Learning Module 4
Overview of Equity Securities
Key Outcomes Summary & Practice Problems
What you must be able to do
Curriculum Year: 2026
Describe characteristics of types of equity securities.
Describe differences in voting rights and other ownership characteristics among different equity classes.
Compare and contrast public and private equity securities.
Describe methods for investing in non‑domestic equity securities.
Compare the risk and return characteristics of different types of equity securities.
Explain the role of equity securities in the financing of a company's assets.
Contrast the market value and book value of equity securities.
Compare a company's cost of equity, its (accounting) return on equity, and investors' required rates of return.
1 · Characteristics of Equity Securities
Equity securities represent ownership claims on a company's net assets. The two primary types are common shares (ordinary shares) and preference shares (preferred stock).
Represent residual ownership after all other claims.
Voting rights: Elect board of directors, approve mergers, select auditors.
Statutory voting: One vote per share; votes evenly across candidates.
Cumulative voting: Total votes = shares × directors to elect; can concentrate votes on one candidate → helps minority shareholders gain board representation.
May have different classes (e.g., Class A voting, Class B non‑voting) with different rights.
Dividends are not guaranteed; may be paid at board's discretion.
Priority over common shares for dividends and liquidation proceeds.
Generally no voting rights (unless specified).
Cumulative: Unpaid dividends accrue and must be paid before common dividends.
Non‑cumulative: Unpaid dividends are forfeited.
Participating: Receive standard dividend plus share of excess profits.
Non‑participating: Fixed dividend only.
Convertible: Can be converted into a specified number of common shares.
Callable: Issuer can redeem at a specified price.
Putable: Shareholder can sell back to issuer at specified price.
Voting rights comparison: Statutory voting gives majority shareholders control of all board seats. Cumulative voting allows minority shareholders to concentrate votes and potentially elect at least one director. Dual‑class structures (e.g., Ford, Viacom) give founders/voting shareholders disproportionate control.
Feature | Common Shares | Preference Shares |
|---|---|---|
Voting rights | Typically yes (one vote per share) | Typically no |
Dividend priority | Residual (after preference) | Priority over common |
Liquidation priority | Residual (after all creditors and preference) | Priority over common (up to par value) |
Dividend obligation | Discretionary | Discretionary (but cumulative feature may accrue) |
Return characteristics | Price appreciation + dividends (uncertain) | Fixed dividend + possible conversion/call features |
Risk | Higher (residual claim) | Lower than common (priority claim) |
2 · Public vs Private Equity Securities
Shares trade on public exchanges (NYSE, NASDAQ, LSE, etc.).
Market‑determined quoted prices.
High liquidity.
Subject to regulatory disclosure requirements.
Examples: common stock of listed companies, ETFs, mutual funds.
Issued to institutional investors via private placements.
No active secondary market → illiquid.
No market‑determined quoted prices; values negotiated.
Limited financial disclosure.
Three main types:
1. Venture capital — seed/start‑up, early‑stage, mezzanine financing.
2. Leveraged buyout (LBO) — use debt to acquire all outstanding shares of a public company (take private).
3. Private investment in public equity (PIPE) — private investor buys a large stake in a public company at a discount.
Why go private? Reduces regulatory and investor relations costs; allows management to focus on long‑term value creation without short‑term earnings pressure. The goal is to restructure and later take the company public again via an IPO.
Venture capital typically has a 3–10 year horizon; exit via IPO or sale.
LBO/MBO candidates have undervalued assets and strong cash flows to service debt.
PIPE transactions allow quick capital infusion; private investors often get a discount and warrants.
Private equity has grown substantially; holding periods have lengthened to ~10 years.
3 · Non‑Domestic Equity Securities
Investors can gain international exposure through several methods. Global equity markets have grown due to technology, deregulation, and the desire for diversification.
Direct Investing
Buy shares directly on foreign exchanges.
Transactions in foreign currency → currency risk.
Must understand local trading, clearing, and settlement procedures.
Less transparency, potentially less liquidity.
Depository Receipts (DRs)
American Depositary Receipts (ADRs): USD‑denominated, trade on US exchanges (NYSE, NASDAQ, OTC).
Global Depositary Receipts (GDRs): Trade outside the US, typically on London/Luxembourg exchanges; can be privately placed in the US.
Sponsored DR: Foreign company is involved; voting rights pass through to investors.
Unsponsored DR: Depository bank creates the DR without the company's involvement; depository bank retains voting rights.
