Introduction and SIE review

Have you passed your SIE?

The Series 7 dives further into many concepts initially introduced on the SIE, while shifting its “big picture” focus primarily to suitability.

If you haven’t yet passed the SIE and need to strengthen your foundational knowledge, please consider purchasing Achievable’s SIE program.

We’ve included a few links to review topics covered in our SIE material; even if you haven’t bought our SIE course, you should still be able to use them as a reference. If you click a link starting with [SIE], just make sure to switch back to the Series 7 course using the dropdown in the navigation menu!

When you prepared for the SIE exam, you learned the fundamentals of common stock. In this intro chapter, we’ll recap and summarize these common stock basics. You can also spend a few minutes watching the following video for a quick refresher.

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.

Definitions

Issuer

An organization that distributes and sells securities to investors

Example: Coca-Cola Company is the issuer of Coca-Cola stock (ticker: KO)

Ticker symbol

A set of characters that represent an investment. Every publicly traded stock has a unique ticker symbol, making it easy to track without typing out the full business name. Examples of ticker symbols:

• TSLA = Tesla Inc.
• BAC = Bank of America Corporation
• MCD = McDonald’s Corporation

Equity

Formal term for ownership

Security

Legal term for a financial investment. Defined by the Supreme Court as meeting these all of these characteristics:

• Investment of money
• Common enterprise*
• Expectation of profit
• Third-party effort**

*Common enterprise occurs when there are multiple investors in a business venture.

**Third-party effort refers to profit made due to the efforts of someone other than the investor. For example, an Amazon (ticker: AMZN) investor does not manage Amazon - its Board of Directors and management team do!

Examples of securities:

• Common stock
• Preferred stock
• Debt securities
• Mutual funds
• Exchange-traded funds (ETFs)

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

Regular-way trades of common stock settle in one business day (T+1), unless performed on a cash settlement basis. Cash settlement finalizes same day, if performed by 2:30pm ET.

Investors have the ability to go long or short shares, depending on their outlook for the company. Going long stock means the investor bought shares and obtained ownership in the company. These investors are bullish on the company, meaning they expect its value to rise. The higher the stock price rises, the more the investor profits.

Going short shares means the investor borrowed shares from a financial institution (typically a broker-dealer) and sold those shares. The investor must return the stock to the financial institution, which requires a repurchase of those shares in the future. If the stock price falls, they can buy them back at a lower price and profit. For example, selling short stock at $50 and later buying it back at $30 nets a $20 profit. These investors are bearish, meaning they expect the security’s value to fall. The more the market price declines, the more the investor profits.

Selling short comes with considerable risk. While short sellers make money when the market falls, they can lose an unlimited amount when the market rises. The further the market price increases, the more expensive it will be to buy back the stock. Therefore, short selling is only suitable for aggressive investors with the ability to afford significant risk.

Common stockholders (that are long the shares) are part 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 they own (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:

• [SIE] Right to pro-rata share of dividends
• [SIE] Right to vote for Board of Directors
• [SIE] Right to inspect books and records
• [SIE] Right to maintain proportionate ownership
• [SIE] Right to vote for stock splits
• [SIE] Right to assets upon dissolution
• [SIE] Right to transfer ownership

The Series 7 may still focus on some details relating to these rights, which could include the following topics.

Proxies

Stockholders have the right to vote on various items, including the Board of Directors and dilutive actions. There are two primary ways for a stockholder to vote: at the annual stockholder meeting or through a proxy.

Every year, publicly traded companies arrange and hold a stockholder meeting. For example, here’s a video of Tesla’s 2019 annual meeting. At these gatherings, a number of issues are discussed, including company performance, the outlook for the future, and important items to be voted on. Most stockholders are unable to attend these meetings, but they can still vote through a proxy.

Proxies are substitutes for voting at these stockholder meetings. With the help of financial firms, the company sends these proxies (voting materials) to the shareholders that don’t attend the annual meeting. That way, every stockholder has voting power, regardless of their ability to attend the meeting.

Types of shares

Shares of stock can be organized into one of four different categories: authorized, issued, outstanding, and treasury.

Authorized stock is the amount of stock that a company is permitted to sell to investors, which is established when the company originally forms. For example, let’s assume ABC company has 1 million shares authorized.

When shares are sold to investors, they are considered issued. Companies typically don’t sell all of their authorized shares up-front, which allows them to raise more capital (money) in the future by selling the leftover authorized shares. Let’s assume ABC company issues 500,000 of the million authorized shares.

Stock owned by the shareholders are known as outstanding. After the initial sale of shares, the number of issued shares and outstanding shares is the same.

