As one of the most discussed and widely known financial products, stocks dominate financial news and are closely tied 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 together those shares represent 100% of 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. Much 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, prices tend to rise when investors buy more shares than they sell, and fall when selling outweighs buying.
We’ll discuss the stock market in more detail in the next chapter.
There are two general ways to make money on common stock.
Investors can earn capital appreciation, also called growth or capital gains. When you buy stock, you pay a specific price per share. If the price later rises and you sell, the difference is your gain.
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. With higher demand in the stock market, Ford’s stock price rises to $25. Stacy sells her shares and locks in a $15 per share profit. This is an example of capital appreciation.
Issuers may also pay cash dividends to their stockholders. While Stacy holds her Ford shares and watches them rise in price, Ford could also pay her a dividend.
A cash dividend is a distribution of company profits to shareholders.
Not all publicly traded companies pay cash dividends. For many companies, especially those focused on expansion, keeping profits inside the business is a priority. 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 because they aim to increase the size of their operations and profitability. While Amazon is large and well-established, start-ups and small businesses can also fall into this category. Investments in growth companies may offer capital appreciation, but they generally do not pay 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 dividend payments. Companies typically won’t distribute all profits - they still need funds to run the business - but they may distribute the “excess” that isn’t needed for operations.
Ford Motor Company is an issuer with a long history of paying cash dividends. Referring to our earlier example, 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 overall profit would be $16 per share ($15 per share from capital appreciation + $1 per share from dividends).
To receive a dividend payable by a company, investors must purchase their shares before the company pays the dividend. We’ll work through dividend timelines later in this unit.
This video serves as a quick visual guide to the basic characteristics of common stock:
Common stockholders are partial owners of the company they invest in and have some control over major business decisions, similar to other business owners. The more shares you own, the larger your percentage ownership, and the more voting power you have on company matters.
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 belongs to the Board of Directors (discussed below). 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.
We’ll dive deeper into analyzing cash dividends later in this unit, but here’s a quick video on the types of companies that pay them:
Stockholders don’t manage an issuer’s day-to-day business operations. However, they can 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 setup is similar to the democratic republic in the United States. U.S. citizens don’t directly create or change laws, but they can vote for the politicians who do. If a politician isn’t performing well, citizens may vote to replace them. Stockholders function similarly: they don’t run the issuer’s business, but they vote in (and vote out) the people on the BOD who make major enterprise decisions.
While the BOD isn’t responsible for day-to-day management, it has significant influence over the company’s direction and success. The BOD is essential to any corporation, and stockholders have the final say in who serves on a company’s board.
“Inspecting books and records” sounds complicated, but the idea is straightforward: investors want to monitor the company’s performance because it affects the value of their investment.
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
In some circumstances*, common stockholders are offered the right to maintain proportionate ownership.
For example, assume you own 10 shares of a company that has 100 shares outstanding, giving you 10% ownership. 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 means selling all company assets - such as buildings, factories, inventory, equipment, and vehicles. The goal is to raise cash to repay creditors as much as possible. Liquidation can also benefit stockholders, but in practice stockholders usually receive little or nothing. The reason is the payout order during liquidation:
Unpaid wages
Unpaid taxes
Secured creditors
Unsecured creditors
Junior unsecured creditors
Preferred stockholders
Common stockholders
In bankruptcy-related liquidations, companies rarely have enough assets to pay all creditors in full. When that happens, there is often 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. 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 by investors. The right to transfer ownership means you aren’t obligated to hold the investment - you can generally sell at any time.
There are exceptions for unregistered (restricted) stock, which we will discuss later in this unit. Otherwise, investors are generally free to buy and sell common stock at will.
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