Level I ADR: OTC, less SEC reporting.
Level II/III ADR: Listed on major exchange; full SEC registration; can raise capital (Level III).
Rule 144A ADR: Private placement to QIBs.
Type | Exchange | SEC Registration | Capital Raising | Key Feature |
|---|---|---|---|---|
Level I ADR | OTC | Form F‑6 | No | Lowest cost, least disclosure |
Level II ADR | NYSE/NASDAQ/AMEX | Form F‑6 | No | Higher visibility, stricter reporting |
Level III ADR | NYSE/NASDAQ/AMEX | Forms F‑1 & F‑6 | Yes | Can raise capital via public offering |
Rule 144A | Private (QIBs) | None | Yes (private) | Only QIBs; no SEC registration |
Other Methods
Global Registered Shares (GRS): Same shares trade on multiple exchanges in different currencies; no currency conversion needed.
Basket of Listed Depositary Receipts (BLDRs): ETFs that hold a portfolio of DRs.
Exchange‑Traded Funds (ETFs): Baskets of international equities that trade like stocks.
Key benefit of depository receipts: Investors avoid currency conversion hassles, unfamiliar market practices, and differences in accounting standards. DRs also allow foreign companies to raise capital from US investors and increase visibility.
4 · Risk and Return Characteristics
Rt = (Pt − Pt−1 + Dt) / Pt−1
For foreign investments, add foreign exchange gain/loss:
Total return (foreign) ≈ Local return + Currency return (if holding period returns are small)
Price appreciation (capital gain)
Dividend income (cash or stock dividends)
Foreign exchange gains/losses (for non‑domestic investments)
Reinvested dividends have a compounding effect — historically, dividends account for a significant portion of long‑term equity returns.
Risk = uncertainty of expected total return.
Preference shares are generally less risky than common shares because:
Dividends are fixed and known.
Priority over common in dividends and liquidation.
Par value is known (if liquidation occurs).
Callable shares are riskier for investors (limit upside).
Putable shares are less risky (floor on price).
Cumulative preference is less risky than non‑cumulative.
Reinvested dividends are powerful: US$1 invested in US equities in 1900 grew to US$1,402 with dividends reinvested vs. just US$11.9 from price appreciation alone. The real annualised return was 6.4% with dividends vs. 2.1% without.
5 · Equity, Company Value, and Key Ratios
Equity securities are issued to finance a company's assets and growth. Management's goal is to increase book value and, ultimately, market value.
Shareholders' equity on the balance sheet.
Increases when a company retains net income.
Reflects historical cost and management decisions.
Rarely equals market value.
Reflects investors' collective expectations of future cash flows.
Influenced by growth opportunities, risk, and investor sentiment.
Market value can exceed book value if future prospects are strong.
ROE = Net income available to common shareholders / Average book value of equity
Or: ROE = Net income / Beginning book value (if using a simpler approach)
Example: Pfizer 2017 ROE = 21,308 / [(59,840 + 71,287)/2] = 32.5%
P/B = Market price per share / Book value per share
Example: Pfizer (2017) P/B = 35.74 / 11.98 = 2.98
A P/B > 1 suggests investors expect future growth (ROE > cost of equity).
P/B varies by industry — high for growth industries (tech), low for mature industries (utilities).
Cost of Equity vs Required Rate of Return
Cost of equity = the minimum return a company must offer to attract equity capital.
Investors' required rate of return = the return investors demand for providing capital, based on the risk of the investment.
If investors require a higher return than the company's cost of equity, they will sell shares → price falls → cost of equity rises to match the required return.
Common models to estimate cost of equity: Dividend Discount Model (DDM) and Capital Asset Pricing Model (CAPM).
The cost of equity is a component of the weighted average cost of capital (WACC), used in capital budgeting.
Intrinsic value vs book value (Warren Buffett): Book value is historical input; intrinsic value is the discounted value of future cash flows. A company can have low book value but high intrinsic value (e.g., a college education). Market value attempts to capture intrinsic value but may be inaccurate.
Global Equity Market Context
Equity market capitalisation exceeds global GDP; US markets represent ~51% of global equity market cap vs. ~25% of GDP.
Historically, equities have provided higher real returns (5.2% p.a.) than bonds (2.0%) and bills (0.8%) over 1900–2017.
Equity ownership as a percentage of population varies widely (e.g., Australia ~36%, South Korea ~10%).