Back to basics: what are equities?

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The differences between bonds and equities, and between income equities and capital equities explained.

Bonds and equities differ in both legal and accounting terms. Bonds are debt, whereas equities are (you guessed it, didn’t you?) equity. So bonds are treated as liabilities while equities are treated as capital, and thus they belong in different places on the balance sheet.

They are also different in investment terms, both as to income and capital values or payments. Bonds, being debt instruments, pay a fixed rate of interest expressed as a percentage of their face value, and repay (redeem) that face value on maturity, which is itself a fixed date. Equities are different.

Equities: income

Let's look at the income side of things first. For the purposes of learning about finance we will assume that the issuer of a bond must pay the interest due to the bond-holder every year, though in practice there are some special types of bonds that have slightly more flexible arrangements. This is not the case with equities.

The directors choose whether to pay a dividend in respect of any one year; they are not obliged to, and in general there is little shareholders can do to challenge their decision. Thus while you may hold equities in the expectation of receiving a dividend, there is no guarantee that this will actually happen.

Nor is there any certainty as to the amount. If a bond with a face value of $100 pays 5% interest, then the amount of the interest payment every year will be $5, irrespective of whether the current price of the bond is $200 or $50.

In the case of dividends, the directors decide how much to pay in respect of every share; again, they have complete discretion on this. The only exception to this are preference shares or preferred stock, which do usually carry a fixed rate of dividend, but in practice most investors treat these in much the same way as they do bonds.

There is only one essential difference, and it affects the business rather than the investor: interest payments on bonds are paid before tax and may be deducted as a legitimate expense when calculating the businesss tax liability, whereas dividends, even on preference shares, are payable after tax.

When viewed purely from the viewpoint of tax efficiency, it is much more desirable for a business to raise debt finance rather than equity.

So, with equities there is a right to receive a dividend only if the directors decide to grant one, and even then there is no certainty as to how much it will be. As a matter of practice, however, most public companies, particularly in the UK, once having established a customary rate of dividend, will strive to maintain it if they possibly can.

Cutting the dividend can be a key indicator of problems within the business and will frequently also cause a drop in the share price, thus both making the company more vulnerable to a take-over and leading to general shareholder dissatisfaction.

If you want to track the dividend policy of a company, you can do it by using the dividend payout ratio. This operates in two ways, one at the level of one individual share, and the other at the level of the company as a whole (though both should give the same result!).The inverse of the dividend payout ratio is called the retention ratio. Whichever one of these you choose to use, they are valuable analysis tools.

Is a company maintaining the dividend yield, but only at the expense of paying out more and more of the company’s profits? If so, how will it fund any necessary capital expenditure in coming years, and what areas might it be starving of cash – new product development, perhaps?

On the other hand, if a business has a large cash pile but is distributing a relatively small amount of earnings every year, then might it not do better to increase the dividend yield, or even to offer to buy back some of its shares from the shareholders?

Equities: capital

Bonds are generally issued for a fixed term, during which they are traded on a public exchange. Thus you have a choice of buying on the primary market (when they are issued) or the secondary (where you buy an existing bond that has already used up some of its lifetime from another investor).

When it comes to realizing some capital, you also have a choice. You can hold the bond to maturity and receive its face value by way of redemption, or you can sell it on the secondary market for its current market price.

This article is adapted from a chapter in the book No Fear Finance by Guy Fraser-Sampson, published by Kogan Page, RRP: £24.99. Special offer for Your Money Readers. Get 20% off No Fear Finance plus free p&p from now until 1st November. Phone: 01206 25 5678 and quote NOFF20 when you place your order. Or buy online www.amazon.co.uk

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