When you prepared for the SIE exam, you learned the fundamentals of common stock. In this intro chapter, we’ll recap and summarize those common stock basics. You can also watch the following video for a quick refresher.
Common stock is a negotiable equity investment that represents ownership and is freely transferable (easy to buy and sell). Negotiable securities trade in the market between investors. This contrasts with redeemable securities, which can only be bought from or sold back to the issuer.
For example, if you buy Disney stock in the market, you’re buying shares from another investor - not from Disney.
Here’s a quick video that compares negotiable and redeemable securities:
Regular-way trades of common stock settle in one business day (T+1), unless the trade is done on a cash settlement basis. Cash settlement finalizes the same day if completed by 2:30pm ET.
Investors can take either a long or short position, depending on their outlook.
Going long stock means the investor buys shares and becomes an owner of the company. Long investors are bullish, meaning they expect the stock’s value to rise. If the stock price increases, the investor profits.
Going short shares means the investor borrows shares from a financial institution (typically a broker-dealer) and sells them. The investor must later return the shares, which requires buying them back in the market. If the stock price falls, the investor can repurchase at a lower price and profit.
For example, selling short at $50 and later buying back at $30 produces a $20 profit.
Short sellers are bearish, meaning they expect the security’s value to fall. The more the market price declines, the more the investor profits.
Selling short involves considerable risk. A short seller’s potential gain is limited (the stock can only fall to $0), but the potential loss is unlimited (the stock price can rise without limit). As the market price rises, it becomes more expensive to buy back the shares. Because of this, short selling is generally only suitable for aggressive investors who can afford significant risk.
Common stockholders (who are long the shares) are part owners of the company and have some control over business decisions, similar to other business owners. The more shares you own, the larger your percentage ownership, and the more voting power you have.
As owners of the company, common stockholders have many rights, which include:
The Series 7 may still test details related to these rights, including the topics below.
Stockholders have the right to vote on various items, including electing the Board of Directors and approving dilutive actions. There are two main ways to vote:
Public companies hold a stockholder meeting each year. For example, here’s a video of Tesla’s 2019 annual meeting. These meetings cover topics like company performance, future outlook, and proposals that require a vote.
Most stockholders don’t attend in person, but they can still vote through a proxy. A proxy is a substitute for voting at the meeting. With the help of financial firms, the company sends proxies (voting materials) to shareholders who won’t attend, so they can still vote.
Shares of stock fall into four categories: authorized, issued, outstanding, and treasury.
Authorized stock is the number of shares a company is permitted to sell to investors. This amount is set when the company is formed. For example, assume ABC Company has 1 million shares authorized.
When shares are sold to investors, they become issued shares. Companies often don’t sell all authorized shares at once, so they can raise more capital later by selling the remaining authorized shares. Assume ABC Company issues 500,000 of its 1 million authorized shares.
Shares owned by investors are outstanding shares. Right after the initial issuance, the number of issued shares and outstanding shares is the same.
Sometimes companies buy back their own stock in the market. 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 commonly use buybacks to fund executive compensation (for example, paying the CEO in shares) or to repurchase shares at favorable prices. Like other investors, the company can later resell (reissue) those shares, potentially at a profit. Buying back shares can also increase demand for the stock, which may contribute to higher market prices and higher earnings per share.
Shares repurchased from the market are called treasury stock.
Assume ABC Company repurchases 100,000 shares a few years after the initial sale. Because those shares are removed from the market, there are now 100,000 fewer outstanding shares.
Let’s summarize the numbers from this scenario:
If a company does anything that reduces investors’ percentage ownership, it’s considered a dilutive action. For example, assume an investor owns 10% of a public company. If the company changes its securities in a way that reduces that investor’s percentage of outstanding shares, the company has diluted the investor’s ownership.
A company can’t simply decide to dilute shareholders without constraints. It must either:
Dilution is generally negative for existing shareholders, so gaining majority approval can be difficult. Two common sources of dilution are issuing new shares and issuing convertible securities.
When a company issues additional authorized shares, it must first offer these shares to current stockholders. We’ll discuss pre-emptive rights offerings later in this chapter. These offerings allow shareholders to maintain proportionate ownership. They can avoid dilution, but doing so requires investing additional money.
Convertible securities - such as convertible bonds and convertible preferred stock - allow investors to convert a fixed income investment into common stock of the same issuer. When conversions occur, new shares are created, increasing shares outstanding. That reduces the percentage ownership of existing common stockholders.
