5 minutes to understanding equity

Equity investing is when you own a share in somebody else’s business. This means that you take the risk that comes with owning a business, but your maximum loss is equal to the amount you have invested. Let us get a better look at this.

Suppose we have a friend, Arun, who makes great pizzas. We —you and I—as friends have told Arun to spin off his talent into a business. This business will cost him Rs 5 lakh, but he has only Rs 3 lakh of his own to invest. Arun does not want a loan since he is unsure when his business will pay back and does not want to pay interest. As friends who know Arun’s skill in pizza making and have trust in his ability to run a business, we offer to give him Rs 1 lakh each. In return Arun gives us a share each in his business. So Arun has three shares in his own business, you have one and I have one.

How can equity grow your money?

There are two ways of making money from equity investments. When the business makes profits, the promoter may share these out proportionately by declaring ‘dividends’. As the profitability of the business grows, other investors in the market will want to buy a share in the business. As demand of such shares goes up, the price of these shares goes up too. Those who sell make a ‘capital gain’. Back to Arun and his Pizza Factory. A year later, Arun’s Rs 5-lakh investment has grown a business that makes a Rs 2-lakh profit. Arun decides to share half these profits with us, the rest he keeps to grow his business. So Arun keeps Rs 60,000 as his share of profit, you and I get Rs 20,000 each. This money is also called dividend. Now, another friend, Vijay, hears about Arun’s business, looks at the profits and wants a share in them. He wants to buy my share. I will sell my share, but at a price higher than I paid because the business is now profitable. So Vijay pays me Rs 1.5 lakh for my one share that had cost me Rs 1 lakh, this extra Rs 50,000 is called my capital gain. I am no longer a share-holder in Arun’s Pizza Factory, Vijay is.

Why do people invest in equity?

Fixed interest investing, that is investing in instruments that give an assured rate of return and then return your original investment, though safe, gives low to moderate returns. Equity investing allows you to earn a higher return, through capital appreciation and dividends, but has a pillion rider called ‘higher risk’. The downside is that you could lose your entire money.

Should you be investing in equity?

Direct equity investing is only for those who understand companies and markets. Else, take the mutual fund route to the stock market. Invest in equity for your long term financial goals. Invest more in equity if you are younger and can take higher risk. Reduce equity exposure as you increase in age or as your risk profile becomes more risk-averse. But remember, sensible equity investing is necessary for growth and to stay ahead of inflation.