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An Introduction to Shares and Debentures

    Mr. Shyam | Monday, April 02,2012, 03:50 PM
 

An Introduction to Shares and Debentures

We often hear about markets coming down and going up, receiving dividends, annual general meetings etc and one of the reasons for all of the above things to happen is shares and debentures. Are there different types of shares and debentures? If yes then what are they called, what is the difference between them, are shares better than debentures, let’s find out answer to all these questions.

Shares

Companies (Private and Public) need capital either to increase their productivity or to increase their market reach or to diversify or to purchase latest modern equipments. Companies go in for IPO and if they have already gone for IPO then they go for FPO. The only thing they do in either IPO or FPO is to sell the shares or debentures to investors (the term investor here represents retail investors, financial institutions, government, high net worth individuals, banks etc). Whether they issue shares or debentures totally depends upon the concerned company.

Shares are the marketable instruments issued by the companies in order to raise the required capital. Shares are issued by each and every company which goes public. These are very popular investments which are traded every day in the stock market and the value of the share at the end of the day decides the value of the firm.

A company when it decides to raise capital from public prepares a memorandum, capital required which is written down in this is called as authorized capital and then prospectus is prepared which is verified by SEBI. SEBI permits the company to raise the capital and as a result company offers it to the public this is known as Issued Capital. Part of the capital issued which is subscribed by public is Subscribed Capital. If the number of subscriptions is more than the number of shares then it is called as over-subscription and if the number of subscriptions is less then it is called as under subscription. The amount paid by the investor is Paid up Capital.

Types Of Shares

The shares which are issued by companies are of two types

  • Equity Shares
  • Preference Shares

Equity Shares

Benjamin Graham one of the most influential and respected investor from America and author of two bestselling books “Security Analysis” and “Intelligent Investor” has said that the investor should not be too worried about the present performance of the stocks in the market and should be bothered about long term. The reason that he gives is that stocks behave like a voting machine in short term and like weighing machine in long term. These sentences are definitely applicable to shares and pretty much define their characteristics. Equity Shares are issued and are traded everyday in the stock market. The returns on the equity shares are not at all fixed. It depends on the amount of profits made by the company. The board of directors decides on how much of the dividends will be given to equity share holders. Share holders can accept to it or reject the offer during the annual general meeting.

Types of Equity shares

The Equity share is a common name, some of the types of equity shares are

  • Blue Chip Shares
  • Income Shares
  • Growth shares
  • Cyclical Shares
  • Defensive shares
  • Speculative shares

Blue Chip Shares


These are the shares of some of the companies which have been doing extremely well in the past few years. These are usually well established companies. The word blue-chip shares came into existence when IBM Company was doing very well and shares of that company were trading at higher prices. The companies which come under this umbrella are never fixed as the performance of some of the companies may suddenly fall down and some of the companies which never did well start to do extremely well. Hence it can be said that list of blue-chip companies keeps on changing each year. The companies which come under this are market leaders and have the potential to dictate terms.

Income Shares


These are the shares of the companies which have stable operations. The companies have a high dividend payout ratio and when the dividends paid are high it implies that the profits saved for company is less and hence less opportunities of growth.

Growth shares


These are the shares of companies which have secured their positions in a particular industry. These shares have less dividend payout ratio and hence high growth potential.

Cyclical Shares


There is a definite business cycle that keeps on operating and these are the shares of that company whose performance varies with the stages of the cycle. It means to say that the prices of the shares are affected by the variations in the economy.

Defensive shares


These are the shares of the company whose performance does not change with the changes in the economy.

Speculative shares


These are the shares which are traded in the company which have a lot of speculations. Shares cannot be put into one category strictly because the characteristics of the shares are overlapping in the sense that the blue-chip shares which are in great demand in the market fall under blue-chip shares and speculative shares.

Further Classification

One more classification of shares is given by one of the most successful and respected investor all around the world Peter Lynch. According to him the shares can be classified into 6 types

  • Slow Growers
  • Fast Growers
  • Stalwarts
  • Cyclicals
  • Turn-around
  • Asset plays

Slow Growers


These are large companies which have the growth rate equal to the industry growth rate or their growth is equal or slightly faster than the GDP (Gross Domestic Product).