Sometimes companies buy back their own stock from the market and there are a few reasons why this may occur. This was a big issue in early 2020 as many companies seeking Covid-19 bailouts had spent a large amount of cash on stock buybacks in previous years.

Companies typically use stock buybacks to fund executive compensation (for example, paying the CEO in shares) or to buy their own stock at favorable prices. Just like normal investors, the company can resell (reissue) those shares at a profit in the future. Additionally, buying back shares increases demand for the stock, resulting in higher market prices and higher earnings per share. Regardless of the reason, shares repurchased from the market are considered treasury stock.

Assume ABC Company repurchases 100,000 shares a few years after they were initially sold. Because shares were taken out of the market, there are now 100,000 fewer outstanding shares.

Let’s summarize the numbers based on the scenario we discussed:

• Authorized = 1,000,000 shares
• Issued = 500,000 shares
• Outstanding = 400,000 shares
• Treasury = 100,000 shares

Sidenote

Earnings per share (EPS)

An important statistic that many investors pay close attention to is earnings per share (EPS), which is determined by dividing the company’s net income by outstanding shares. Here’s the formula:

$\text{EPS}=\frac{\text{Net\hspace{0.33em}income }}{\text{Outstanding shares}}$

EPS is typically utilized to determine the profitability of a company. There are three general scenarios that influence EPS:

• Sales of products and services
• Liabilities (debts)
• Outstanding shares

Starting with the obvious, EPS is heavily influenced by the amount of products and/or services sold by a company. The more revenue the company makes, the higher its earnings.

Even if a company has a significant amount of revenue, earnings are directly affected by liabilities. To calculate net earnings (income), a company subtracts the cost of goods sold (COGS), operating expenses, interest expenses, and taxes from its revenues.*

*These are line items on an income statement, which is covered later in this chapter.

If these liabilities and expenses are significant, they can completely offset a large amount of revenue, sometimes resulting in net losses. For example, Lyft reported $339 million in revenue for Q2 2020 but ended up with a net loss of $437 million after deducting liabilities and expenses. This resulted in the company reporting a -$0.86 EPS (a negative EPS).

The last significant contributor to EPS is outstanding shares. The more shares outstanding, the lower the EPS, and vice versa. We previously discussed how stock buybacks increase EPS, so let’s demonstrate that through an example. First, let’s re-establish the EPS formula:

$\text{EPS}=\frac{\text{Net income }}{\text{Outstanding\hspace{0.33em}shares}}$

Let’s assume a company reports $10 million of net income with 5 million shares outstanding.

$\text{EPS}=\frac{\text{\$10,000,000 }}{\text{5,000,000}}$

$\text{EPS}=\$2$

Assume we fast forward one year, and the company reports the same earnings ($10 million), but they bought back 1 million shares from the market. Let’s calculate the EPS now:

$\text{EPS}=\frac{\text{\$10,000,000 }}{\text{4,000,000}}$

$\text{EPS}=\$2.50$

As you can see, the amount of outstanding shares directly impacts a company’s EPS. Of course, it costs money to buy back stock, but a declining number of outstanding shares contributes to an increasing EPS.

Dilutive actions

If the company does anything to reduce the ownership of investors, it’s considered a dilutive action. For example, assume an investor owns 10% of a publicly traded company. If the company restructures its securities in a way that drives down the investor’s percentage ownership of the outstanding shares, the company performed a dilutive action.

Fortunately for investors, the company can’t just decide to dilute its shares. They must gain stockholder approval to do so or offer the opportunity to maintain proportionate ownership. Dilution negatively affects shareholders, so gaining majority approval could be a tough sell. Issuing new shares and convertible securities are two common ways companies dilute ownership.

When a company issues additional authorized shares, it must first offer these shares to its current stockholders. We’ll discuss pre-emptive rights offerings later in this chapter, which allow shareholders to maintain proportionate ownership. By offering pre-emptive rights, the company provides investors the opportunity to avoid dilution, although it will cost them money.

Convertible securities, like convertible bonds and convertible preferred stock, allow investors to convert their fixed income investment into shares of common stock of the same issuer. When a conversion occurs, new shares of stock are created, which increases the number of shares outstanding. In effect, conversion decreases ownership for current stockholders.

To demonstrate this, assume you own 100 shares of a company with 1,000 shares outstanding. The company then issues convertible securities, some conversions occur, and there are now 250 additional shares outstanding.

You still own 100 shares of the company, but you went from owning 10% to 8% of the outstanding shares. Your vote when it comes to important company-related issues is worth less than it was before.

Whether it’s issuing convertible securities or any other dilutive action (like issuing warrants), companies must gain stockholder approval before the action occurs. In the end, issuance of the security may be in the best interest of stockholders although dilution occurs.

