Chapter 1: What is a Security? - C. Why Do People Buy Common Stock?

Capital Appreciation/Growth

The main reason people invest in common stock is for capital appreciation. They want their money to grow in value over time. An investor in common stock hopes to buy the stock at a low price and sell it at a higher price at some point in the future.

Example:

An investor purchases 100 shares of XYZ at $20 per share on March 15, 2011. On April 30, 2012, the investor sells 100 shares of XYZ for $30 per share, realizing a profit of $10 per share, or $1,000 on the 100 shares.

Income

Many corporations distribute a portion of their earnings to their investors in the form of dividends. This distribution of earnings creates income for the investor. Investors in common stock generally receive dividends quarterly.

Example:

ABC pays a $.50 quarterly dividend to its shareholders. The stock is currently trading at $20 per share. What is its current yield (also known as dividend yield)?

annual income / current market price = current yield

$.50 x 4 quarters = $2.00 $2 / $20 = 10%

The investor in the above example is receiving 10% of the purchase price of the stock each year in the form of dividends.

What Are the Risks of Owning Common Stock?

The major risk in owning common stock is that the stock may fall in value. There are no sure things in the stock market and even if a company seems great, an investor may end up losing money.

Dividends May Be Stopped or Reduced

Common stockholders are not entitled to receive dividends just because they own part of the company. It is up to the company to elect to pay a dividend. The corporation is in no way obligated to pay common shareholders a dividend.

Junior Claim on Corporate Assets

A common stockholder is the last person to get paid if the company is liquidated. It is very possible that after all creditors and other investors are paid, that there will be little or no money left for the common stockholder.

Preferred Stock

Preferred stock is an equity security with a fixed income component. Like a common stockholder, the preferred stockholder is an owner of the company. However, the preferred stockholder is investing in the stock for the fixed income that the preferred shares generate through their semi-annual dividends. Preferred stock has a stated dividend rate, or a fixed rate, that the corporation must pay to its preferred shareholders. Growth is generally not achieved through investing in preferred shares.

Features of Preferred Stock

Par Value

Par value on preferred stock is very important because it is what the dividend is based on. Par value for preferred shares is $100. Companies generally express the dividend as a percentage of par value for preferred stock.

Example:

How much would the following investor receive in annual income from the investment in the following preferred stock?

An investor buys 100 shares of TWT 9% preferred

$100 x .09 = $9 per share x 100 = $900

Payment of Dividends

The dividend on preferred shares must be paid before any dividends are paid to common shareholders. This gives the preferred shareholder a priority claim on the corporation’s distribution of earnings.

Distribution of Assets

If a corporation liquidates or declares bankruptcy, the preferred shareholders are paid prior to any common shareholder, giving the preferred shareholder a higher claim on the corporation’s assets.

Perpetual

Preferred stock, unlike bonds, is perpetual, with no maturity date. Investors may hold shares for as long as they wish or until they are called in by the company under a call feature.

Non-Voting

Most preferred stock is non-voting. Occasionally if the company has been in financial difficulty and has missed preferred dividend payments for an extended period of time preferred shareholders may receive the right to vote.

Interest Rate Sensitive

Because of the fixed income generated by preferred shares, their price will be more sensitive to change in interest rates than the price of their common stock counterparts. As interest rates decline, the value of preferred shares tends to increase. When interest rates rise, the value of the preferred shares tends to fall. This is known as an inverse relationship.

Types of Preferred Stock

Preferred stock has different features associated with it than common stock. Most of the features are designed to make the issue more attractive to investors and therefore benefit the owners of preferred stock.

Straight / Non-Cumulative Preferred

Straight, or non-cumulative, preferred stock has no additional features. The holder is entitled to the stated dividend rate and nothing else. If the corporation is unable to pay the dividend, it is not owed to the investor.

Cumulative Preferred

A cumulative feature protects the investor in cases when a corporation is having financial difficulties and cannot pay the dividend. Dividends on cumulative preferred stock accumulate in arrears until the corporation is able to pay them. If the dividend on a cumulative preferred stock is missed, it is sill owed to the holder. Dividends in arrears on cumulative issues are always the first dividends to be paid. If the company wants to pay a dividend to common shareholders, they must first pay the dividends in arrears as well as the stated preferred dividend before common shareholders receive anything.

Test Focus!

GNR has an 8% cumulative preferred stock outstanding. It has not paid the dividend this year or for the prior three years. How much must the holders of GNR cumulative preferred be paid per share before the common stockholders are paid a dividend?

The dividend has not been paid this year nor for the previous three years, so the holders are owed four years worth of dividends or

4 x $8 = $32 per share

Participating Preferred

Holders of participating preferred stock are entitled to receive the stated preferred rate as well as additional common dividends. The holder of participating preferred stock receives the dividend payable to the common stockholders over and above the stated preferred dividend.

Convertible Preferred

A convertible feature allows the preferred stockholder to convert or exchange their preferred shares for common shares at a fixed price known as the conversion price.

Example:

TRW has issued a 4% convertible preferred stock, which may be converted into TRW common stock at $20 per share. How many shares may the preferred stockholder receive upon conversion?

par value / conversion price (CVP) = number of shares

$100 / $20 = 5

The investor may receive five common shares for every preferred share.

Callable Preferred

A call feature is the only feature that benefits the company and not the investor. A call feature allows the corporation to call in or redeem the preferred shares at their discretion or after some period of time has expired. Most preferred stock that is callable cannot be called in the first few years after its issuance. This is known as “call protection.” Many callable preferred shares will be called at a premium price above par. For example, a $100 par preferred stock may be called at $103. The main reasons a company would call in their preferred shares would be to eliminate the fixed dividend payment or to sell a new preferred stock with a lower dividend rate when interest rates decline. Preferred stock is more likely to be called by the corporation during a decline in interest rates.

D. Types of Dividends
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