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 that:
- its owners—stockholders—are liable only for the amount invested;
- the corporation 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.
Capitalization = Equity + Debt
The net worth, or stockholders' equity, is the difference between total assets and total liabilities of the corporation.
Stockholders' Equity = Assets - Liabilities
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.
- This right is no longer universal, since some companies, such as Google, are issuing classes of stock with no voting rights.
- The right to receive any declared dividends, and to sell the stock.
- The right to information and to receive financial reports about the company.
- Sometimes they may have 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. Whether they have this privilege is determined by law or by the company's charter.
Common stockholders, unlike preferred stockholders, usually have the right to vote for the corporate board of directors, who, in turn, have complete control of the company. However, corporations, such as Google, Discovery Communications, and Comcast are increasingly issuing stock with no voting rights, which have a lesser value than voting shares, and many companies issue shares with greater voting rights that are usually retained by the founders or executives of the company. Google, for instance, has Class A shares with 1 vote, Class B shares with 10 votes, and Class C shares with no voting rights.
Most stocks still give the stockholder 1 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 other, for instance.
If a stockholder cannot attend a meeting to vote, then he can cast his vote by proxy through the mail, or have someone else at the meeting cast his vote.
However, the voting privilege is not as much as a privilege as the word may suggest:
- Shareholders don't select the board nominees.
- Directors can win without a majority, so withholding votes is usually ineffective. However, many companies are requiring majorities for directors to be elected.
- When stocks are held in street name, your broker can vote your shares without your permission, but starting in 2010, they will require your permission.
- Stocks held by a mutual fund or pension are technically owned by the fund, so only the fund's managers can vote the shares.
- The Securities and Exchange Commission may adopt a new rule that would require that companies include in their proxy materials the nominees of shareholders of large companies who own at least 1% of the shares.
The reason why voting privileges are given to shareholders is so that the controlling executives of the company serve the interest of the shareholders. However, voting does not solve the principal-agency problem, where the agents (board members and company executives) work for their own interest rather than for the interest of the principal (shareholders), much like politicians who serve themselves and special interests after they are elected rather than the voters who elected them. The reason is because most shareholders own only a small portion of the company; hence, they have little influence on the Board of Directors. Even major shareholders often do not have an interest in exercising their voting rights because they may have different objectives. For instance, high-frequency traders are only interested in taking advantage of price discrepancies on different trading systems or different related securities; mutual funds and exchange traded funds that track indexes buy stocks only because they are part of the index and sell the stocks when they are removed from the index; even institutional investors do not want to bother with trying to influence management because it is easier to simply sell the stock if they are dissatisfied with performance, although there have been a few instances of shareholder activism, where major institutional investors have pressured management and the board of directors to improve results.
Right to Information
In addition to the reports that shareholders receive, which includes audited financial statements every year, they also have 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.
A pre-emptive right gives current stockholders the right to purchase new issues of company stock before it is offered publicly, so they 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.
No Stock Rights for Beneficial Owners of Shares Held in Street Name
Most retail investors use brokers to buy and sell stock, and these stocks are usually held in the broker's name or the street name as it is usually called. This is done so that the securities are readily available for trading and it reduces the costs of transferring certificates. It also allows the broker to lend out the securities for a fee to others who want to sell the stock short. Because the stocks are actually in the name of the broker, the broker's customers who actually bought or borrowed the stock are considered the beneficial owners of the stock, and, hence, they have no stock rights—no right to vote, to receive information or dividends. In fact, the registrar of the stock does not even have the names of the beneficial owners, only the real owners who are the brokers for the stocks held in street name.
However, most brokers do pass the information and dividends that they receive for the stock to the beneficial owners, and they will generally vote the way the beneficial owners request.
However, there could be a problem with voting if the stocks were lent to be sold short, because a broker does not have the voting rights for stock lent out or sold short; otherwise more votes could be cast than are allowed by the number of outstanding stocks. However, a broker may still be able to vote the stocks according to the instructions of the beneficial owners if the broker has other shares of the same stock that was not lent out and if some of the beneficial owners have not sent instructions to vote a particular way. However, if the broker does not have enough shares to satisfy all requests to vote, then the votes may be apportioned according to the number of requests for voting and the number of shares held by each beneficial owner compared to the number of shares available for voting. For instance, suppose John is the beneficial owner of 300 shares of XYZ stock and Jane is the beneficial owner of 500 shares of XYZ stock, and both use the same brokerage, but their broker lent out 400 shares to be sold short. If John and Jane both issue voting instructions for different board candidates, then the broker can only vote half of the shares still retained, so the broker would vote 150 shares according to John's instructions and 250 shares according to Jane's.
