Common Equity and its relevance are often a grey area for many of us. But in today’s economy, it is essential for individuals to know about common equity, its relevance in our economy and why and how do we invest in it.
What is common equity?
Simply put, common equity is the total value of all the common shares that all the common shareholders have invested in a company. This also includes retained earnings, common shares, and additional paid-in capital. Retained earnings mean the portion of the amount which is left with the company after it has distributed dividend to its shareholders and additional paid-in capital referred to the amount that is in excess of a stock’s par value. It is important to note that common equity does not include the preferred shareholder’s equity.
Common equity is an essential indication of preparing a guideline for investors who are looking to invest in a company. It is known as the equity that is being offered to the common shareholders of a corporation. When financial statements are issued by a company, common equity is calculated by subtracting the preferred equity of shareholders from the total equity of shareholders. Common equity is important in determining how lucrative it is for an investor to invest in a company. Using common equity, one can estimate the ratios and projected returns on equity which shows how profitable it is to act as a shareholder in a particular company.
Common Equity = Common shares + Surplus Capital (additional paid in capital)
+ Retained Earnings - Preferred shareholder’s equity
Common shares (stocks)
Two classes of securities are issued by the company, one is common shares (stocks) and the other is preferred shares (stocks). Both of these securities represent a degree of ownership of the investor in a company but they also differ in their own ways. This means that when company profits are distributed, both lenders and preferred stockholders receive their payments before common shareholders do. Common shareholders receive what is called the residual claim of the company''''s assets and income.
Important points to note between common and preferred shareholders are:
Common shareholders have voting rights in the company but preference shareholders do not.
Preference shareholders will receive dividends while common shareholders may or may not receive so.
Preferred shares are not as lucrative as common shares are.
Paid in Capital
When a stock is issued, paid-in capital is the amount of funds that are raised through investors including the par value of the shares. Paid-in capital includes the funds raised from equity but not the ones from the ongoing operations. It includes all the funds that are raised from the equity except preferred equity.
Retained Earnings along with paid-in capital makes up common equity. These are the earnings that are held back by the company and are later reinvested in the company or are paid off as debts rather than dividends.
Return on Common Equity
Return on Common Equity refers to the profit on equity that investors get from the company.
ROCE is different from ROE (Return on Equity). In ROCE, the company sees the return on solely common equity rather than the total returns that the company generates from all its equity. By that, we mean that ROCE excludes the returns from preferred equity making it more conducive for common equity investors.
Return on Equity is important because it isolates the returns from common equity. It is used to evaluate the dividends and the management’s use of capital. Investors use ROCE to assess the probability and the size of dividends the company may payout in the future. The higher the ROCE, the higher is the profits from its equity investments and more is the likelihood of dividend payouts. A high ROCE also suggests how well the company is managing its capital by investing in NPV projects thus creating higher value for its shareholders.
Return On Common Equity = Net Income/Average Common Equity
Why is Common Equity important?
Common equity is important due to quite a few reasons. Return on Common Equity is an indication for potential common shareholders to analyse how profitable it is to invest in the company. Knowing the ROCE amount gives them a precise idea of the returns received by common shareholders when preferred shareholders are not taken into account. Often an employee’s compensation package includes the buying of their own organisation’s common shares. This boosts their motivation causing them to work harder. Common equity is also beneficial to startups to attract experienced people on affordable salaries. In fact, common equity is ideal in providing an incentive to employees and founders alike to work harder as success will result in higher common equity shareholdings.
How to invest in Common Equity?
You can invest in common equity either by enlisting the services of a broker, a brokerage firm, or directly from the company.
If you go the broker route, you will be required to choose your broker. For you to choose your broker, you need to consider some important things like the brokerage fees involved and how easily available your broker is. You may need to contact your broker urgently on short notice to complete sales or investments and thus they should be easily available to you and responsive. Subsequently, you will be required to open a brokerage account.
If you wish to buy common stock directly, you can visit the Investor Relations page of the company you want to invest in and follow the steps as mentioned to buy the stock. The other available option is to buy the stock if available from an exchange agent.
If you want to invest in common equity and are looking for the right broker to choose and trust, look no further than LKP Securities Ltd. LKP Securities is an old and trusted firm that is renowned for the services they provide. In case of any further doubts and questions regarding common equity and how you can invest in them, you can easily get in touch with our customer care executives.