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Common Stocks, Preferred Stocks—Basic Concepts

Stocks, which represent ownership in a corporation are, and have been, one of the best investments one can make. The potential for profit is much greater than with guaranteed investments or interest-paying investments.

The main benefits of corporations over sole proprietorships and partnerships are owners—stockholders—are liable only for the amount invested; it can raise large amounts of money through the sale of stocks and bonds; and complete control is vested in a board of directors, which the stockholders choose through voting. The main disadvantage is that a corporation is carefully regulated by law, and must publish and distribute numerous reports to stockholders and various government agencies.

Corporations are business entities that operate under a charter from a state and raise capital by selling stocks and bonds, a form of capitalization.

Stocks are equity capital, giving the owners of stock a part ownership in the corporation, and bonds are debt capital. Bond holders lend money to the corporation by buying their bonds.

Total capitalization is the sum of equity and debt capitalization.

The net worth or stockholders’ equity is the difference between total assets and total liabilities of the corporation.

Corporate Ownership — Stocks

Stocks, as a unit of ownership, can be broadly classified as common and preferred—all corporations issue common stock.

Legal Rights of Common Stockholders

Common stockholders have the following legal rights:

• The right to receive stock certificates as evidence of ownership.
• The right to vote at stockholders’ meetings.
• The right to receive any declared dividends, and to sell the stock.
• The right to information and to receive financial reports about the company.
• The right to buy newly issued shares of stock by the company before the shares are sold to the public, so that current owners can maintain their proportionate interest in the company, if they so choose.

Voting Privileges

Common stockholders, unlike preferred stockholders, have the right to vote for the corporate board of directors, who, in turn, have complete control of the company. Each stock gives the stockholder one vote for each director position that is up for voting, but that vote may be apportioned in 2 different ways. Statutory voting allows using all votes for each of the vacancies for the board of directors; cumulative voting increases the number of votes that a stockholder can use for a particular candidate. For instance, if there are 4 different vacancies on the board and a stockholder owns 500 shares, then a statutory voting privilege allows the stockholder to cast 500 votes for each of 4 candidates for the 4 vacancies for a total of 2,000 votes, but no more than 500 can be cast for any candidate. Cumulative voting would give the shareholder 2000 votes (500 X 4) that could be apportioned in any way: all 2000 votes for one candidate, or 1,000 for one, 500 to each of two others, and none to the others, for instance.

If a stockholder cannot attend a meeting to vote, then he can cast his vote by proxy through the mail, or having someone else at the meeting to cast his vote.

Classified Stock

Some companies issue different classes of stocks (aka complex capital structure, multiple capital structure), which generally differ by voting privileges. This is most often done so that the founders of a company can retain control of their company by retaining the class of stock with the greatest voting rights. Most often, these different classes are referred to as Class A and Class B stock; however, which one has the greater voting rights may differ. For instance, Google has 2 classes of stock. Class B gives the holder 10 votes per share compared to the 1 vote of Class A. The 2 founders of Google and its CEO at the time of Google's IPO held the Class B shares while selling the Class A shares in a Dutch auction. Berkshire Hathaway issued a Class B stock that sold for far less than the Class A stock, which is currently above $100,000 per share, so that smaller investors could purchase some shares.

The different stock classes may also differ in dividends or liquidation priority. The share classes are defined in the corporate charter and bylaws.

Right to Information

In addition to the reports that a shareholder receives, which includes an audited financial statements every year, he also has the right to the minutes of the meetings of the board of directors and to examine the list of stockholders, although these rights are not usually exercised.

Pre-emptive Rights

A pre-emptive right is the right of existing stockholders to purchase new issues of the company stock before it is offered to the public, so that existing stockholders can maintain proportionate ownership of the company, if desired. Although most states have laws that give shareholders pre-emptive rights, the company may, depending on the law, pay stockholders a fee to waive their pre-emptive rights or the pre-emptive rights may exist only if so specified in the corporate charter. Pre-emptive rights were more prevalent in the past, but are rare today.

