be cut or suspended.
Dilution: When a company issues new equity shares, it can dilute the ownership stake and earnings per share of existing shareholders.
Limited Control for Small Investors: While equity shares carry voting rights, individual small investors typically have very limited influence on corporate decisions due to the dispersed nature of ownership.
Market Manipulation and Fraud: Despite regulatory oversight, equity markets can be susceptible to manipulation, insider trading, and fraudulent activities, which can lead to significant losses for investors. Lawsuits sometimes arise from allegations that companies misled investors about the safety or effectiveness of products related to their common stock, highlighting potential pitfalls.²,¹

Equity Shares vs. Preferred Shares

Equity shares (or common stock) and preferred shares both represent ownership in a company, but they differ significantly in terms of rights and privileges.

Feature	Equity Shares (Common Stock)	Preferred Shares
Voting Rights	Typically carry voting rights, allowing shareholders to influence company decisions.	Generally do not carry voting rights.
Dividend Payments	Dividends are variable and not guaranteed; paid after preferred dividends.	Usually pay fixed dividends, and preferred shareholders have priority for dividend payments.
Claim on Assets	Have a residual claim on assets during liquidation, meaning they are paid last after all debts and preferred shareholders.	Have a higher claim on company assets than common shareholders in the event of liquidation.
Potential Return	Higher potential for capital appreciation if the company grows significantly.	Lower capital appreciation potential; often behave more like bonds with fixed income.

The primary distinction often causes confusion: common equity shares offer greater potential for capital gains and voting influence, while preferred shares offer more predictable income and a higher claim in the event of liquidation, at the cost of voting power and often growth potential. Many private company structures do not have this distinction until they consider public markets or complex financing.

FAQs

What does it mean to own equity shares?

Owning equity shares means you are a partial owner of the company that issued them. As an owner, you have a claim on the company's assets and earnings, and typically have the right to vote on important corporate matters, such as electing the board of directors.

How do equity shares make money for investors?

Investors can make money from equity shares in two main ways: through capital appreciation and through dividends. Capital appreciation occurs when the share price increases, allowing you to sell your shares for more than you paid for them. Dividends are periodic payments of a company's profits distributed to its shareholders.

Are equity shares a safe investment?

No investment is entirely "safe" as all investments carry some level of risk. Equity shares are considered riskier than some other investments, like bonds, because their value can be volatile and there's no guarantee of returns. The value of equity shares can fluctuate based on market conditions, company performance, and economic factors. Portfolio diversification can help manage this risk.

Can a company issue different types of equity shares?

Yes, a company can issue different classes of equity shares, such as Class A and Class B shares. These classes often come with different voting rights or dividend entitlements. For example, some classes might have one vote per share, while others might have multiple votes per share, allowing founders or specific groups to retain control.

What happens to equity shares if a company goes bankrupt?

If a company goes bankrupt and enters liquidation, holders of equity shares are typically the last in line to receive any remaining assets after all creditors and preferred shareholders have been paid. In many bankruptcy cases, common shareholders receive little to nothing.