Investment Securities - Corporate Securities: Common Stock
A corporation is owned by its shareholders, who elect its board of directors to oversee the company. The board in turn appoints senior managers to run the company. A corporation generally issues two types of stock: common and preferred.
If the topic of equity securities is new to you, or you would like a quick review our Stock Basics tutorial is a useful read.
The most common equity security owned by investors is common stock. Common stock shareholders have certain rights that are specified in the corporation's charter and bylaws. Below is a summary of the rights and privileges enjoyed by the common stockholder:
- Stock Certificate: A shareholder has the right to receive one or more certificates as proof of ownership of a stock if the company issues physical shares. Each certificate will state the name of the corporation, the owner's name and the number of owned shares, plus the names of the transfer agent and the registrar. It is also signed by an authorized corporate officer.
The transfer agent for the company keeps a list of all registered stockholders and cancels old stock certificates while issuing new ones when shares are transferred. The registrar verifies that the company has not issued more shares than authorized by its charter.
- Limited Liability: Since a corporation is a separate person according to the law, an individual shareholder generally cannot be held responsible for the company's debts: if the business fails, shareholders only lose their original investment. If the business thrives, however, the shareholders expect to share in the company's profits in the form of dividends and in the increased value of company stock, as reflected in the stock price. This limitation of loss to the original amount invested is referred to as limited liability.
- Right to Earnings: The shareholder's most fundamental right (and incentive to purchase the stock!) is the ability to share in the earnings of the company - both through the dividends that might be paid as well as the increase in the value of the stock itself.
- Right of Transfer: A shareholder may freely transfer shares by selling them, giving them away or bequeathing them to heirs. An exception to this rule is the shareholder who is an employee of the company and acquires stock directly as part of a compensation package.Ceratin restrictions on transfer may be placed on how insiders sell shares.
Voting Rights: Only common stockholders have voting rights. The number of votes that each shareholder gets is determined by the number of shares he or she owns. A shareholder who owns 1,000 shares will get 1,000 votes. These votes may be cast at the shareholder annual meeting, mailed in by proxy or cast online. Votes are cast on decisions to add members to the board of directors, acquire or merge with other companies, offer stock options to employee benefit packages, and so on.
There are two types of voting rights: cumulative and statutory.
- Statutory voting is the standard "one share one vote" counting that governs voting procedures in most corporations. Shareholders may cast one vote per share either for or against a board of director nominee, but may not give more than one vote per nominee per share.
- Cumulative Voting: Unlike statutory voting, where any shareholder with over 50% of the shares has the potential to control the voting outcome, cumulative voting improves minority shareholders' chances of naming nominees to the board of directors. In general, shareholders are able to weight their votes towards one or more candidates.
- Right to Dividends: Remember, common stock does not necessarily pay a specific annual dividend. The board of directors will decide what dividends, if any, are paid to common stockholders. However, if the board does declare a dividend for, say, $.50 per share, a shareholder with 1,000 shares will receive $500 by right. Dividends are usually paid on a quarterly basis and are taxable in the year in which they are received.
Here\'s a simple formula to keep in mind for calculating yields on common stocks:
Current yield = Annual dividend/share
For example, let\'s calculate the current yield of a stock that is currently paying a quarterly dividend of $.40 and trading at $44 a share:
3.6% yield = $.40 x 4
- Right of inspection: Stockholders have the right to inspect company books and records, including the minutes of shareholder meetings and the list of stockholders.
- Preemptive right: Preemptive right refers to the right of shareholders to maintain a proportional ownership by purchasing newly issued shares of common stock from the company before they are offered to the public. Otherwise, a new issue would dilute the value of their investment.
- Stock splits: A company may wish to decrease the price of its stock and make it more marketable. The par value and the market price of the stock are adjusted according to a particular ratio, for example: 2-for-1, 3-for-2, 4-for-3. So, even though the stockholder's number of shares increases, the absolute value of an investor's shareholding does not change. This is also referred to as a "forward stock split".
- A company may also perform a reverse stock split. Here, the shareholder will received a decreased number of shares at a higher per-share value. For instance, if a company's stock is trading at $2 per share, investors may avoid buying shares because they believe the price is too low. To make the price of shares more appealing, the company could issue a reverse stock split at a 1-for-10 ratio. A shareholder with 1,000 shares now owns 100 shares at $20 a piece.
- Stock buybacks: A corporation that wants to increase the price of its shares will sometimes buy back shares on the open market. The repurchased stocks, called treasury stock, are put aside as non-voting shares that do not pay a dividend. Since the outstanding stock remaining is reduced in number, the price of the stock goes up.
- Stock dividends: Instead of paying dividends to shareholders in cash, a company may elect to pay dividends with additional shares of stock. For example, a stockholder with 1,000 shares of a company that decides to pay a 3% stock dividend will receive an extra 30 shares. (1,000 x .03 = 30) Unlike cash dividends, which are taxable in the year in which they are received, stock dividends are taxable only when they are sold.
Exam Tips and Tricks
For the exam, make sure you know the privileges given to common stockholders!