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Risk and return characteristics of equity securities

Different equity securities have different risk and return characteristics depending on their features such as whether they are plain-vanilla, callable, putable, whether they pay dividends, etc.

Return characteristics of equity securities

The total return of regular equity securities has two components: price appreciation and dividend income. In case of mature companies which pay dividends, total returns are calculated as follows:

$$ Total Return = \frac{P_t-P_{t-1}+D_t}{P_{t-1}} $$

Where Pt is the new stock price at the end of the current period, Pt-1 is the stock price at the end of the last period and D is the dividends declared during the current period.

Growth companies typically do not pay dividends because they have enough profitable reinvestment opportunities in which case total return equals price appreciation, i.e. Dt is 0 in the above formula.
Investments in depositary receipts or foreign equities have another component of return which emanates from the foreign exchange gain or loss.

Risk characteristics of equity securities

The risk of equity securities depends on the volatility of its total return (i.e. price appreciation and dividends). It is measured by calculating its standard deviation. One way to calculate the expected return and standard deviation is to base it on the historical average. Another method is to work out the probability distribution and use it to work out expected return and standard deviation.

Comparison of risk level of preference shares and common shares

Preference shares have lower risk than common shares because (a) preferred dividends are fixed and they form a larger portion of total return in case of preference shares, (b) preference shares rank above common shares in their claim on earnings, and (c) in event of liquidation, preference shares have senior claim on net assets. Common shares, on the other hand, have riskier cash flows because a major portion of total return comes from price appreciation, which is riskier and even where they earn dividends, those are paid only when preferred dividends have been paid. Further, common shares have the last claim on any liquidation proceeds.

Risk characteristics of putable shares and callable shares

Putable shares have a lower risk than callable or non-callable shares because they can be sold back to the issuer if the stock price falls below a threshold. This is why putable shares have lower dividends. Using the same logic, callable shares have greater than non-callable shares. Generally, the better earnings and cash flows that a company has, the lower risk its securities have. Similarly, cumulative shares have a lower risk (and hence lower dividends) than non-cumulative shares.

by Obaidullah Jan, ACA, CFA on Tue Feb 18 2020

This article can help you prepare for Reading 39 LOSe.

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