When the corporation does give its stockholders pre-emptive rights, it generally issues subscription rights that show how many shares the stockholder can buy and at what price. For instance, if shareholder John Doe owns 10% of the company, and the company issues 100,000 new shares of stock, then the company will allow John Doe to buy at least 10,000 shares of stock before the stock is presented to the public, so that he can maintain his proportionate ownership of the company. He can refuse to buy any new issues, or only some of them, but then his ownership percentage in the company will decline, and along with it, the number of pre-emptive rights received in any future rights offering.

Rights to Dividends

A corporation does not have to distribute profits to shareholders in the form of dividends, and indeed, many growth companies re-invest profits for greater growth rather than distribute them to shareholders, but if the company does declare a dividend, which  is equal to a specific amount for each share of stock, then common shareholders are entitled to the dividend amount times the number of shares that they own. However, common shareholders have inferior rights to dividends than preferred shareholders, if the company has preferred shareholders.

Classification of Common Stock

Authorized shares are the shares that have been authorized by the charter when the corporation was formed. Issued shares are authorized stock that has been sold to investors. Issued shares and unissued shares make up all authorized stock. Outstanding stock is stock that is owned by investors. All outstanding stock has been issued, but sometimes a company will buy back its own stock, which then becomes treasury stock, which reduces the number of outstanding shares.

Treasury stock is stock that had been issued by the company, but was bought back by the company. Treasury stock has no voting rights, does not receive dividends, is not used in the computation of earnings per share, and is no longer outstanding stock. Companies buy back their stock for any of the following reasons:

• to increase the market value of each share by limiting supply;
• to provide stock options and bonuses for officers and employees of the company;
• to have additional shares for the acquisition of another company;
• or to prevent a takeover by another company.

Par Value, Stated Value, Legal Capital

Par value is the value assigned to a share of stock when it is authorized, and is much less than its expected market value. Sometimes a stock will not have a par value, but will have a stated value in the corporation's financial records. Par and stated values set the minimum requirement for legal capital, which is the number of shares of outstanding stock multiplied by the par or stated value of each share. A corporation cannot pay dividends or buy back its stock, if doing so reduces the amount of legal capital below the minimum required by state law. Par value is more, however, for preferred stock, because they pay a fixed dividend that is a set percentage of the par value.

American Depositary Receipt (ADR)

ADRs simplify buying shares of foreign companies by eliminating the need for the American investor to worry about currency exchange rates or dealing with a foreign language. A U.S. depositary bank buys stock of a foreign company and deposits the certificates—American Depositary Shares—in a bank of that country, called the custodian bank. The depositary bank then issues an ADR, each of which represents an interest in a specified number of shares of the foreign company, in the United States. The ADR holder is paid any dividends in equivalent U.S. dollars, and all communications and records are in English. Note, however, that there is still a currency exchange risk with ADRs, and there may be foreign taxes deducted from any dividends.

Residual Claim

If a company liquidates, common stockholders have a claim to the residue—what is left after all creditors and all preferred stockholders have been paid. In most cases of liquidation, the common shareholder gets nothing.

Rights and Warrants

Rights and warrants are much like options. They give the owner the right, but not the obligation to buy new shares of stock at a specified price, and they expire at a specified date. Unlike options, the company issues rights and warrants to raise more money for the company. The money for options initially goes to the option writer, who probably has no association with the company other than possibly being a stockholder.

Rights (Synonyms: Pre-Emptive Rights, Subscription Rights, oversubscription Privilege)

If a corporation wants to raise more money, it will frequently do so by issuing more shares from the authorized, but unissued shares. However, as discussed above, existing shareholders may have the right to maintain their proportionate ownership of the company, so the company provides existing stockholders with subscription rights (aka rights certificates), giving stockholders the right, but not the obligation, to buy the new shares at a specified price—the subscription price—which is usually lower than the market price. A benefit for the company of selling to existing shareholders is that marketing costs will be less than selling to the general public. The rights offering is generally handled by investment bankers in a standby commitment, where the investment bank agrees to buy any shares not subscribed to by the holders of rights.

A stockholder usually receives 1 right for each stock owned at the rights record date, when the rights certificates are issued to shareholders as of the rights record date. This gives the stockholder the right, but not the obligation, to buy additional shares of stock at the subscription price. To buy an additional share of stock requires a certain number of rights, and the number of rights required will be the quotient of the number of issued shares divided by the number of newly issued shares. If there is a remainder, then there will be a dollar amount added to the number of rights required to purchase each share. This will allow the shareholder to buy enough shares to maintain proportionate ownership, but no more.

