The basics of equity

Because the S&P 500 index is sometimes viewed as a surrogate for the performance of the overall US equity market, many people assume that the range of potential equity investment might be limited to only 500 individual companies.

But while these 500 companies do represent more than three quarters of the US's total equity market value, they're only a small fraction of the thousands of companies in the US equity investment universe. An understanding of the equity investment class can help you find opportunity in this vast space.

An overview of stock

Stock represents ownership of a company. In a historical and legal sense, this ownership could be expressed as a portion of the company's net realizable asset value, in other words, a share of the cash that would remain after all assets are liquidated (presumably at fair market value) and all liabilities are satisfied. However, in an investment sense, a company could be seen as a going concern where the whole value of company assets may be greater than the sum of the individual asset parts. From this perspective, shares of stock represent the ownership of portions of the future earnings potential of the firm. This is why projections of future performance can have a significant influence on daily stock trading prices.

Stock may be issued by any company, public or private. However, for an individual equity portfolio investor, only public companies are important.

What is a public company? It's any company whose shares may be bought and sold using regulated brokers, exchanges, and public trading networks. Public companies are expected to adhere to legal requirements for governing themselves and for protecting the interests of passive shareholders. Public companies are also expected to publish periodic reports on their finances and to make that information readily available to actual and potential shareholders.

A private company, by contrast, has its own sets of governance and reporting requirements, and it does not have to reveal its finances on demand to outsiders and cannot issue tradable equity securities.

The common vocabulary of equity

Common stock is the term used to describe shares representing an equity stake in the firm. A common shareholder can only receive a share of annual profits (i.e., dividends) after all bondholders receive their interest payments and other investors and creditors receive any payment preferences they might have been due. Common shareholders also generally have the right to vote in elections determining the company's board of directors.

Some companies issue multiple classes of common stock, generally to give a limited number of shareholders influence over corporate governance well beyond their numbers. This system can allow favored company insiders to retain control of a firm while spreading its economic base. In many cases, the super voting shares trade infrequently, if at all.

Preferred stock is the term used for shares that give their holders a higher claim on any profits or proceeds from asset sales, putting their shareholders ahead of common stockholders, but behind bondholders. Preferred stock does not represent a company debt that must be repaid. It is, rather, a fixed claim on future profits. It does not generally give shareholders any voting rights.

Additionally, some companies may report the existence of restricted stock. This generally represents the holdings of active employees who earned the shares through incentive or employee stock ownership programs. These shares generally have full economic rights to dividends and distributions, but they may be forfeited if regulations are not followed.

Valuation principles and pricing

Investors in equity must consider a number of risks that are unique to these types of securities. Here are some of the widely observed risks that impact broad sections of the market:

  • Market price – The market price of a stock can give you the market's appraisal of the worth of that company at a particular point in time. Price changes are typically driven not only by objectively measurable changes in business conditions and the economic environment, but also by changes in investor emotion.
  • Price-to-earnings ratio – This number, which is derived by dividing the stock price by the company's earnings per share, is used to determine what an investor is paying for the earning power of the company. The ratio can be calculated using either the most recent reported earnings, or an analyst's projection of expected future earnings. It's one figure that can be used in comparing the value of several companies even though their prices may be vastly different.
  • Dividend yield – The dividend yield, determined by dividing the amount of the dividend by the share price, simply indicates what percent return the company is paying its investors. This number can also be used in a comparison of companies.
  • Payout ratio – This figure represents the percentage of earnings a company is paying out to its investors. It's an indication of whether most of a company's earnings are being paid to its investors or whether they are being reinvested in the growth of the company.

Companies can be categorized by their primary business focus, their size, and their level of business maturity. While the basic concepts of equity may apply to all stocks, each of these categories can have unique aspects and different benchmarks. The most actionable analyses should take account of as many of these factors as possible.

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© 2017 by DST Systems, Inc. Reprinted with permission from DST Systems, Inc. The statements and opinions expressed in this article are those of the author. Fidelity Investments cannot guarantee the accuracy or completeness of any statements or data.

Stock markets are volatile and can fluctuate significantly in response to company, industry, political, regulatory, market, or economic developments. Investing in stock involves risks, including the loss of principal.