As one of the most discussed and widely known financial products, stocks dominate the financial news and are consistently tied to the economy’s overall performance. There are two types of stock: common stock and preferred stock. We’ll focus on common stock in this chapter.
So, what exactly is common stock? It’s a representation of ownership in a company (issuer). If you “go long” (buy) one share of stock in a company like Coca-Cola, you’re an owner (stockholder) of Coca-Cola. Granted, you own a tiny piece of the company. For context, Coca-Cola has over 4 billion shares outstanding. It’s common for companies to have millions or billions of outstanding shares that represent the company’s overall ownership. Because of this, common stock is referred to as an equity security.
Common stock prices rise and fall in the stock market depending on demand. Most of the time, demand is influenced by the company’s success. If Coca-Cola has a good business year, its shares will likely rise in value due to higher demand for its stock (and vice versa). Simply put, prices rise if more stock is purchased than sold by investors (and vice versa). We’ll discuss more about the stock market in the next 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, 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 more demand in the stock market, its 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 pay her a dividend. A cash dividend represents profit made by the company that is then distributed to its shareholders.
Not all publicly traded companies pay cash dividends. When companies grow, retaining and reinvesting profits into the business is essential. For example, Amazon has never paid a dividend to its shareholders. With every dollar the company makes, 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 also fall into this category. Investments in growth companies provide the opportunity for capital appreciation but generally do not pay income (dividends) to shareholders.
When a company is nearing the end of its growth cycle (when there’s not much more room to expand its operations significantly), 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” that isn’t needed.
Ford Motor Company is an issuer with a long history of paying cash dividends. 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).
To receive a dividend payable by a company, investors must purchase their shares before the company pays the dividend. We’ll go further with dividend timelines later in this unit.
This video should serve as a quick visual guide to the basic characteristics of common stock:
Stockholder rights
Common stockholders are partial owners of the company they invest in and have some control of business decisions, just like any other business owner. The more shares one owns, the more of the company one owns (on a percent basis), and the further their vote on company-related issues goes.
As owners of the company, common stockholders have many rights, which include:
Right to pro-rata share of dividends
As discussed above, some common stock issuers pay cash dividends to their shareholders. This is especially true for large and well-established companies like Coca-Cola. In fact, Coca-Cola is known as a “dividend king,” which is an issuer that’s paid at least 50 years of annually increasing cash dividends to shareholders.
Stockholders have no right to vote for dividends; that’s the responsibility of the Board of Directors (discussed below). If the board votes to pay dividends, shareholders maintain the right to their pro-rata share of those dividends. For example, a person owning 5% of an issuer’s stock will receive 5% of the dividends paid.
We’ll dive further into analyzing cash dividends later in this unit, but here’s a quick video discussing the types of companies that pay them:
Right to vote for Board of Directors
Stockholders don’t have the authority to manage an issuer’s business operations. However, they maintain some influence over big business decisions through their power to vote for the individuals who serve on the board of directors (BODs). The BODs determine the general direction of a company through a variety of different actions, including:
Hiring and/or firing senior-level employees
Managing senior-level employee compensation
Creating and implementing general company policies
Approving dividend payouts to investors
This system is similar to the democratic republic in the United States. U.S. citizens do not have the power to create or change laws, but they maintain the ability to vote for the politicians that do. If a politician isn’t performing well at their job, citizens tend to vote for other candidates to replace them. Stockholders function similarly; they do not manage an issuer’s business, but vote in (and vote out) people to serve on the BOD that are in charge of big enterprise decisions.
While the BOD is not responsible for the day-to-day management of the company, they certainly have a significant influence over its general direction and success. The BOD is essential to any corporation, and stockholders have the final say in who serves on a company’s board.
Right to inspect books and records
Inspecting books and records sounds complicated, but it’s fairly straightforward. A company’s performance is something investors want to keep track of. Stockholders should be concerned with the success of their company as their performance influences profit.
Investors maintain the right to “inspect the books and records” of the companies they’re invested 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:
In some circumstances*, common stockholders are offered the right to maintain proportionate company ownership. For example, assume you own 10 shares of a company that has 100 shares outstanding, providing you 10% ownership 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.
Right to assets upon dissolution
A company can be liquidated due to bankruptcy. When a company can no longer pay its obligations (debts), it is typically sued by creditors (which includes bondholders) in bankruptcy court. The company is typically liquidated if no agreement can be made between the failed company and its creditors.
Liquidation is the sale of all company assets, which includes buildings, factories, inventory, equipment, and vehicles. The company will attempt to sell everything it can 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:
Unpaid wages
Unpaid taxes
Secured creditors
Unsecured creditors
Junior unsecured creditors
Preferred stockholders
Common stockholders
When bankruptcy-related liquidations occur, companies rarely can pay back all their creditors. When this happens, 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. 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.
Right to transfer ownership
Common stock can generally be bought and sold freely by investors. The right to transfer ownership means an investor has no obligation to hold the investment and may sell generally at any time. There are some exceptions with unregistered (restricted) stock, which we will discuss later in this unit. Otherwise, investors are free to buy and sell common stock at will.
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