For example, convertible bonds are issued with lower interest rates (coupons) than non-convertible bonds. Savings from paying lower interest rates on borrowed funds increases the profitability of the company although dilution occurs. In the long run, investors are most interested in the financial success of the companies they invest in.

One last dilutive action worth mentioning involves corporate issuers offering stock options to employees, which is a typical form of compensation for executives (officers and directors). An option allows a purchase of stock at a fixed price. For example, a director may be given stock options allowing the purchase of their company’s stock at $60 when the market price is $40. While there’s no point in exercising at that point, options are typically issued to provide incentives for employees to increase productivity and sales. If this occurs on a widespread basis, the successes are reported on the company’s financial statements, which drive demand for the stock. If the stock price in our example rises above $60, the option is valuable (known as intrinsic value). If you’re confused, we’ll learn more about options in a future chapter. For now, just keep in mind issuing stock options to employees is a dilutive action.

Statutory vs. cumulative voting structure

Companies maintain one of two voting structures for the BOD: statutory or cumulative. Each stockholder gains one vote for every share they own, but the way votes are cast is dependent on the company’s voting structure. Here’s what you need to know about both:

Statutory
Allows the stockholder to apply only the amount of votes they have to each BOD position being voted on. Statutory voting structures are more beneficial for larger stockholders.

Cumulative
Allows the stockholder to apply the total amount of votes they have to any BOD position being voted on. Cumulative voting structures are more beneficial for small stockholders.

Let’s take a look at a few examples to understand how this concept applies:

An investor owns 100 shares of stock with a statutory voting structure. There are 3 open board positions.

The investor has 300 votes

• 100 shares x 3 open positions
• Can only apply up to 100 votes per position

An investor owns 100 shares of stock with a cumulative voting structure. There are 3 open board positions.

The investor has 300 votes

• 100 shares x 3 open positions
• Can apply up to 300 votes in any manner

As you can see, a cumulative voting structure allows the investor to apply all of their votes toward one single board position. Assume a stockholder really liked John for a BOD position. They could only apply 100 votes to John with a statutory voting structure, while they could apply 300 votes with a cumulative voting structure.

With this disproportionate voting style, cumulative voting structures tend to favor small investors. With the ability to apply all votes in one manner, a few small shareholders could work together to apply all their votes to one single open position.

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.

Definitions

Liquidate

To turn an asset or investment into cash

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 the 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 its 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 one business day (T+1 / trade date plus one business day) and is one of the reasons why stock trades don’t happen immediately.

Dividends

Stockholders do not have the right to vote for dividends but do have the right to receive their pro-rata share of dividends. Pro-rata relates to the number of shares owned. For example, if a stockholder owns 10% of the outstanding shares, they should receive 10% of the dividends paid. Only the Board of Directors (BOD) approves dividend payouts. We’ll discuss the BOD in further detail in the next section.

Common stocks may pay dividends in three different forms: cash, stock, and product, all of which are detailed below:

Cash dividend
When a company makes a profit on its products and/or services, they have a choice to make. They can retain the profit (also known as retained earnings), pay the profit to their shareholders in the form of a cash dividend, or a little of both. Smaller, growing companies (known as growth companies) generally do not pay cash dividends. In order to expand their business, they’ll need to invest every dollar they make in profit into their business.

Stock dividend
A payment of extra shares to stockholders. Although investors receive more shares of stock with a stock dividend, a stock dividend is ultimately a wash. Stock dividends are simply a “re-shuffling” of numbers in order for the company to manipulate its stock price. If a company pays a stock dividend of 25%, each investor will end up with 25% more shares. However, each share will drop proportionally in price. Ultimately, a stock dividend does not increase the overall value of a stock position.

Product dividend
Companies can make dividend payments in the form of inventory or another company’s stock. This type of dividend is not commonly issued.

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.

Key points

Common stock

• Negotiable equity security
• Regular-way settlement in T+1

Proxies

• Provide voting rights to stockholders unable to attend the annual meeting

Dilutive actions

• Reduce proportionate ownership
• Must be approved by stockholders
• Rights offerings avoid dilution

Statutory voting structures

• Beneficial for large shareholders

Cumulative voting structures

• Beneficial for small shareholders

Transfer agent

• Responsible for maintaining the book of stockholders
• Issues and redeems shares when a transaction occurs
• Distributes proxies (voting materials) to stockholders
• Distributes dividend payments to stockholders

Registration format

• Securities are registered in book-entry format

Corporate liquidation priority

1. Unpaid wages
2. Unpaid taxes
3. Secured creditors
4. Unsecured creditors
5. Junior unsecured creditors
6. Preferred stockholders
7. Common stockholders