Common Stock

1. Characteristics of Common Stock. Common stock represents the ownership interest of corporations, or the equity of the stockholders, and we can use the term equity securities interchangeably. If a firm's shares are held by only a few individuals, the firm is said to be "closely held."

   Most companies choose to "go public;" that is, they sell common stock to the general public. This action is taken primarily to enable the company to raise additional capital more easily. If a corporation meets certain requirements. It may, if it chooses to, be listed on one or more exchanges. Otherwise, it will be listed in the over-the-counter market.

   As a purchaser of 100 shares of common stock, an investor owns 100/n percent of the corporation (where n is the number of shares of common stock outstanding). As the residual claimants of the corporation, stockholders are entitled to income remaining after the fixed-income claimants (including preferred stockholders) have been paid; also, in the case of liquidation of the corporation, they are entitled to the remaining assets after all other claims (including preferred stock) are satisfied.

   As owners, the holders of common stock are entitled to elect the directors of the corporation and vote on major issues. Each owner is usually allowed to cast votes equal to the number of shares owned for each director being elected. Such votes occur at the annual meeting of the corporation, which each shareholder is allowed to attend. Most stockholders vote by proxy meaning that the stockholder authorizes someone else (typically management) to vote his or her shares. Sometimes proxy battles occur, whereby one or more groups unhappy with corporate policies seek to bring about changes. The Public Register's Annual Report Service

   Stockholders also have limited liability, meaning that they cannot lose more than their investment in the corporation. In the event of financial difficulties, creditors have recourse only to the assets of the corporation, leaving the stockholders protected. This is perhaps the greatest advantage of the corporation and the reason why it has been so successful.

   The par value (stated or face value) for a common stock, unlike a bond or preferred stock, is generally not a significant economic variable. Corporations can make the par value any number they choose. Some corporations issue no-par stock. New stock is usually sold for more than par value, with the difference recorded on the balance sheet as "capital in excess of par value."

   The book value of a corporation is the accounting value of the equity as shown on the books (i.e., balance sheet). It is the sum of common stock outstanding, capital in excess of par value, and retained earnings. Dividing this sum, or total book value, by the number of common shares outstanding produces the book value per share. In effect, book value is the accounting value of the stockholders. equity. Although book value per share plays a role in making investment decisions, market value per share is the critical item of interest to investors.

   The market value (i.e., price) of the equity is the variable of concern to investors. The aggregate market value for a corporation, calculated by multiplying the market price per share of the stock by the number of shares outstanding, represents the total value of the firm as determined in the marketplace. The market value of one share of stock, of course, is simply the observed current market price.

   Dividends are the only cash payments regularly made by corporations to their stockholders. They are decided upon the declared by the board of directors and can range from zero to virtually any amount the corporation can afford to pay (typically, up to 100 percent of present and past net earnings). Although roughly three-fourths of the companies listed on the NYSE pay dividends, the common stockholder has no specific promises to receive any cash from the corporation since the stock never matures, and dividends to not have to be paid. Therefore, common stocks involve substantial risk because the dividend is at the company. s discretion and stock prices typically fluctuate sharply, which means that the value of investors. claims may rise and fall rapidly over relatively short periods of time.

   The following two dividend terms are important:

   1. The dividend yield is the income component of a stock. s return stated on a percentage basis. It is one of the two components of total return. Dividend yield typically is calculated as the most recent 12-month dividend divided by the current market price.

   2. The payout ratio is the ratio of dividends to earnings. It indicates the percentage of a firm. s earnings paid out in cash to its stockholders. The complement of the payout ratio, or (1.0 . payout ratio), is the retention ratio, and it indicates the percentage of a firm. s current earnings retained by it for reinvestment purposes.

   Dividends are declared and paid quarterly. To receive a declared divided, an investor must be a holder of record on the specified date that a company closes its stock transfer books and compiles the list of stockholders to be paid. However, to avoid problems, the brokerage industry has established a procedure of declaring that the right to the dividend remains with the stock until four days before the holder-of-record date. On this fourth day, the right to the dividend leaves the stock; for that reason this date is called the ex-dividend date.

   Stock dividends and stock splits attract considerable investor attention. A stock dividend is a payment by the corporation in shares of stock instead of cash. A stock split involves the issuance of a larger number of shares in proportion to the existing shares outstanding. With a stock split, the book value and par value of the equity are changed; for example, each would be cut in half with a 2-for-1 split. However, on a practical basis, there is little difference between a stock dividend and a stock split.

   Example. A 5 percent stock dividend would entitle an owner of 100 shares of a particular stock to an additional five shares. A 2-for-1 stock split would double the number of shares of the stock outstanding, double an individual owner. s number of shares (e.g., from 100 shares to 200 shares), and cut the price in half at the time of the split.

   Stock data, as reported to investors in most investment information sources and in the company. s reports to stockholders, typically are adjusted for all stock dividends and stock splits. Obviously, such adjustments must be made when stock splits or stock dividends occur in order for legitimate comparisons to be made for the data.