Fast Growers


These are shares of newly started successful companies which have a very good growth rate (the rate is usually 10 to 25 percent) per year.

Stalwarts


These are shares of very large companies which have stable growth. The dividend payout ratio is high. These companies are growing but not rapidly as in the case of fast growers.

Cyclicals


These are the shares of the company which is going through the business cycle or there is variation due to economic factors.

Turn-around


These are the shares of the companies which have started performing very well. These companies were fairing badly in the past and all of a sudden there is a turn-around in their performance.

Asset plays


These are the shares of the companies who are not given any recognition though they have a large asset base.

Advantages

  • Equity shares give greater returns if the company makes profits. It is in comparison to debenture holders or preference share holders.
  • There is a tremendous amount of capital appreciation if the shares are of a good performing company.
  • The equity shares are easily transferable.
  • The equity shares are traded at the stock exchanges so they can be bought and sold easily. These can be easily liquidated.
  • The equity share holders have got the right to vote in the annual general meeting.
  • Only the equity share holders have the right to choose the board of directors.
  • Equity share holders have the right to oppose any of the decisions taken by the board of directors. This is what happened when Mr. Ramalinga raju tried to buy Maytas company

Advantages

  • No doubt equity shares have attractive and better returns but in case the firm has not performed well or is going for diversification or is investing in some venture then the profits carried forward will be more and the dividends paid will be less.
  • In worst cases if the company goes bankrupt then it is dissolved. The assets are sold and the money obtained is distributed amongst the stake holders then only if something is left out after it is distributed to debenture holders and preference share holders it is given to equity share holders.

No doubt equity shares have both advantages and disadvantages but the fact is that equity shares are the most sought financial instruments for both investment or for speculation.

Preference Shares

These are other type of shares. The preference shares are market instrument issued by the companies to raise the capital. Preference shares have the characteristics of both equity shares and debentures. Fixed rate of dividends are paid to the preference share holder as in case of debentures, irrespective of the profits earned company is liable to pay interest to preference share holders.

Types of Preference Shares

Preference shares are divided into :

  • Cumulative & Non cumulative shares
  • Redeemable & Non-redeemable
  • Convertible & Non-convertible shares
  • Participating and non-participating

Cumulative & Non cumulative shares


Suppose a company does not make any profits for two successive years and makes huge profits in the third year. Then the people who have cumulative shares will get the interest of the three years and in case of non-cumulative share holders they do not receive the interest of past two years.

Redeemable & Non-redeemable


The redeemable shares are redeemed within the life time of the company or before the company closes down or to say that these shares have a maturity period. In case of non-redeemable shares they mature only upon closing down of the company

Convertible & Non-convertible shares


Classes of shares which can be converted to other forms of shares or securities are called as convertible shares. Whether they are converted to equity shares, debentures depend on the rules laid down by the company. If the shares are not convertible to any other security on their maturity period are called as non-convertible shares.

Participating and non-participating


A company goes bankrupt and is dissolved. Now its assets are sold and liabilities are paid up. First debenture holders are paid then preference share holders and at last the equity share holders. After paying up each one of them still there is some surplus amount left now if the investors have participating preference shares then the surplus amount left will be distributed equally between equity share holders and participating share holders. These are very less preferred in the market because the investor is looking out for long term investment and good returns.

Advantages

  • These yield fixed rate of returns
  • Preference is given compared to equity share holders while distributing the dividends and once the company is dissolved.
  • It’s a hybrid instrument having some of the characteristics of debentures and equity shares.

Disadvantages

  • They do not provide the investor with any of the voting rights.
  • If the company gets huge profits then they won’t get any extra bonus.

Without having a proper knowledge of stocks and debentures it is not advisable to enter stock market. The reason behind, if you build a 100 floor building without having a strong basement, it will lead to the collapse of building at any time. We believe this article will help you to understand the basics of stocks and debentures.

Mr. Shyam

IndianMoney.com Research Associate

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