Return On Equities
Dec 03,2019 Shares
As we know holding equity shares of a company is akin to holding a proportional share in a company without the requirements or responsibilities of (1) entrepreneurship (i.e. running the company) and (2) any liability associated with the running of the business. An investor in equity is eligible to get a proportional profit of a business and stands to lose his entire investment at maximum if the business makes continuous losses.
Hence returns from equities come from profits of the business which are then available for proportionate distribution amongst all the equity shareholders. This distribution of profits is called Dividend. However, the management of companies does not distribute all profits. A portion of the profit is retained by the company for investment into the business or for future business purposes. These retained earnings get added to the reserves of the company thereby increasing the book value of each equity share. Such investment increases the earning potential of the company thus increasing the intrinsic value of a company which is a subjective parameter calculated differently by different investors.
The company which are listed on stock exchanges gets a higher or lower price than the face value of equity shares due to such intrinsic value associated with a company. Different investors assign different intrinsic values thereby resulting in transactions in the market at various prices. Investors who think the current market price is lower than intrinsic value will buy and vice versa. This higher market price over the face value or purchase/sale price results in gains for the investor thus yielding the second stream of returns over and above dividends. In fact, such gains in market value constitute the majority of returns from holding equity. Such market gains are called capital gains and normally forms an important part of the returns from equities. Balance returns come from dividends distribution. Negative returns from equity emanate when the market value of shares is lower than the face value or purchase price of shares.
These market returns are closely tied to the business and economic performance of the company in the long run, however, in the short term markets get driven by sentiments and herd instincts also.
As per the efficient market hypothesis, all available information is baked into the price and hence listed markets provide a significantly better price discovery than over the counter transactions where information are asymmetric meaning all participants do not have identical access to price-sensitive information. In listed markets regulations strive toward information symmetry so that all stakeholders participate in transactions with all available information about stocks and markets in general.
It must be borne in mind that businesses do not always give steady profits. They follow the business cycle of ups and downs. Hence dividends, as well as the market value of the stock, get impacted by such cycles. This element of uncertainty of business lends uncertainty to returns from equities also. That's the primary risk element of holding equities that get impacted by the business cycle as well as short term sentiments of the overall markets. Hence returns from equity cannot be guaranteed and at times also it yields negative returns. Facing such risk associated with business and short term sentiments of markets is the flip side of holding equity. But as there is a risk there are rewards too of holding equities on a long term basis which comes from higher returns than debt or fixed income instruments.
This excess return of equity over debt is also known as equity market risk premium which holders of equity expect.
Net returns from holding equity basically constitute Capital Gains + Dividends. Historically in India equity market returns have hovered around 10% - 12% and dividend yields have been in the range of 2-3%. Thus overall returns have been around 12-15% on an average basis. But there have been times when returns have been negative too, mainly due to capital gains being in negative. Dividends can never be negative. Hence good companies paying regular and rising dividends are valued higher as they tend to soften the blow of negative market returns in adverse market conditions.
Similarly for unlisted or Pvt limited companies the returns from equity emanate from Dividend plus change in book value or net worth of companies. Generally, book value is an accounting concept and doesn't capture the true economic or intrinsic value of equity shares. For listed shares, this true value is determined by the open market mechanism. But for unlisted or private limited corporations this true value is determined over the counter transactions between buyers and sellers.
Nowadays many investors invest in unlisted stocks with expectations of listing gains also. The market for unlisted stocks are not regulated and has limited liquidity leading to deep mispricing due to lack of efficient price discovery that happens in listed stocks where thousands of buyers and sellers bid their price to value a company basis fundamental (related to current and expected business working) and technical (related to volume and price at which thousands of transactions happen) information available.