When a stock with rights is trading on the stock exchange, it is said to have cum-rights, and it will probably have a higher market value than the same stock trading ex-rights (aka rights off)—without rights. The ex-rights date begins 2 days before the rights record date, because the purchase of stocks takes 3 days to settle, and ends when the rights expire. From the time of the announcement of the rights offering to the ex-rights date, the rights are attached to the stock. During the ex-rights period, the rights are sold separately, just like a stock. When a stock is trading with rights, the value of a right is (market value – subscription value)/(number of rights to buy 1 share +1).

However, this value is theoretical because the right is attached to the stock and therefore is bought and sold with the stock during the cum-rights period. During the ex-rights period, the rights are sold separately, like a stock, and the formula is the same, but without the +1 in the denominator.

When the rights expire, usually 4 to 6 weeks after the ex-rights date, they become worthless.

The advertisement below the chart is for a rights offering by USG Corporation (NYSE: USG, Rights Symbol: USG RT) that appeared in the Wall Street Journal on Wednesday, July 19, 2006. The closing prices for the stock on June 30, July 19, and July 27, 2006 were $72.93, $47.65, and $46.12. Directly below is a 2 month chart (source: BigCharts.com) showing the daily stock prices before and after the rights offering.

 Warrants

A warrant is a security that gives its owner the right, but not the obligation, to purchase a stipulated number of shares at a stipulated price anytime before the warrant expires. When the warrant is first issued, the stipulated price is always above the current market price, usually well above, because warrants have a much longer lifetime than rights.

Warrants are frequently sold attached to bonds, to lower the interest that the corporation has to pay, since the bondholder has the additional option of exercising the warrant for profit if the company does well. They may be attached to preferred stock as well. Sometimes the warrant is detachable—that is sold separately from the stock or bond—after a certain time; otherwise the warrant is nondetachable.

Stock Splits

When a stock appreciates considerably, the corporation will sometimes declare a stock split, which will lower the market price of the stock, and therefore, hopefully entice more investors to buy the stock. The split ratio is usually 2:1, that is, 2 shares of stock now replace every share of stock, but the ratio can be 3:1, 4:1, 5:3 or anything else. If an investor had 100 shares of stock selling at $80 per share, he will have 200 shares selling at $40 per share after a 2:1 split. All financial ratios with the share price as one of the terms and the par value of the stock will be adjusted accordingly. The number of outstanding stocks will also increase.

Whether the stock split entices more people to buy it is questionable, and necessarily limited. If this were not true, a corporation could continually split its stock to increase its value, even without increasing profits.

Reverse Stock Splits

When a company has financial difficulties, sometimes its stock falls to a low value. Often, this is seen as a sign of risk and bad performance, so the company will do a reverse split, where 2 or more shares of stock are exchanged for 1, thereby increasing the value of each share. The company itself is not worth more, but it may appear more valuable to inexperienced investors.

Stock Dividend

Large companies that are profitable, but have little potential for growth, will start paying dividends, usually quarterly. Usually the dividend is paid in cash, but sometimes, to conserve cash, a company will declare a stock dividend instead of a cash dividend. The stock dividend is stated as a percentage of stock owned. Thus, with a 10% dividend, each stockholder will get 1 more share of stock for every 10 that he owns. There is no change to the par value and the shareholders’ proportionate interest in the company is unchanged. Each share will be worth less, however.

Preferred Stock

Preferred stock is much like common stock, but preferred stockholders usually have no voting privileges, but they do have priority for dividends and for the proceeds of any corporate liquidation should the company fail. Companies issue preferred stock to appeal to investors who want income and greater safety, but issuing preferred stock instead of bonds gives the company more flexibility. If the company is financially stressed, it can skip dividend payments to preferred stockholders, but not to bondholders. Oftentimes, preferred stock is issued when a company is having financially difficulties. It brings in more money at a time when the company needs it, but it doesn't obligate a company to future payments in the way that bonds do.