   The important question to investors is the value of the distribution, whether a dividend or a split. It is clear that the recipient has more shares (i.e., more pieces of paper), but has anything of real value been received? Other things being equal, these additional shares do not represent additional value because proportional ownership has not changes. Quite simply, the pieces of paper, stock certificates, have been repackaged. For example, if you own 1000 shares of a corporation that has 100,000 shares of stock outstanding, your proportional ownership is 1 percent; with a 2-for-1 split, your proportional ownership is still 1 percent, because you now own 2000 shares out of a total of 200,000 shares outstanding. If you were to sell y our newly distributed shares, however, your proportional ownership would be cut in half.

2. Capitalization

   Stocks are sometimes categorized by their size. Market capitalization refers to a company. s size and is derived by multiplying the number of shares outstanding by the current market price of the shares. This is a very important concept. Stock A may be trading at $22 per share and stock B trading at $20 per share. One cannot assume that company A is therefore . worth more. than company B. Company A may have one million shares outstanding and company B could have eight million shares outstanding, making the total value of all it. s stock (market capitalization) much greater than that of company A. Generally, stocks are considered to fall into one of the following three categories:

   • Small Cap(italization) . Stocks with a market capitalization of less than $750 million. Historically these have been among the best and worst performers within the stock market because they are usually younger, less established companies. They obviously carry more investment risk because of that.

   • Mid Cap - Stocks with market capitalization of from $750 million to $3 or $4 billion. While the standard deviation (risk measurement) is higher for these stocks than the large caps, it is considerably less than small caps. Over one thousand companies fit this category and some are household names.

   • Large Cap - Stocks with market capitalization over $4 billion. Many of these companies are among the largest in their respective field and are household names. This category of stocks tends to be the most widely covered by research analysts and institutions. Click here for a discussion of large cap stocks.

3. Industry or Sector

   Stocks are usually categorized according to the industry group within which they operate; for example, food and beverage stocks, telecommunications stocks, consumer non-durable stocks, energy stocks, and so on. By grouping companies this way it makes for a clearer comparison and analysis of companies management, products, balance sheets, operating histories, etc.

   In addition to being able to purchase shares of stock of companies in a preferred sector, one can purchase groups of representative stocks from a sector. These "groups of stocks" are similar to indexes and trade on a listed exchange much like an individual stock. Additionally, one can purchase mutual funds that invest only in stated industries or sectors. This offers an individual the potential to prosper from growth in the group with the element of diversification without the burden of selecting "the stock" one thinks will best perform.

4. Domestic and Foreign

   In addition to investing in U.S. stocks, opportunities exist in the stocks of companies throughout the world. In fact, many companies may be headquartered in one country but with the majority of its revenues derived from foreign operations. For example, a majority of the sales of Coca Cola Company come from outside the United States. With more and more companies taking on a multi-national status, the distinction between domestic and foreign may not be as clear as it once was.

   However, one should note that there are some additional risk factors associated with foreign stock ownership including regulatory differences, accounting practices, currency fluctuations, and political unrest. There are many mutual funds available that offer foreign investments. Be aware that the term "international fund" usually means the fund invests only in stocks outside the U.S, whereas "global fund" means U.S. stocks may be included in the portfolio. Foreign firms can also arrange to have their shares traded on an exchange or a market in another country. In the United States, two alternatives are available for trading internationally listed foreign securities. One is for the shares to be traded directly. The second alternative is via American Depository Receipts (ADRs), which have existed since 1927. ADRs represent indirect ownership of a specified number of shares of a foreign company. These shares are held on deposit in a bank in the issuing company. s home country, and the ADRs are issued by U.S. banks called depositories. The prices or ADRs are quoted in dollars, and dividends are paid in dollars.

   In effect, ADRs are tradable receipts issued by depositories that have physical possession of the foreign securities through their foreign correspondent banks or custodian. Holders can choose to convert their ADRs into the specified number of foreign share represented by paying a fee, although this is rarely done. ADRs can be an effective way for an American investor to invest in specific foreign stocks without having to worry about currency problems.

5. Initial and Secondary Offerings

   As companies grow and need to access capital to fuel that growth, they sometimes determine to "go public" by selling some of their privately held shares in the company to the public. This results in an initial offering, also known as an IPO. In the course of selling new securities, issuers often rely on an investment banker for the necessary expertise as well as the ability to reach widely dispersed suppliers of capital. Along with performing activities such as helping corporations in mergers and acquisitions, investment banking firms specialize in the design and sale of securities in the primary market while operating simultaneously in the secondary markets.

   Investment bankers act as intermediaries between issuers and investors. The issuer sells its securities to investment bankers, who in turn sell the securities to investors. For firms seeking to raise long-term funds, the investment banker can provide important advice to their clients during the planning stage preceding the issuance of new securities. This advice includes providing information about the type of security to be sold, the features to be offered with the security, the price, and the timing of the sale.

   Investment bankers often underwrite new issues by purchasing the securities and assuming the risk of reselling them to investors. Investment bankers are compensated by a spread, which is the difference between what they pay the issuer for the securities and what they sell them for to the public. Often investment bankers will protect themselves by forming a syndicate, or group of investment bankers to share the risk of not being able to successfully resell the securities to the public. Their can be a selling group which includes syndicate members and, if necessary, other firms affiliated with the syndicate.

   The IPO may not be the only time the company needs to raise significant amounts of new funds through an equity offering. Subsequent offerings are termed secondary offerings. One of the main differences with a secondary offering is that the pricing of the security is much easier to determine since the stock has already been actively trading in the marketplace.

Preferred stock