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What is an Equity Stake?

We often come across news of mergers and acquisitions, where one company acquires a significant equity stake in another. Equity stake represent the percentage of the business owned by an individual or a company, through the purchase of shares of that business. Shareholders owning a significant equity stake often have a say in the organization’s policy making and some level of control in the financial decisions too.

This concept is often used by start-ups to incentivise their employees, giving out equity stakes in their companies to employees rather than higher salaries. Creditors can also acquire equity stakes in organizations, in lieu of debt. In trading, equities are one of the principal asset classes in the global financial markets. Before we move on to equities trading, let us understand the concept in detail.

Difference between Equity Stake, Shares and Stocks

In most cases, these three terms usually are synonymous with each other, but there are some specific differences.

Shares

Each unit of a stock issued by a company is called a share. This represents one unit of ownership in the organisation. Shares can also represent other forms of investments, such as mutual funds. Shareholders are always stakeholders in a publicly traded company, but stakeholders need not always be shareholders. Stakeholders do not necessarily own the company’s stock. Two types of shares exist – common stock and preferred stock.

  • Common Stock: These are shares usually traded on major exchanges, with their price and dividend pay-outs varying over time. The values of these shares are tied to a company’s profitability.
  • Preferred Stock: Owners of preferred stock are entitled to receive a fixed dividend amount at regular intervals. The value of such shares is tied to the dividend amount and the company’s credit rating.

Stocks

Broadly, there are two types of investments that a company can opt for in order to raise capital –debt financing and equity financing. In the latter case, companies issue stock, which are basically securities representing ownership in the firm. Stockholders have a claim on the company’s assets and earnings when they purchase such stock. They are also rewarded with quarterly or annual dividends in return. Traders speculate on stock prices, wherein if a company’s stock price goes up, the trader can make a profit by selling at the increased price.

Stakes

As we said earlier, stockholders or shareholders are always stakeholders, and that stake represents the percentage of the company that they own. You may be a bond holder, which means you will have much to gain if the company performs well. A bond holder is also a stakeholder.

These terms often overlap and are used interchangeably. In short, all shareholders are equity holders, but not all equity holders are shareholders. Not all businesses issue shares of their stock, but it is possible to have ownership interest in them.

What Exactly is a Stockholder’s Equity Stake?

This can be explained with the help of a simple accounting equation:

Assets – Liabilities = Equity

So, if a company uses up all its assets to meet its debt liabilities and other payment obligations, the amount that is left over is a shareholder’s equity. Assets here can include land, buildings, machinery, capital goods and inventory, and earnings. One can calculate the equity of an organisation after assessing the value of these assets at market price.

The stockholder’s equity comes from two sources:

  1. Money invested in a company initially, along with added investments. Companies issue shares in the primary market to raise money.
  2. Retained earnings reserves, which a company builds up over time. This is the net income from business activities. In successful companies, this retained earnings figure often surpasses the initial investment made.

Equity Trading in the Primary Markets

These are places where shares are issued by companies and traded on exchanges or Over-The-Counter (OTC). A vital part of the global economy, these markets strengthen companies by allowing them access to investors, in order to raise money for business activities. In return, the investors gain a portion of ownership in the organisation and are able to benefit from dividends, based on the company’s yearly performance.

Most equity trading takes place on stock exchanges around the world, such as the NYSE and NASDAQ, where the former is a physical stock exchange, while the latter is a virtual trading market.

How Do Traders Pick the Right Stock?

Traders try to ascertain the fundamentals of the share value before investing in a company’s stock. This depends on the trading style and investment goals to a great extent. Investors who are interested in capital preservation tend to look for low-growth companies in the utilities sector. Those who do not have much appetite for risk-taking tend to invest in stable blue-chip companies. Investors looking for appreciation of their capital reserves usually look at stocks with ranging market caps.

There are quite a few factors to consider while choosing a stock to invest in:

  1. Invest in an industry that you know about. This means that the company’s and the stock’s performance will be easier to understand for you.
  2. Choose companies with established branding or ones that have strong emerging brands. Branding differs according to industry. For example, a company engaged in diamond mining will not follow the branding process used in the retail industry. Overall choose a trusted name, which carries weight.
  3. Strong past performance, even in the most volatile market conditions. It is vital to stay updated with current market news and opinions on the company that you are looking to invest in. Searching for stock analysis articles and financial media stories is a great way to go about it. ETFs also tend to a good way to track the performance of a particular sector, which in turn can help stock picking. Here are some things to evaluate in a company’s balance sheet:
  • P/E Ratio
  • Debt to Equity Ratio
  • Inventory Turnover Ratio
  1. Focusing on companies that pay out regular dividends. This indicates a stable financial structure, stable internal management and stable performance. But, not every company pays out a dividend, so this factor doesn’t hold true for all stocks. Also, extremely high yields often signal future instabilities.

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