Characteristics

As one of the most discussed and widely known financial products, stocks dominate the financial news and are consistently tied 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.

The basics

Common stock is a negotiable equity investment that provides freely-transferable (easy to buy and sell) ownership. Negotiable securities are traded in the market between investors, as opposed to redeemable securities that can only be bought or sold with the issuer. If you were to buy Disney stock in the market, you buy those shares from another investor, not Disney the company.

Here’s a quick video detailing the differences between negotiable and redeemable securities:

Shares of common stock rise and fall in price depending on how well a company performs and the demand for its shares in the market. If Coca-Cola has a good business year, Coca-Cola stock (symbol: KO) will likely rise in value due to higher demand for its stock (and vice versa).

The stock market is where stocks are traded between investors; stock prices are dictated by supply and demand. Simply put, prices rise if more investors wish to purchase stock, and prices fall if more investors wish to sell stock. We’ll discuss more about the stock market in the secondary market chapter.

There are two general ways to make money on common stock. First, investors can obtain capital appreciation, also known as growth or capital gains. When an investor purchases stock, it is purchased at a specific price per share.

For example, let’s say Stacy purchases Ford stock (symbol: F) at $10 per share. Stacy invested in Ford because she believes in its products and business model. Over the next few years, the company sells more cars and trucks than expected, and demand for Ford stock increases. With more demand in the stock market, their stock price rises to $25. Stacy sells her shares for $25 per share, locking in a $15 per share profit. This is an example of capital appreciation.

Cash dividends

Issuers may also pay cash dividends to their stockholders. While Stacy holds her Ford shares and watches them rise in price, Ford could pay her a dividend. A cash dividend represents profit made by the company that is then distributed to its shareholders. When a profit is made, companies can do one of two things (or a little of both): retain the profit and reinvest it back into the business, or pass on the profit to their stockholders.

Not all publicly traded companies pay cash dividends. When companies grow, it’s important to retain and reinvest profits back into the business. For example, Amazon (symbol: AMZN) has never paid a dividend to its shareholders. With every dollar the company make in profit, it reinvests those retained earnings back into the business and uses it to expand operations, hire employees, and pursue opportunities in new industries.

Companies like Amazon are known as growth companies, aiming to increase the size of their business operations and profitability. While Amazon is large and well-established, start-ups and small businesses often fall into this category as well. Investments in growth companies provide the opportunity for capital appreciation, but generally do not pay income (dividends) to shareholders.

When a company is towards the end of its growth cycle (when there’s not much more room to expand its operations), it’s more likely to share its profits with shareholders through dividend payments. Companies won’t share all of their profits (they’ll need to pay for their current operations), but will typically share the “excess” not needed.

A company’s Board of Directors (BOD) determines if a dividend will be paid by shareholders. The BOD’s role is to represent the interests of the company’s shareholders and guide the direction of the business. They hire (and can fire) the executive team (e.g. CEO, CFO) and make the “big decisions” that are then executed by company employees. One of those decisions is whether or not a dividend will be paid to shareholders.

For example, Ford has been paying a dividend to shareholders since 1903 (that’s not a typo!). However, Ford’s BOD has suspended its dividend multiple times in the last 100+ years due to declining profits. Most recently, Ford stopped paying dividends due to economic challenges brought on by COVID-19. However, the company started paying dividends again in 2021 after the economy recovered.

Cash dividends represent another form of investment return for an investor. Referring to our previous example (above), Stacy could have made more than her $15 per share profit from capital appreciation. If Ford paid dividends amounting to $1 per share over the time Stacy held her shares, her overall profit is $16 per share ($15 per share from capital appreciation + $1 per share from dividends). However, they are never guaranteed, even if the company has historically paid them for a number of years.

This video should serve as a quick visual guide to the basic characteristics of common stock:

Transferring ownership

The right to transfer ownership, which is one of several rights provided to common stockholders, simply means stockholders can freely sell their shares whenever they want. Some securities aren’t easy to liquidate (sell), but common stock typically isn’t one of them. There are exceptions, including lesser-known or generally unwanted stock that trades in the OTC markets (discussed later). Most of the time, it just takes a few clicks online or a simple call to your broker to cash in stock.

When an investor buys or sells a stock, the transfer agent is responsible for facilitating the trade. The transfer agent is a company that is hired to do several things:

• Transfer ownership from sellers to buyers after trade occurs
• Maintain book of stockholders
• Make dividend payments to stockholders
• Distribute proxies (voting materials) to stockholders
• Keep an accurate count of shares outstanding

When an investor purchases shares of stock, the transfer agent is required to follow a few procedures. First, they redeem the shares of the seller, which means they cancel their ownership. Most securities today are in book-entry format, which essentially means computer databases keep track of who owns what stock. The transfer agent updates their database of owners 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, which displays all of the current shareholders. On the settlement date, the seller is officially removed from the stockholder list, and the buyer is added. Last, the transfer agent will electronically issue shares to the buyer, now registered in their name.

This process will occur over the settlement timeframe of two business days (T+2 / trade date plus two business days ) and is one of the reasons why stock trades don’t happen immediately.

Liquidation priority

A company can be liquidated due to bankruptcy. When a company can no longer fulfill its obligations (debts), it is typically sued by creditors (which includes bondholders) in bankruptcy court. If no agreement can be made between the failed company and its creditors, the company is typically liquidated.

Liquidation is the sale of company assets, which could include buildings, factories, inventory, equipment, and vehicles. The company will attempt to sell everything it can in order to satisfy and pay back its creditors as much as possible. Additionally, the liquidation is meant to serve the stockholders. However, you’ll see why stockholders typically won’t receive compensation when their company goes bankrupt. Here’s the order of payout during a company’s liquidation:

1. Unpaid wages

2. Unpaid taxes

3. Secured creditors

4. Unsecured creditors

5. Junior unsecured creditors

6. Preferred stockholders

7. Common stockholders

When a bankruptcy-related liquidation occurs, companies rarely are able to pay back all of their creditors. When this occurs, there is little to nothing left over 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.