Welcome to our 3-part series on investment instruments! In this first part, we will introduce you to the world of Equity investing.

Introduction

Investing in equity means buying shares of a company, essentially becoming a part-owner.

Picture a video game development company needing funds to create an exciting new game. To raise money, the company can either borrow from the bank, or offer a portion of ownership of the company to investors in exchange for funding. Investors can buy this portion of ownership as shares. When you as an investor buys shares, you’re investing in the company’s success. To start off our 3-part series on Investment Instruments, we will focus on the latter, which is known as equity.

There are two ways that equity investors can earn money – dividends and capital gains.

If the game does well and the company makes profits, they may distribute a portion of those profits to investors. This is known as dividends.

If the company is successful, more people might want to buy more shares, causing the share price to increase. Investors that sell their stock at a higher price than what they bought it for benefit from capital gains. Note that the value of shares can fluctuate – if the game disappoints, share prices may drop and investors may lose money. Hence, investing in equity comes with risks and should be performed with due diligence.

Let’s explain dividends and capital gains in depth.

Dividends

Dividends are payments that some companies distribute to their shareholders from their profits. These payments are typically made on a regular basis, such as quarterly or annually. When you own shares of a company that pays dividends, you receive a portion of those dividends based on the number of shares you own. For example, if the game company pays a $1 dividend per share and you own 100 shares, you would receive $1×100 shares=$100 in dividend income. Dividend income can provide a steady stream of cash flow for investors.

There are commonly 2 ways to identify firms that pay higher dividends: Dividend Yield and Dividend History. Dividend yield is like an interest rate indicating how much you might earn from a stock in dividends relative to its price. For instance, if your game company provides a 5% yield and you own $100 of that stock, you’d expect to receive $100×5%=$5 in dividends over a year.

However, it’s crucial to approach very high yields with caution as this might be unsustainable – companies with financial distress may offer higher yields in compensation for the higher risk involved.

Additionally, it’s beneficial to examine a company’s dividend history. A consistent record of paying or even increasing dividends over the years is a positive sign. Companies with a longstanding history of consistent dividends are often termed “dividend aristocrats”. However, always remember, a stock’s past performance does not guarantee future results.

Capital Gains

Capital gains are profits earned from the increase in the value of your stocks over time. A stock’s value can be significantly influenced by a company’s earnings and the news surrounding it. Referring to the game company, if the game company reports increasing earnings, it’s generally perceived as more valuable, often leading to a rise in its stock price as more investors buy it.

Simultaneously, any positive news about the company, such as successful product launches, upbeat earnings reports, or ambitious expansion plans, can generate heightened interest among investors and further elevate the stock price. When you buy shares at a certain price and sell them at a higher price, the difference is your capital gain. If you buy a stock from the game company for $50 per share and sell it later for $70 per share, you have a $20 per share capital gain, or $20/$50=40% gain in capital.

So how do we identify which companies have potential to generate capital gains? Investors use a combination of technical analysis and fundamental analysis tools to evaluate companies.

Technical analysis involves the use of tools such as moving averages and the relative strength index (RSI) to gain insights into market trends and momentum. Quantitative researchers often specialize in technical analysis to make informed investment decisions.

Fundamental analysis, on the other hand, delves into not only a company’s business model and financial statements but also compares the company against its peers in the industry to better understand its relative valuation. There are several key indicators that equity investors often use to analyze companies:

Indicator	Description	Interpretation
Price-to-earnings (P/E) ratio	Assesses a stock's relative value based on its earnings.	High P/E ratio means investors are willing to pay more now as they are expecting higher future earnings growth. Low P/E ratio could mean that the stock is undervalued, or there are concerns about future growth.
Return on Equity (ROE)	Measures a company’s profitability by comparing net income to shareholders’ equity.	High ROE indicates that a company efficiently utilizes its equity to generate profits.
Price-to-book (P/B) ratio	Gauges the relationship between a stock's current market price and its book value.	P/B ratio > 1 suggests that stock may be trading at a premium, potentially indicating investor confidence in the company’s assets.
Debt-to-equity (D/E) ratio	Shows the company’s financial leverage and risk.	High D/E in comparison to peers suggests higher financial leverage and potentially greater risk.

Calculation of Returns

To calculate the total percentage return of equity, you need to consider both capital gains (or losses) and any income from dividends. The formula for calculating the total percentage return of equity is:

Total Percentage Return (%) = [(Ending Value – Beginning Value + Dividends) / Beginning Value] * 100

Let’s say you invested $100 to buy stocks from the video game development company at the beginning of the year. At the end of the year, your investment has grown to $120, and you received $5 in dividends during the year.

Total Percentage Return = [($120 – $100 + $5) / $100] * 100

Total Percentage Return = [($25) / $100] * 100

Total Percentage Return = 25%

In this case, you have earned a 25% annual return!

Tips for First Time Investors

Investors often choose to allocate a portion of their portfolio into equity due to the potential for higher returns compared to investing in bonds or putting money into a savings account. Some investors also enjoy regular streams of income from companies that pay stable dividends. When investing, it is always crucial to understand your risk profile and investment goals before choosing your investments.

For beginners, it is generally advisable to begin with companies that are easy to comprehend. Focus on analysing businesses that have a well-established track record and have a history of consistent performance. Here are some qualities to consider for your investments:

Qualities	Description
Dividend-Paying Companies	Companies that pay dividends can provide a steady income stream, which can be appealing to beginners. Look for companies with a history of consistent or growing dividends.
Diverse Revenue Streams	Companies with revenue coming from multiple sources or geographic regions may be more resilient in economic downturns.
Profitable and Growing	Look for companies that have a history of profitability and potential for future growth. Positive earnings and revenue growth can be good indicators.
Strong Management	Research the company's leadership team. Competent and ethical management is crucial for a company's long-term success.

Final Words

Remember, investing in stocks carries inherent risks, and there are no guarantees of profit. Therefore, it is crucial to start small, gain experience, and continue learning as you build your investment portfolio. Cultivating emotional discipline and refraining from making hasty decisions especially during market fluctuations is of paramount importance.

Keep updated on our blog for the second part of the Investment Instruments 101 series!

If you are keen to learn more, do join us in NUS Investment Society to learn more about this dynamic and exciting field of investing!