Risk and return of equity securities, and why companies issue them

Where does an equity’s return come from?

An equity’s total return has two parts for a domestic share: the change in price and the dividends received. A third part appears for a foreign share held in another currency: foreign exchange gains (or losses) .

Total returnwhat the investor earns in the period

• Price change Memorize sale price minus purchase price
• Dividend income Memorize cash or stock dividends received
• Currency gain or loss Use it foreign shares only

$$R = \frac{P_1 - P_0 + D_1}{P_0}$$

Dividend income may be paid in cash or in shares. A share that pays no dividend earns its return from price change alone. Young, fast-growing companies tend to reinvest earnings and pay none. Mature companies with fewer growth projects return cash to shareholders.

$$R_{home} = (1 + R_{local})(1 + R_{FX}) - 1$$

A falling currency does the reverse. An 8% local return in a currency that loses 8% leaves slightly less than nothing: 1.08 × 0.92 − 1 = −0.64%.

Go deeper How much do reinvested dividends matter?

Reinvested dividends are dividends used to buy more shares, so they earn returns of their own. Over many years this compounding is a big share of an equity’s total return. Take a share worth 100 whose price grows 5% a year and which pays a dividend yield of 3% a year, so its total return is about 8% a year.

1. Price only: 100 × 1.05^20 = 265.33 after 20 years.
2. With the dividends reinvested, the holding grows at the 8% total return: 100 × 1.08^20 = 466.10.

The dividend half of the return adds about 200 to the final value. That is why total return indexes, not price indexes, are the right yardstick for a long-term investor.

Twenty years of compounding

TI BA II Plus HP 12C

1. 1.08y^x20×100= 466.10
2. 1.05y^x20×100= 265.33

y^x power

1. 1.08ENTER20y^x100× 466.10
2. 1.05ENTER20y^x100× 265.33

ENTER enter (on the HP, puts the number on the stack) · y^x power

Which equities are riskiest?

Equity risk is the uncertainty of the security’s future total return, usually measured by the standard deviation of returns. It comes from the uncertainty of its future cash flows, so features that make cash flows more certain lower risk.

Preference share risk is lower than common risk for three reasons: the dividend is known and fixed and is most of the return; it is paid before any common dividend; and the liquidation amount is known, the par value, though not guaranteed. A common share’s return depends on future price appreciation and uncertain dividends, and in a liquidation it gets only what remains. Lower risk comes with lower expected return.

Risk of equity securitiescertain cash flows lower it; issuer options raise it

• Preference shares Memorize less risky than common: fixed dividend, paid first, priority in liquidation
  • Putable Memorize lowest: holder can sell back
  • Cumulative Memorize missed dividends wait for you
  • Non-cumulative Memorize missed dividends are lost
  • Callable Memorize highest: issuer can end a good deal
• Common shares Memorize residual claim, last in line, unlimited upside
  • Putable common Memorize lowest: price floor
  • Ordinary common middle
  • Callable common Memorize highest: issuer can buy back

Within each group, features rearrange the risk.

• Putable shares let the holder sell the shares back to the issuer at a set price. This sets a minimum price and reduces uncertainty, so putable shares are the least risky and generally pay a lower dividend.
• Callable shares let the issuer redeem them at a set price. When the shares are doing well the issuer takes them away, so the holder has the downside without the full upside. Callable shares are riskier than otherwise identical non-callable ones.
• Cumulative preference shares are safer than non-cumulative because missed dividends are not lost.

The rule: anything that makes cash flows more certain or gives the holder an option lowers risk. Anything that gives the issuer an option raises it. For all preference shares, the main risk is whether the issuer can pay the dividend, which depends on its earnings and cash flow.

Each rung compares otherwise identical shares one feature at a time. Real shares often combine features (cumulative and callable, say), and the rule above tells you which way each feature pushes.

Exam tip You are rarely asked to rank all seven. Questions compare two or three features, so apply the rule to each pair.

Why do companies issue equity?

Companies issue equity to raise capital and to create a tradable security. The money pays for long-term assets, research and development, expansion into new products or regions, and acquisitions. A listed share is also a currency: it can pay for acquisitions and reward employees through share-based pay. Sometimes the need is defensive, such as meeting regulatory capital requirements or debt covenants, or staying a going concern.

Why companies issue equitycapital with no required payments

• Finance assets and growth Memorize long-term assets, research, new regions, acquisitions
• Create a currency Use it shares for acquisitions and pay for employees
• Cushion creditors Memorize absorbs losses first, so debt is cheaper and available

Equity also protects creditors. It absorbs losses first, so a company with more equity can borrow more cheaply and on easier terms. And although equity carries no required payment, it is not free: investors expect a return. The aim is to put the capital to work at a return above its cost, so net income and the market value of the equity rise.

Go deeper Long-run evidence and preference shares

Over long periods, equities have earned higher returns than bonds and cash, with higher volatility. That is the premium investors earn for carrying residual risk. Preference shares trade in between: a fixed income stream, but without a contractual right to it. Credit agencies rate them in the same way as bonds, and a missed preference dividend in the market is read as a sign of trouble.