» A business has to choose between equity and debt when it needs to issue securities to raise capital to fund its operations and expansion.
» Equity represents a risky, long-term, growth oriented investment that can show a high volatility in prices, depending on how the underlying business is performing. It does not offer assured returns.
» Debt represents a relatively lower risk, steady, short-term, income-oriented investment.
» The process of distributing savings between equity and debt is known as asset allocation. An investor's asset allocation choices depend on his expected return, investing time period, risk appetite and financial needs.
» Equity capital is denominated in equity shares, with a face value.
» Investors who buy equity shares become shareholders with ownership and voting rights in proportion to their shareholding.
» Equity investors are paid periodic dividend, which is not pre-determined or mandatory but depends on the profitability of the business and availability of surplus after meeting all other dues.
» Equity capital is raised for perpetuity.
» Debt capital is raised by issuing debt instruments such as debentures, bonds, commercial papers, certificates of deposits or pass-through certificates.
» A debt instrument is defined by its tenor, or the time period to maturity and the pre-determined rate of interest it is liable to pay.
» The interest rate on debt is specified in terms of percent per annum, and can be fixed or floating.
» Interest payment to lenders is a legal obligation that has to be paid before taxes and before any distribution to equity investors.
» If there is a failure of the business, lenders will receive their settlement before other stakeholders such as employees and equity investors.
» Lenders do not participate in management or ownership, but they may ask for security to safeguard their lending.
» The following are the key factors to consider between Equity and Debt:
Ability to pay periodic interest.
Willingness to dilute ownership in the company by offering equity to outsiders.
Ability to give collateral as security to debt financiers
Period for which capital is required.
» Debt instruments can be classified by type of borrower and by tenor of the instrument.
» The two main borrower categories are governments and non-government agencies like banks, corporations and other such entities.
» In terms of tenor, debt is classified as short-term, medium term and long term. Securities with maturities up to one year are issued and traded in the money market. Longer maturities are considered to be part of the capital markets.
» The basic features of a debt instrument are Principal, Coupon and Maturity.
» There are two notions of value in equity investing-intrinsic value and market price.
» Intrinsic value is the estimated value per equity share, based on the future earning potential of a company.
» Market price is the price at which the share trades in the stock market, based on several factors.
» Since equity markets are not perfectly efficient, market prices may not always reflect the underlying intrinsic value of the share.
» If the intrinsic value is perceived to be more than market value, the scrip is said to be undervalued. If intrinsic value is perceived to be less than market value, the scrip is said to be overvalued. The goal of investment strategies is to buy undervalued shares, and sell overvalued ones.
» Equity investment process is based on careful selection of securities, market timing, and appropriate weighting to different sectors and segments of the market.
» Equity research is a specialized pursuit that uses financial analysis and valuation models to generate recommendations on whether to buy, sell or hold stocks.
» Equity analysis involves studying a range of variables, factors and numbers and their implications for the future potential of a stock. The E-I-C framework, which studies the economy, industry and company specific factors, is a commonly used framework.
» Equity investment can be evaluated using fundamental analysis or technical analysis.
» Valuation of equity shares may be carried out using Discounted Cash Flow (DCF) models and relative valuation models, market-based indicators such as Price-Earnings multiple (PE), Price-to-book-value (PBV) ratio and dividend yield.
» The money market includes instruments for raising and investing funds for periods ranging from one day up to one year. Money market securities consist of repos/reverse repos, CBLOs (Collateralized borrowing and lending obligations), Certificates of Deposits, Treasury Bills, Commercial Paper.
» Debt valuation is based on the concept of time value of money.
» The fair value of a debt security is the sum of discounted values of all future cash flows from it. The discount rate is called the yield, and the fair value is represented by market price.
» Yield and price of a debt security are inversely related.
» The risks of investing in debt securities include inflation risk, credit risk, interest rate risk, re-investment risk, call risk and liquidity risk.
» Hybrid instruments such as preference shares and convertible debentures have some features of equity and some of debt securities.
» Depository receipts (DRs), including ADRs, GDRs and IDRs are financial instruments that represent shares of a local company but are listed and traded on a stock exchange outside the country.
» FCCBs are foreign currency (usually dollar) denominated debt raised by companies in international markets which have the option of converting into equity shares of the company before they mature.
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