Lesson 1 of 7 · All lessons in this module
- Equity versus debt, why companies issue shares, and equity in global markets
- Equity instruments: shareholder rights, the residual claim and equity cash flows
- Preference shares: cumulative, participating and convertibleVideo lesson
- Preference share contingencies: upside, downside, and how preference sits between debt and common
- Publicly listed versus private companies: why list, who stays private, and how the two differ
- Private versus public equity: venture capital, buyouts and PIPEs
- Private equity across the company life cycle: venture, growth, buyout, special situations and PIPE dilution
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Lesson 1 of 7 · 11 min
Equity versus debt, why companies issue shares, and equity in global markets
Equity is a residual ownership claim with no promised payments, which is why it carries more risk than debt, has historically earned more, and gives companies flexible capital to grow.
In short
- Debt is a liability with contractual interest and principal; equity is not a liability and promises nothing. Shareholders hold the residual claim on assets after all liabilities are paid.
- Equity investors seek total return (price appreciation plus dividends); bond investors holding to maturity seek interest income.
- Companies issue equity in the primary market to raise capital and gain liquidity, which also gives them a 'currency' for acquisitions and stock-option pay.
- Capital is mostly used for long-lived assets, expansion, R&D, new products or regions and acquisitions; sometimes it is raised just to stay a going concern (regulatory capital, debt covenants).
- Over more than a century, equities earned clearly higher real returns than government bonds and bills, which roughly kept pace with inflation; the higher return compensates for higher risk and volatility.
- The ratio of equity market capitalisation to GDP is a rough gauge of whether a market looks under- or overvalued relative to its own history.
Debt or equity: two ways to finance a company
A company can finance itself by borrowing or by selling ownership. Debt is a liability: the company must pay interest and repay the principal on fixed dates, whether business is good or bad.
Equity is not a liability. The company never has to repay what shareholders paid in, and it owes them no periodic payment. In exchange, shareholders own whatever is left after creditors are paid: the residual claim on the company's net assets. That residual claim is what makes them owners.
Because nothing is promised, equity investors look for total return: capital appreciation plus any dividends. They expect management to run the company to maximise the market value of the shares, that is, shareholder wealth.
Companies issue two kinds of equity: common shares (also called ordinary shares or common stock) and preference shares (preferred stock). The next two lessons cover each.
| Debt | Equity | |
|---|---|---|
| Liability of the company? | Yes | No |
| Must the money be repaid? | Yes, at maturity | No |
| Periodic payments | Contractual interest | Discretionary dividends |
| Claim in liquidation | Ahead of equity | Residual: what is left |
| What investors seek | Interest income | Total return (price gain + dividends) |
Why companies issue equity
Companies sell new shares in the primary market to raise capital and to increase liquidity. Once shares trade, the company also has an extra 'currency': it can pay for acquisitions with its own shares and reward employees with stock options.
The main purpose of the capital is to fund activities that generate revenue and net income, and so raise shareholder wealth. Typical uses are long-lived assets, capital expansion, research and development, entry into new products or regions, and buying other companies.
Sometimes a company is forced to raise equity just to keep operating as a going concern: to meet regulatory capital rules, improve capital adequacy ratios or stay within debt covenants. This is a necessity, not the usual goal.
Issuing equity to raise ROE is a classic wrong answer. More equity means a bigger denominator; ROE only rises if the new money earns enough net income.
Equity in global markets
Analysts compare a market's total market capitalisation (share price × shares outstanding, summed over all listed firms) with the country's GDP. A ratio far above its long-run average hints at overvaluation; far below hints at undervaluation. It is only a rough indicator.
The US equity market is large relative to the US economy: it has made up roughly half of world market capitalisation in older data (nearer 40% in recent data) while producing about a quarter of world GDP. As markets elsewhere develop, their share of world capitalisation is expected to move closer to their share of GDP, so equities must be analysed globally.
Rankings of exchanges depend on the yardstick: market capitalisation, value traded and number of listed companies give different orders.
Over the very long run (1900 onwards), world equities earned real returns of roughly 5% a year, against about 2% for government bonds and under 1% for bills. Bonds and bills roughly kept pace with inflation. Equities earned more because they are riskier and more volatile, which fits the idea that return rises with risk.
Willingness to own shares also differs across countries: the share of adults owning equities directly or through funds varies widely and has fallen in several countries during volatile periods.
Formula
- Market capitalisation
A market's total capitalisation is the sum over all listed companies; comparing it with GDP gives a rough valuation gauge.
Worked examples
Example 1 Classifying the claim
Brenna Foods has EUR 400m of bank loans and EUR 250m of shareholders' equity. A drought cuts profits sharply and the board skips this year's dividend and the scheduled loan interest. Which of the two missed payments is a default?
Example 2 Which reason for issuing equity?
Three issuers raise new equity: (1) Corvo Biotech to fund a new lab, (2) Lindqvist Bank because its capital ratio fell below the regulatory minimum, (3) Arden Media because a lender requires a lower debt-to-equity ratio. Which is the normal, primary goal of raising equity, and which are going-concern cases?
Example 3 Reading market cap to GDP
Country X has listed companies worth USD 1.8 trillion and GDP of USD 1.5 trillion. Its long-run average market cap to GDP is 0.9. What does this suggest?
On the exam
Expect concept items: equity is not a liability and dividends are not obligatory; which reasons for issuing equity are primary; and that equities have historically earned more than bonds and bills because they are riskier.
- Saying a company is obliged to pay dividends on common shares. It is not; only debt payments are contractual.
- Listing 'to increase return on equity' as a reason to issue shares. New equity raises the denominator of ROE.
- Treating 'stay a going concern' as the main goal of raising equity. It is a forced, occasional reason.
Check yourself
Q1Which of the following is least likely a characteristic of common equity?
Q2A company issuing new common shares in the primary market is least likely to be seeking to:
Q3Compared with debt investors who hold to maturity, investors in equity securities are primarily seeking:
Q4Over long periods, the real returns on government bonds and bills have most likely:
Q5Which of the following is least likely a primary use of capital raised by issuing equity?
Answer the 5 questions: +10 XP for each one you get right first time.
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