Equity as an asset class #1 – The basics

With this post, I am starting a new series on Equity as an asset class. Over the past few years I have got to realize that the amount of misconception that is there about this asset class is staggering. Some people think it is the only thing to invest in and that there are no risks at all. Many others avoid it with almost pathological hatred, thinking that equity investing is similar to gambling. Yet others, think that equity Mutual funds are completely separate from stocks etc.

Let us first try to understand equity with a very simple example. We are talking about a bright person X who has just passed out of his MBA course from a top institute. He has a bright idea of starting up an e-commerce venture as he does not want to get into a regular job. He is having 10 lacs with him and he puts that into his venture called E-coaching. The business model is to offer online coaching and mentoring for aspirants of different types of competitive exams. X feels that with the current situation in India his company will do very well. Note that in the beginning ALL the money that is in the venture belongs to X and therefore he owns 100 % equity in the company. In simple words Equity can be treated as ownership.

After 1 year goes by E-coaching is quite successful and is making good profits. However X needs to hire a larger office, more people, spend on marketing expenditure and participate in some exhibitions etc. He needs extra funds to be brought into the company for this and at first looks into his own set of friends and relatives. They are willing to invest in E-coaching as they see it being a successful venture and believe in X. Now X is able to get another 20 lacs from his sources. Note that this extra money now pushes total capital in the company to 30 lacs. However, X may still own about 60 – 70 % of the company. This is because people starting initially take the maximum risk and so people coming in at a later date need to put a much higher premium to acquire the shares of the company.

The third stage will be when E-coaching still needs more funds for expansion purposes. This could be used in several ways to boost the prospects of the company. Having already tapped his known sources, X now has to go to professional Venture capital firms to request their participation. Based on the success of his venture there will be VC interest in his company and X needs to negotiate on how much money they bring in and what proportion of equity will be due to them. The capital of the company will obviously now be in tens of crores, but X will still own a reasonable part of it.

With the passing years E-coaching will need more funding and this can be done through more VC funding. Another option, however, is to take the company public. Here E-coaching is offering to sell shares to the general public and giving them an opportunity to be part owners of a successful company. People who invest their money in the Initial Public Offering ( IPO ) will be the first set of people outside the promoters and VC to own part of E-coaching.

After the IPO is over E-coaching will list in the markets like BSE and NSE. The price of the shares will be a function of demand and supply that we will talk of in a later post. The key issue now is that the shares are available in the secondary market and most of us can buy them directly now. The price of the shares at which we buy and the subsequent changes will depend on how E-coaching does, how the industry is looking, the Indian economic situation and other global factors.

A fund manager from one or more Mutual Fund schemes may also be interested in investing in E-coaching as an upcoming company. If that is done and you invest in that particular MF scheme then you too will become an owner of that company, although in an indirect manner.

Once you are an owner or you have Equity / Shares in the firm, you need to understand that it is a financial asset for you and will rise or fall in value like any other asset. Understanding how this takes place is critical to your financial welfare and we will get to this and much more in the next posts of the series.

Advertisements

4 thoughts on “Equity as an asset class #1 – The basics

  1. now that’s a called a pragmatic example of explaining the concept. every layman should read your blog. Please also enlighten us on stock picking and valuation.

    Like

  2. Hello sir,

    I really thank you for writing such good blogs for free.

    I have one suggestion. As you are writing blogs in a series, request you to add a feature to have links of previous, next blog in the series so that it will be easy to navigate.

    Like

Leave a Reply

Fill in your details below or click an icon to log in:

WordPress.com Logo

You are commenting using your WordPress.com account. Log Out / Change )

Twitter picture

You are commenting using your Twitter account. Log Out / Change )

Facebook photo

You are commenting using your Facebook account. Log Out / Change )

Google+ photo

You are commenting using your Google+ account. Log Out / Change )

Connecting to %s