As one of the most widely discussed financial products, stocks dominate financial news and are often linked to the overall performance of the economy. There are two types of stock: common stock and preferred stock. We’ll focus on common stock in this chapter.
Common stock is a negotiable equity investment that provides freely transferable ownership (it’s generally easy to buy and sell). Negotiable securities trade in the market between investors, unlike redeemable securities, which can only be bought from or sold back to the issuer.
For example, if you buy Disney stock in the market, you’re buying shares from another investor - not from Disney.
Here’s a quick video that explains the difference between negotiable and redeemable securities:
Shares of common stock rise and fall in price based on (1) how well the company performs and (2) investor demand for its shares. If Coca-Cola has a strong business year, Coca-Cola stock (symbol: KO) will likely rise in value because more investors want to buy it (and the opposite can happen if demand falls).
The stock market is where stocks trade between investors, and stock prices are dictated by supply and demand. In plain terms:
You’ll learn more about how this works in the secondary market chapter.
There are two general ways to make money on common stock. First, investors can earn capital appreciation, also called growth or capital gains. When you buy stock, you pay a specific price per share.
For example, suppose Stacy purchases Ford stock (symbol: F) at $10 per share because she believes in the company’s products and business model. Over the next few years, Ford sells more cars and trucks than expected, and demand for Ford stock increases. As demand rises, the stock price increases to $25. Stacy sells her shares for $25 per share, locking in a $15 per share profit. That $15 increase is capital appreciation.
Issuers may also pay cash dividends to stockholders. While Stacy holds her Ford shares, Ford could pay her a dividend.
A cash dividend is a portion of company profits distributed to shareholders. When a company earns a profit, it generally has two choices (or it can do a mix of both):
Not all publicly traded companies pay cash dividends. Companies that are still expanding often keep profits to fund growth.
For example, Amazon (symbol: AMZN) has never paid a dividend to its shareholders. Instead, it reinvests profits as retained earnings to expand operations, hire employees, and pursue opportunities in new industries.
Companies like Amazon are often described as growth companies because they focus on increasing the size of their operations and profitability. Investments in growth companies may offer capital appreciation, but they generally don’t provide income (dividends) to shareholders.
When a company is closer to the end of its growth cycle (meaning there’s less room to expand), it’s more likely to share profits with shareholders through dividends. Even then, companies typically don’t distribute all profits - they still need cash to run the business - so dividends usually come from profits not needed for operations.
A company’s Board of Directors (BOD) decides whether a dividend will be paid. The BOD represents shareholders’ interests and helps set the company’s direction. It hires (and can fire) the executive team (e.g., CEO, CFO) and makes major decisions, including whether to pay dividends.
For example, Ford has paid dividends to shareholders since 1903 (that’s not a typo!). However, Ford’s BOD has suspended the dividend multiple times over the last 100+ years when profits declined. Most recently, Ford stopped paying dividends due to economic challenges brought on by COVID-19. The company then started paying dividends again in 2021 as conditions improved.
Cash dividends are another potential source of return. Going back to Stacy’s example, she could earn more than the $15 per share from capital appreciation. If Ford paid dividends totaling $1 per share while she held the stock, her total profit would be $16 per share ($15 from price appreciation + $1 from dividends). Dividends are never guaranteed, even if a company has paid them consistently in the past.
This video provides a quick visual guide to the basic characteristics of common stock:
One of the key rights of common stockholders is the right to transfer ownership. This means you can generally sell your shares whenever you want.
Some securities aren’t easy to liquidate (sell), but common stock typically is. There are exceptions, such as lesser-known or unpopular stocks that trade in the OTC markets (discussed later). Most of the time, selling stock is as simple as placing an order online or calling your broker.
When an investor buys or sells stock, the transfer agent helps facilitate the change in ownership. The transfer agent is a company hired to handle several tasks:
When an investor purchases shares of stock, the transfer agent follows a few steps. First, it removes the seller’s ownership. Most securities today are held in book-entry format, meaning ownership is tracked electronically rather than with paper certificates. The transfer agent updates its records by canceling the seller’s ownership.
Next, the transfer agent adds the buyer to the list of stockholders. The transfer agent maintains an electronic book of ownership that shows the current shareholders. On the settlement date, the seller is officially removed from the stockholder list and the buyer is added. Finally, the transfer agent electronically issues the shares to the buyer, now registered in the buyer’s name.
This process occurs over the settlement timeframe of one business day (T+1 / trade date plus one business days ) and is one reason stock trades don’t settle immediately.
A company can be liquidated due to bankruptcy. When a company can no longer fulfill its obligations (debts), it’s typically sued by creditors (including bondholders) in bankruptcy court. If the company and its creditors can’t reach an agreement, the company is often liquidated.
Liquidation means selling company assets, which can include buildings, factories, inventory, equipment, and vehicles. The goal is to raise cash to repay creditors as much as possible. Any remaining value would then go to stockholders. In practice, you’ll see why stockholders typically receive little or nothing in bankruptcy.
Here’s the order in which claims are generally paid during a company’s liquidation:
Unpaid wages
Unpaid taxes
Secured creditors
Unsecured creditors
Junior unsecured creditors
Preferred stockholders
Common stockholders
When a bankruptcy-related liquidation occurs, companies rarely repay all creditors in full. When that happens, there’s usually little to nothing left for stockholders. In most cases, stockholders receive no compensation in bankruptcy.
There can be some confusion from the order of unpaid wages & taxes vs. secured creditors depending on the source of information. Secured creditors have first rights to the collateral backing the loan. If the collateral backing the loan is liquidated and does not cover the loan balance, the liquidation priority above applies.
To demonstrate this, assume a secured creditor is owed $1,000, and $100 of wages and $100 of taxes are outstanding. If the collateral backing the secured loan is liquidated for a total of $600, all goes to pay back the secured creditor, bringing their loan balance down to $400. Now, the rest of the company’s assets are liquidated for a total of $500. $100 goes to unpaid wages, $100 goes to unpaid taxes, and the remaining $300 goes to the secured creditor. This leaves the secured creditor with $100 unpaid.
The order of unpaid wages & taxes vs. secured creditors is not a heavily tested concept. Questions on the priority of creditors (bondholders) vs. equity holders (stockholders) are much more common on the exam.
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