Explain the return and risk features of equity securities
The idea
Equity return comes from price appreciation and from dividends, and over long horizons equities have delivered higher real returns than bonds or cash together with much higher volatility and deeper drawdowns. The residual nature of the claim explains both: shareholders are paid last, so they absorb the variability that fixed claims are insulated from. Preference shares are less risky than common because their claim is prior and their dividend fixed, and putable shares less risky than ordinary ones. Risk is a consequence of position in the capital structure, not a property of the label.
Formulas
Holding period return on a share
HPR = (P₁ − P₀ + D₁) ÷ P₀
- P₀
- the price at the start
- P₁
- the price at the end
- D₁
- any cash received over the period
Both sources of equity return in one number, on the money actually put up. Leaving the dividend out understates the return by the dividend yield, which over long periods is most of it.
A practice question
What are the two components of return on an equity security?
- Coupon and principal repaymentWhy not: Those are a bond's contractual payments, and a share has neither.
- Price appreciation and dividends - correct
- Interest and capital gainWhy not: Shares pay dividends at the board's discretion rather than interest under a contract.
A share has no promised payments, unlike a bond. Its total return comes from two parts. One is price appreciation, the change in the share price. The other is dividends, whatever cash the board chooses to pay out. Formula: Total return = (Ending price - Beginning price + Dividends) / Beginning price. Coupon and principal belong to bonds, and interest is a contractual payment, which shares do not have.
A harder one
Tallis Energy has net income before preference dividends of $10.0 million. Its preference shares carry a fixed dividend of $4.0 million a year, which is covered in every scenario. All remaining income belongs to common shareholders. A downturn cuts net income before preference dividends by 30% to $7.0 million. How do the income of preference shareholders and of common shareholders change?
- Preference down 30%; common down 30%Why not: This spreads the loss proportionally and ignores priority. The fixed preference dividend is paid first and stays at $4.0 million.
- Preference unchanged; common down 30%Why not: This applies the 30% fall in total income to common holders alone. They absorb the whole $3.0 million shortfall from a base of only $6.0 million, which is 50%.
- Preference unchanged; common down 50% - correct
Preference holders are paid first and their dividend is fixed. Common shareholders get what is left over. Formula: Common income = Net income - Preference dividend. Before: 10.0 - 4.0 = $6.0 million. After: 7.0 - 4.0 = $3.0 million. Change = (3.0 - 6.0) / 6.0 = -50%. Preference income stays at $4.0 million. Total income fell only 30%, but the whole $3.0 million fall hits the common holders because they are paid last. The residual claim absorbs all the swing.
The hardest tier
Why have equities historically delivered higher real returns than bonds over long horizons?
- Because shareholders are paid for bearing more risk - correct
- Because equity dividends are tax exemptWhy not: Dividends are taxed, and tax treatment varies by jurisdiction and investor, so it cannot explain a general excess return.
- Because bond issuers default more often than equity issuersWhy not: If anything the reverse is true: bondholders rank ahead, so a default hurts shareholders first and does not explain their higher average return.
Shareholders are paid last, and their income swings the most, so investors demand extra return for holding them. This extra is the equity risk premium. Formula: Expected equity return = Bond return + Risk premium. For example, a bond may promise 4% and pay it most years, while a share might return 20% one year and -15% the next. The higher long-run average is the reward for putting up with that swing. It is not guaranteed, and equities have lagged bonds for decades at a time.
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