There is no similar problem for dividends, because borrowers of stock are required to pay the dividend to the lenders of the stock.
Stocks in Margin Accounts Can Lead to Empty Voting and Payment in Lieu of Dividends
There are 2 disadvantages to holding stocks in a margin account, which are often lent out to short sellers:
stock borrowers, but not stockholders, can vote shares when the shares are lent out, which leads to what is being called empty voting;
and if the stocks pay a dividend, the stockholders actually get — instead of a dividend that may qualify for the favorable tax rate of 0%, 15%, or 20% — a payment in lieu of dividends, which is taxed as ordinary income that may be as high as 37%. See Taxation of Dividends for more information.
Worse, the borrowers of the stock, often short-sellers, can vote against the corporation's interest to put downward pressure on the stock price, so as to increase short-selling profits — thus, voting against the interests of the true stock owners.
A possible scenario is for a hedge fund, which frequently profits from short selling, to borrow the shares right before the record date—usually 30 days before the vote, and vote in its own interests. Delaware law, which governs most large companies because they are incorporated in that state, gives voting rights to whomever happens to have the stock on the record date. Often, the beneficial owners of the stock are unaware of the lending, and that their right to vote has been transferred to someone else.
Sometimes, because of inadequate accounting, both actual stockholders and the borrowers vote, leading to overvoting, which the New York Stock Exchange had found to be a frequent occurrence in some instances.
Some companies issue different classes of stocks, and thus, are said to have a complex capital structure, or a 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 number of 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 for 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.
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.
Issued Shares = Outstanding Stock (held by investors) + Treasury Stock (stock bought back by company)
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;
- to prevent a takeover by another company; or
- to pay estate costs.
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 relevant, however, for preferred stock, because they pay a fixed dividend that is a set percentage of the par value.
Why do Stocks have Par Value or Stated Value that is this Less than the Market Price?
When a company first becomes incorporated, the state of incorporation must approve the number of shares of stock that the corporation is authorized to sell—authorized stock, or capital stock. Many states require that the stocks also have a par value, or nominal value, to provide a minimum amount of legal capital to pay creditors. The legal capital is equal to the par value multiplied by the number of shares of outstanding stock, which is the number of shares currently held by investors. The corporation is not legally permitted to pay dividends or buy back its own stock, if doing so reduces the amount of legal capital below the required minimum. The par value is printed on each stock certificate. The par value of each stock is also changed accordingly by stock splits. A 2-for-1 split, for instance, would halve the par value.
The par value is often $1 or less, which is much less than the market price or the expected market price of the stock. The par value is set low, because the stock cannot be issued for less than par value. If par value were higher and if the demand for the stock was less than anticipated, the corporation would be unable to sell the number of shares that it planned, since it would not be able to lower its price below par value in order to increase demand for its stock. Moreover, the cost of incorporation in some states is based on the total par value of the stocks being registered, so minimizing the par value reduces the cost of incorporation in those states.
The issue price is the amount for which the stock is sold. The difference between the issue price and the par value is recorded in the company's books as the share premium:
Share Premium = Issue Price – Par Value
The par value of preferred stock is much higher than common stock because preferred stock pays a fixed dividend that is a designated percentage of par value.
No-par stocks have no par value printed on its certificates. Instead of par value, some states allow no-par stocks to have a stated value, set by the board of directors of the corporation, which serves the same purpose as par value in setting the minimum legal capital that the corporation must have after paying any dividends or buying back its stock.
If a corporation's stock has neither par value nor stated value, then the legal capital required is equal to the total amount received when the stock was first issued.
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.
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 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 stock 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, after a certain time, it can be sold separately from the stock or bond; otherwise the warrant is nondetachable.
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.
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 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.
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.
An adjustable-rate preferred stock pays a dividend that is pegged, usually quarterly, to a current interest rate bellwether, such as Treasury notes.
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.
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.
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.
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.
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;
- the arrangement 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.