Dividends

Preferred stock is preferred because preferred shareholders have first claims to any dividends and company assets, if liquidation occurs, over the common stockholder. However, creditors still get paid before preferred shareholders. The dividend for the common stock may fluctuate from year to year, or even from quarter to quarter, but the preferred dividend is fixed. Preferred stockholders get their dividend at a fixed rate before any dividends are paid on common stock. However, dividends are not guaranteed even to preferred stockholders.

Unlike common stock, the par value of preferred stock is more significant to the stockholder because the dividend is expressed as a percentage of the par value, which doesn’t vary with the market price. If the stock has no par value, then the dividend will be stated as a fixed sum per share.

Preferred stockholders also have no voting rights unless the company defaults on the dividend for a specific number of quarters, or if the company wants to issue a new class of preferred stock equal to or better than the existing preferred stock.

In addition, preferred stock may have the following features: adjustable rate, cumulative, convertible, callable, participating, and prior preferred.

Adjustable Rate

An adjustable-rate preferred stock pays a dividend that is pegged, usually quarterly, to a current interest rate bellwether, such as Treasury notes.

Cumulative

If preferred stock has a cumulative dividend right, then, if the company misses any payment of dividends to preferred shareholders, all dividends of all missed payments must be paid before any common stockholder. If the company liquidates, then the cumulative option gives preferred shareholders the right to all of the missed payments before the common stockholders’ residual interests.

Example: preferred stockholder get $40 per quarter for the preferred stock. The company has missed 3 quarterly payments in the past year, however. For the current quarter, the company would have to pay preferred stockholders $120 plus the $40 due this quarter before anything can be paid to common stockholders.

Convertible

The convertible feature allows the shareholder to convert his preferred stock to common stock at any time. Preferred stock is generally bought for its fixed dividend, but it is not as volatile as the common stock of the same company. If the common stock rises sharply, the convertible preferred stock will rise more than the preferred stock without the convertibility feature. Thus, the convertible feature allows the investor to enjoy a fixed income in a flat market, but also to profit from any significant rise in the market price of the common stock.

Callable

This feature benefits the company. It allows the company to call back, or to redeem, a callable preferred stock at a specific price, the call price, which is printed on the stock certificate. It can also buy back the stock on the open market, and will do so if the current market price is below the call price.

Participating

This increasingly rare preferred stock not only receives its stated, fixed dividend, but it can also participate, or receive a portion, usually 50%, 75%, or 100%, of the common stocks’ dividend.

Prior Preferred, First Claim Preferred, or Senior Preferred

These terms describes the preferred stock that has first claims on any dividend, and on assets if the corporation dissolves. Thus, prior preferred stock will have a superior claim over all preferred and common stock, but will still have an inferior status to creditors, including all holders of debt securities.

Tracking Stock

Many large companies are conglomerates that consists of different types of businesses, and, usually, 1 component is growing faster than the rest of the conglomerate. Some of these conglomerates will issue tracking stock in the fast-growing component, which is stock giving the stockholder a beneficial interest in that specific component, but not ownership interest. The tracking stock may be issued as an initial public offering or distributed to existing shareholders.

This is similar to spin-off, but the parent keeps ownership and control of the subsidiary, and gets more capital at a lower cost. Other benefits include:

• the parent and subsidiary can share expenses, such as marketing and administrative costs;
• the parent can help the subsidiary in its business by providing easy access to more capital;
• offers certain tax advantages; and
• the company can use the tracking stock to pay for acquisitions rather than using cash.

The major disadvantage to tracking stock for investors is that there are usually lesser voting rights compared to the parent stock, or even none at all.

Transfer Agent and Registrar

The transfer agent, which could be a bank, trust company, or the issuer, effects the actual transfer of securities from its former owner to its new owner. It certifies any required documents, issues new certificates to the new owner and cancels the certificates of the former owner. Since the transfer agent keeps track of owners of record, it usually is responsible for sending dividend payments, voting proxies, and notices of the annual stockholders’ meeting.

The registrar is an officer or agent of the corporation, usually a bank, that maintains a record of its shareholders and the number of shares they own. When securities are transferred, the registrar audits the work of the transfer agent, particularly ascertaining that the number of new certificates issued equals the number canceled.

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