As one of the most discussed and widely known financial products, stocks dominate financial news and are often linked to the economy’s overall performance. There are two types of stock: common stock and preferred stock. This chapter focuses on common stock.
Common stock represents ownership in a company (the issuer). If you “go long” (buy) one share of stock in a company like Coca-Cola, you become a stockholder - an owner of Coca-Cola.
Of course, one share is usually a very small slice of the company. For context, Coca-Cola has over 4 billion shares outstanding. Many companies have millions or billions of shares outstanding, and those shares collectively represent the company’s ownership. Because common stock represents ownership, it’s called an equity security.
Common stock prices rise and fall in the stock market based on supply and demand. Most of the time, demand is influenced by the company’s success. If Coca-Cola has a strong business year, investors may want to buy more of its stock, increasing demand and pushing the price up (and vice versa).
Put simply:
You’ll learn more about how the stock market works in the next chapter.
There are two general ways to make money on common stock:
Capital appreciation happens when you buy stock at one price and later sell it at a higher price.
For example, Stacy purchases Ford Motor Company stock at $10 per share. She invests 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. As demand rises in the stock market, Ford’s stock price increases to $25. Stacy sells her shares and locks in a $15 per share profit. This is capital appreciation.
Issuers may also pay cash dividends to their stockholders. A cash dividend is company profit distributed to shareholders.
Not all publicly traded companies pay cash dividends. Many companies - especially those focused on growth - keep profits inside the business so they can reinvest and expand. For example, Amazon has never paid a dividend to its shareholders. Instead, it reinvests those profits (its retained earnings) to expand operations, hire employees, and pursue opportunities in new industries.
Companies like Amazon are often described as growth companies. Their goal is to increase the size of their operations and profitability. Investments in growth companies may offer capital appreciation, but they generally do not provide income (dividends) to shareholders.
When a company is closer to the end of its growth cycle - meaning there’s less room to expand operations significantly - it’s more likely to share profits with shareholders through dividends. Companies typically won’t distribute all profits (they still need to fund ongoing operations), but they may distribute the “excess” that isn’t needed.
Ford Motor Company is an issuer with a long history of paying cash dividends. Going back to the example above, Stacy could have earned more than her $15 per share profit 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 capital appreciation + $1 from dividends).
To receive a dividend payable by a company, investors must purchase shares before the company pays the dividend. You’ll work through dividend timelines later in this unit.
This video provides a quick visual guide to the basic characteristics of common stock:
Common stockholders are partial owners of the company they invest in. That ownership comes with certain rights, including some influence over major company decisions. In general, the more shares you own, the larger your ownership percentage, and the more voting power you have.
As owners of the company, common stockholders have many rights, which include:
As discussed above, some common stock issuers pay cash dividends to their shareholders. This is especially common for large, well-established companies like Coca-Cola. In fact, Coca-Cola is known as a “dividend king,” meaning it has paid at least 50 years of annually increasing cash dividends to shareholders.
Stockholders do not vote on whether dividends are paid; that decision is made by the Board of Directors (discussed below). However, if the board declares a dividend, shareholders have the right to receive their pro-rata share. For example, someone who owns 5% of an issuer’s stock will receive 5% of the dividends paid.
You’ll go deeper into analyzing cash dividends later in this unit. For now, here’s a short video on the types of companies that tend to pay them:
Stockholders don’t manage an issuer’s day-to-day business operations. Instead, they influence major decisions by voting for the individuals who serve on the board of directors (BODs).
The BODs set the company’s general direction through actions such as:
This is similar to a democratic republic in the United States. U.S. citizens don’t directly create or change laws, but they vote for the politicians who do. If elected officials aren’t performing well, voters can replace them. Stockholders function similarly: they don’t run the issuer’s business, but they can vote in (and vote out) the people responsible for major corporate decisions.
While the BOD isn’t responsible for day-to-day management, it has significant influence over the company’s direction and long-term success. Stockholders have the final say in who serves on the board.
“Inspecting books and records” sounds technical, but the idea is simple: investors want to monitor how the company is performing, because company performance affects stock value and potential profits.
Stockholders have the right to inspect the books and records of the companies they invest in. The Securities and Exchange Commission (SEC) enforces reporting requirements for publicly traded companies by requiring documents like these to be created and distributed regularly:
10-K annual report
10-Q quarterly report
Right to maintain proportionate ownership
In some circumstances*, common stockholders are offered the right to maintain proportionate ownership in the company. For example, assume you own 10 shares of a company that has 100 shares outstanding, so you own 10% of the company’s stock. Suppose the company plans to issue more stock. The issuer may be required to give you the right to purchase 10% of those new shares before anyone else.
*Not all issuers are required to offer stockholders the right to maintain proportionate ownership. It depends on the way the stock is originally structured.
Issuers typically fulfill this right through a pre-emptive rights offerings, which you’ll learn more about later in this unit.
A company can be liquidated due to bankruptcy. When a company can no longer pay its obligations (debts), creditors (including bondholders) may sue in bankruptcy court. If no agreement can be reached between the company and its creditors, the company is typically liquidated.
Liquidation is the sale of all company assets, including buildings, factories, inventory, equipment, and vehicles. The company sells what it can to repay creditors as much as possible. Liquidation can also benefit stockholders, but stockholders are last in line - so they typically receive little or nothing.
Here’s the order of payout during a company’s liquidation:
Unpaid wages
Unpaid taxes
Secured creditors
Unsecured creditors
Junior unsecured creditors
Preferred stockholders
Common stockholders
When bankruptcy-related liquidations occur, companies rarely have enough assets to pay all creditors in full. When that happens, there is little to nothing left for stockholders. In most cases, common 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. The liquidation priority above applies if the collateral backing the loan is liquidated and does not cover the loan balance.
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.
Common stock can generally be bought and sold freely. The right to transfer ownership means you aren’t required to hold the investment - you can usually sell at any time.
There are exceptions, such as unregistered (restricted) stock, which you’ll learn about later in this unit. Otherwise, investors are generally free to buy and sell common stock at will.
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