To see this, assume you own 100 shares of a company with 1,000 shares outstanding. The company issues convertible securities, conversions occur, and 250 additional shares are created.
| Shares owned | Shares outstanding | Percent ownership |
|---|---|---|
| 100 | 1,000 | 10% |
| 100 | 1,250 | 8% |
You still own 100 shares, but your ownership drops from 10% to 8%. That means your vote on company matters carries less weight than it did before.
Whether the company issues convertible securities or takes another dilutive action (like issuing warrants), it must obtain stockholder approval before the action occurs. Even when dilution happens, issuing a security can still be in stockholders’ best interest.
For example, convertible bonds typically have lower interest rates (coupons) than non-convertible bonds. Paying lower interest on borrowed funds can increase profitability, even though conversions may dilute ownership later. Over time, investors generally care most about the company’s financial success.
One more dilutive action to know: corporate issuers often grant stock options to employees, especially executives (officers and directors). An option gives the right to buy stock at a fixed price.
For example, a director might receive options to buy the company’s stock at $60 when the market price is $40. There’s no reason to exercise at that moment, but options are designed to incentivize employees to improve performance. If the stock price later rises above $60, the option has value (intrinsic value). We’ll cover options in a future chapter. For now, remember that issuing employee stock options is a dilutive action.
Companies use one of two voting structures for the BOD: statutory or cumulative. In both structures, each stockholder gets one vote per share owned. The difference is how those votes can be allocated.
Here’s what you need to know:
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 look at examples.
An investor owns 100 shares of stock with a statutory voting structure. There are 3 open board positions.
The investor has 300 votes
An investor owns 100 shares of stock with a cumulative voting structure. There are 3 open board positions.
The investor has 300 votes
With cumulative voting, the investor can concentrate all votes on a single candidate. If a stockholder strongly supports John for a BOD seat, they could cast only 100 votes for John under statutory voting, but they could cast all 300 votes for John under cumulative voting.
Because votes can be concentrated, cumulative voting tends to favor smaller investors. A group of small shareholders can coordinate and pool votes to improve the chances of electing a preferred candidate.
The right to transfer ownership means stockholders can sell their shares whenever they want. Some securities are difficult to liquidate (sell), but common stock typically isn’t. One exception is lesser-known or generally unwanted stock that trades in the OTC markets (discussed later). Most of the time, selling stock is as simple as placing an online order or calling your broker.
When an investor buys or sells stock, the transfer agent facilitates the ownership change. A transfer agent is hired to:
When an investor purchases shares, the transfer agent follows a standard process. First, it redeems the seller’s shares, meaning it cancels the seller’s ownership. Most securities today are held in book-entry format, so ownership is tracked electronically. The transfer agent updates its records to remove the seller.
Next, the transfer agent adds the buyer to the list of stockholders. The transfer agent maintains an electronic book of ownership showing current shareholders. On settlement date, the seller is officially removed and the buyer is added. Finally, the transfer agent electronically issues the shares to the buyer, now registered in the buyer’s name.
This process occurs over the regular settlement timeframe of one business day (T+1 / trade date plus one business day), which is one reason stock trades don’t settle immediately.
Stockholders don’t have the right to vote on dividends, but they do have the right to receive their pro-rata share of any dividends that are paid. Pro-rata means “in proportion to 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 more detail in the next section.
Common stocks may pay dividends in three forms: cash, stock, and product.
Cash dividend
When a company earns a profit from its products and/or services, it can:
Smaller, growing companies (growth companies) generally don’t pay cash dividends because they reinvest profits to expand the business.
Stock dividend
A payment of additional shares to stockholders. A stock dividend is ultimately a wash. It reshuffles the share count and price. For example, with a 25% stock dividend, each investor receives 25% more shares, but each share’s price drops proportionally. The overall value of the position doesn’t increase.
Product dividend
A dividend paid in inventory or another company’s stock. This type of dividend is not commonly issued.
A company may be liquidated due to bankruptcy. When a company can’t meet its obligations (debts), creditors (including bondholders) may sue in bankruptcy court. If the company and its creditors can’t reach an agreement, the company is typically liquidated.
Liquidation means selling company assets - such as buildings, factories, inventory, equipment, and vehicles - to raise cash. The goal is to repay creditors as much as possible. Liquidation can also benefit stockholders, but stockholders are last in line, which is why they often 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 a bankruptcy-related liquidation occurs, companies rarely repay all creditors in full. When that happens, there is 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. 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.
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