Two kinds of capital
Before the vocabulary, the choice every business makes. Capital comes as equity or as debt, and the two behave nothing alike.
| Equity | Debt | |
|---|---|---|
| How long the money stays | As long as the business needs it | Returned after a specified time |
| Return to the investor | No fixed annual return | Fixed rate of interest, principal back at maturity |
| Who the investor is | An owner | A lender |
| Role in management | Participates | None |
| Claim on profits | Everything left over: the residual | Only the interest and the principal |
| Character | Risky, long-term, growth-oriented, volatile, no assurance of return | Lower risk, steady, income-oriented, as long as the borrower stays solvent |
A business borrows at 12% and earns 14% on the assets it bought with the loan. The lender gets 12%, as promised. The extra 2% belongs to the equity holders. Now the assets earn only 10%. The lender still gets 12%; the equity holders must give up part of their own return to make up the difference. If the business fails outright, the lenders may recover something from the assets and the equity holders usually recover nothing.
Investors who want lower risk and will accept a lower, stable return choose debt. Those who want more return cannot usually get it without taking on equity's risk. Most people allocate between the two according to expected return, horizon, risk appetite and needs. The rest of this chapter is the vocabulary each side uses.
Face value: the number printed on the share
The face value is the nominal price of a share. Multiply the number of shares issued by the face value and you have the company's equity share capital: one lakh shares of face value 10 make share capital of 10 lakh. Shares can be issued at face value (at par), above it (at a premium) or below it (at a discount).
Face value normally never changes. The exceptions are a split, which lowers it, and a consolidation, which raises it. Split one share of face value 10 into five and each new share has face value 2; the holder of one share now holds five.
A 30% dividend on a share of face value 10 is 3 rupees a share. The same 30% on a share of face value 2 is 60 paise. The market price is irrelevant to the calculation. Questions routinely quote a market price alongside the percentage to tempt you into applying it to the wrong base.
Book value: what the accounts say a share is worth
Book value is the net worth of the company, and book value per share is net worth divided by the number of shares outstanding. In plain terms it is the theoretical amount each share would receive if the company were wound up and every asset fetched exactly its book value.
The balance sheet lists assets at book value, meaning cost less depreciation. What they would actually fetch is never known with certainty. If every asset converted to cash at book value and every liability were paid in full, what remained for shareholders would equal net worth: equity plus reserves. Whether the company can actually meet its liabilities depends on what the assets really realise.
Market value and replacement value
Market value is simply the market price of the share. Multiply it by the total number of outstanding shares and you have market capitalisation, the subject of the next topic. The market price depends on the company's expected performance, market sentiment, liquidity and much else.
Replacement value is the market value of all the company's assets today: what a new company would have to spend to set up the same plants and infrastructure that the existing company already has.
Intrinsic value: what it is really worth
The intrinsic value of an asset is the present value of the free cash flows it is expected to produce. Warren Buffett's version, quoted in the syllabus, is the discounted value of the cash that can be taken out of a business during its remaining life. For a share, it is the discounted value of the future benefits to the investor.
Discounting needs a rate, and the rate is what turns a stream of future cash into one intrinsic value today. The appropriate rate is the investor's required rate of return, adjusted for the nature of the business and its particular risks. Later chapters build that rate; for now, know that a different rate produces a different intrinsic value from the same cash flows.
Equity investing requires identifying and exploiting inefficiencies, and the syllabus is explicit that it is not amenable to mathematical formulation. The same cash flows and a different discount rate give a different answer, and what is being priced is the unknown future of the company. Making these evaluations correctly and consistently is hard, which is why judgement sits at the centre of the work rather than a formula.
Equity investing, in this framing, is estimating a share's intrinsic value and deciding what price to pay today to earn that value in the future. Which sets up the comparison the exam loves.
The goal of an investment strategy is to buy undervalued shares and sell overvalued ones. Doing that correctly and consistently is hard, because what is being priced is the unknown future of the company. Qualitative judgements about management, marketing strategy and financing capability make equity investing an art as much as a science, and the market where these estimates meet is a social system shaped by the behavioural and cognitive limits of people acting in groups.
- Equity is owner's capital: permanent, no fixed return, residual profits, a say in management, high risk and high potential return. Debt is lender's capital: returned at maturity, fixed interest, no residual claim, no management role, lower risk.
- Face value is the nominal price; share capital equals shares times face value; dividends declared as a percentage are a percentage of face value; a split lowers face value and a consolidation raises it.
- Book value per share is net worth (capital plus reserves) divided by shares outstanding, the theoretical payout per share if assets realised their book values. Market value is the price; replacement value is what the assets would cost to build today.
- Intrinsic value is the present value of expected free cash flows. Intrinsic above market means undervalued; intrinsic below market means overvalued. The strategy is to buy the first and sell the second.