Chapter 4

Equity

The truth is rarely pure and never simple.

—Oscar Wilde

Shareholders have an equity interest, that is, direct ownership, in the companies whose shares they hold. Share value is determined by the firm's earnings potential, its prospects for paying future dividends, and investors’ subjective valuation of future payoffs. Dividends are paid out of earnings and earnings are related to sales, which, themselves, turn on consumer demand, itself a function of income, relative prices, and sentiment. In this complex environment, reported earnings, especially at the company level, can be quite volatile. Efforts by the firm's managers to smooth the market's assessment of share value during periods of fluctuating earnings is clearly a challenging task in a volatile market, especially during crises such as the credit market collapse of 2008.

While the fates of shareholders are tied inexorably to the anthropology of market dynamics, holders of investment grade bonds are optimistic about their prospects of receiving scheduled coupons. Thus, while bondholders forfeit prospects of bigger gains by not buying shares, they can enjoy the greater certainty of a more modest, yet stable, stream of cash flows. Bondholders are the firm's creditors; they will get paid their promised coupons unless the firm defaults, in which case bondholders will get to divide the remaining value while shareholders go home empty-handed. I discuss the nature of the firm's capital structure as it relates to options theory in Chapter 16. Thus, other things constant, bondholders face relatively less risk. They occupy a higher place in the capital structure than do shareholders, which means that shareholders suffer losses before bondholders. For example, coupons are paid out of available earnings even when things go bad, and dividends may suffer if the firm has no alternative way of paying shareholders. Thus, shareholder expectations are adversely affected in down markets and the return to equity is generally thought to require a premium over bonds so as to induce investors to hold shares, which are inherently riskier than bonds. The excess return to equity over bonds is therefore referred to as the equity risk premium.