An Overview on Capital Appreciation

Capital appreciation refers to growth in the market value of assets or investments. For most people, the ultimate objective of investing is capital appreciation - buying assets cheap and selling them at a relatively higher price. Capital appreciation can occur in different asset classes such as real estate,mutual fund, commodities, equities, etc. This article provides a detailed analysis of capital appreciation in equity shares.

What is capital appreciation?

There are two forms of returns on equity investments - dividends and capital appreciation. A dividend is the distribution of a company's profits to its shareholders. On the other hand, capital appreciation is an increase in the value of shares while the investor still holds them. Combined, dividend income and capital appreciation give the total return delivered by equity shares.

A company’s stock is not redeemable until its closure. However, equity shares are free to be traded in secondary markets, allowing investors to release their funds from the company at their discretion. This ensures wealth creation in the hands of equity shareholders in the form of capital appreciation which are changes in the stock prices. It does not include any other forms of value, such as income generated through dividends.

Reasons for capital appreciation

Capital appreciation in equity shares is passive and gradual. It can occur due to macroeconomic and microeconomic factors such as:

• Strong economic growth
• Overall sectoral growth
• Demand and supply of the stocks in the market
• Lower interest rates on bonds attract investors towards equity, leading to an increase in the demand for stocks and, in turn, an increase in their value
• Speculative trading
• Improved financial performance of the company, i.e., improved asset fundamentals.

Capital appreciation due to a company's better financial health is considered more sustainable than capital appreciation due to other reasons.

Investors may decide not to record capital appreciation in their books of accounts. This is because the gain is unrealized yet. However, they may choose 'recognize' the gain if accounting principles permit the same.

Capital gain v/s capital appreciation

Capital gain is when investments are transferred (sold, exchanged, etc.), and a profit is realized. In other words, capital appreciation, when realized, is called a capital gain.

Capital gains attract taxes, which usually depend upon the duration for which the stocks were held. Capital appreciation does not have any tax implications. One may say capital appreciation is not taxed until realized. Capital appreciation is simply an indication of the profits that an investor may earn if he chooses to sell the shares at the given moment.

Depreciation

The opposite of capital appreciation is depreciation. Depreciation occurs when the value of investments is eroded over time. For instance, an investor buys shares worth INR 5 lacs. After four months, the market value of shares declines to INR 4 lacs. The value of shares has fallen by INR 1 lac. If the investor decides to liquidate his holding at this point, he will incur a 'capital loss' of INR 1 lac.

Investing for Capital Appreciation

Capital appreciation is the growth in the principal amount invested in a company's stock. It is the ultimate goal of investors seeking long term growth. Investments chosen for capital appreciation are well-suited for risk-tolerant investors. These investments are riskier than assets selected for capital preservation or income generation, such as government bonds or dividend-yielding shares.

In the mutual fund industry, 'growth funds' often invest in capital appreciation funds. These funds invest in young stocks that can grow big and rise in value based on the company's improved fundamental metrics. These companies usually grow quickly, leading to an increase in their worth.

Example of Capital Appreciation

Capital appreciation is calculated by comparing the current market value of shares to the amount paid to buy them (cost-basis).

For example, Mr D bought 10 shares of Company C for INR 100 each. After 6 months, Company C declared and paid a dividend of INR 1 on each of its shares issued which were trading at INR 115 at that time.

Calculating Mr D's return on Company C's shares-

• Capital appreciation (in absolute terms) = INR (115-100) * 10 shares = INR 150

  Dividend income(in absolute terms) = INR 1 * 10 shares = INR 10

  Total return(in absolute terms) = (15+1) * 10 shares = INR 160

• Capital appreciation (%) = (150/ 1000)*100 = 15%

  Dividend yield (%) = (10/ 1000)*100 = 1%

  Total return (%) = (160/ 1000)*100 = 16%

Conclusion

Capital appreciation indicates the increase in an asset's value and gives the equity holder an idea about its current profitability. It is one of the ways to accumulate wealth over time. Along with income from dividends, capital appreciation is part of the total return of an equity investment.