Common stocks, also known as equity securities, or equities, represent ownership shares in a corporation. Each share of common stock entitles its owners to one vote on any matters of corporate governance put to a vote at the corporation’s annual meeting and to a share in the financial benefits of ownership1 (e.g., the right to any dividends that the corporation may choose to distribute).
Acorporation is controlled by a board of directors elected by the shareholders.2 The board, which meets only a few times each year, selects managers who run the corporation on a dayto- day basis. Managers have the authority to make most business decisions without the board’s approval. The board’s mandate is to oversee management to ensure that it acts in the best interests of shareholders.
The members of the board are elected at the annual meeting. Shareholders who do not attend the annual meeting can vote by proxy, empowering another party to vote in their name. Management usually solicits the proxies of shareholders and normally gets a vast majority of these proxy votes. Thus, management usually has considerable discretion to run the firm as it sees fit, without daily oversight from the equityholders who actually own the firm.
We noted that there are several mechanisms to alleviate the potential agency problems that might arise from this arrangement. Among these are compensation schemes that link the success of the manager to that of the firm; oversight by the board of directors as well as outsiders such as security analysts, creditors, or large institutional investors; the threat of a proxy contest in which unhappy shareholders attempt to replace the current management team; or the threat of a takeover by another firm.
The common stock of most large corporations can be bought or sold freely on one or more of the stock exchanges. A corporation whose stock is not publicly traded is said to be closely held. In most closely held corporations, the owners of the firm also take an active role in its management. Takeovers generally are not an issue.
Characteristics of Common Stock
The two most important characteristics of common stock as an investment are its residual claim and its limited liability features. Residual claim means stockholders are the last in line of all those who have a claim on the
assets and income of the corporation. In a liquidation of the firm’s assets, the shareholders have claim to what is left after paying all other claimants, such as the tax authorities, employees, suppliers, bondholders, and other creditors. In a going concern, shareholders have claim to the part of operating income left after interest and income taxes have been paid. Management either can pay this residual as cash dividends to shareholders or reinvest it in the business to increase the value of the shares.
Limited liability means that the most shareholders can lose in event of the failure of the corporation is their original investment. Shareholders are not like owners of unincorporated businesses, whose creditors can lay claim to the personal assets of the owner—such as houses, cars, and furniture. In the event of the firm’s bankruptcy, corporate stockholders at worst have worthless stock. They are not personally liable for the firm’s obligations: Their liability is limited.
Stock Market Listings
The NYSE is one of several markets in which investors may buy or sell shares of stock.. To interpret the information provided for each stock, consider the highlighted listing for General Electric. The first column is the percentage change in the stock price from the start of the year. GE shares have fallen 22.3% this year. The next two columns give the highest and lowest prices at which the stock has traded during the previous 52 weeks, $57.88 and $28.50, respectively. Until 1997, the minimum “tick size” on the New York Stock Exchange was $1⁄8, which meant that prices could be quoted only as dollars and eighths of dollars. In 1997, all U.S. exchanges began allowing price quotes in increments of $1⁄16. By 2001, U.S. markets moved to decimal pricing, which means that stock prices can be quoted in terms of dollars and cents.
The .64 figure in the listing for GE means that the last quarter’s dividend was $.16 a share, which is consistent with annual dividend payments of $.16 4 $.64. This value corresponds to a dividend yield of 1.7%: Since GE stock is selling at 37.25 (the last recorded, or “close,” price in the next-to-last column), the dividend yield is .64/37.25 .017, or 1.7%. The stock listings show that dividend yields vary widely among firms. High dividend-yield stocks are not necessarily better investments than low-yield stocks. Total return to an investor
comes from both dividends and capital gains, or appreciation in the value of the stock. Low dividend-yield firms presumably offer greater prospects for capital gains, or else investors would not be willing to hold the low-yield firms in their portfolios.
The P/E ratio, or price-to-earnings ratio, is the ratio of the current stock price to last year’s earnings. The P/E ratio tells us how much stock purchasers must pay per dollar of earnings the firm generates for each share. For GE, the ratio of price to earnings is 27. The P/E ratio also varies widely across firms. Where the dividend yield and P/E ratio are not reported in Figure 2.9, the firms have zero dividends, or zero or negative earnings. We shall have much to say about P/E ratios in Part Four.
The sales column (“Vol”) shows that 151,392 hundred shares of GE were traded on this day. Shares commonly are traded in round lots of 100 shares each. Investors who wish to trade in smaller “odd lots” generally must pay higher commissions to their stockbrokers. The last, or closing, price of $37.25 was up $.10 from the closing price of the previous day.
Preferred Stock
Preferred stock has features similar to both equity and debt. Like a bond, it promises to pay to its holder a fixed stream of income each year. In this sense, preferred stock is similar to an infinite-maturity bond, that is, a perpetuity. It also resembles a bond in that it does not give the holder voting power regarding the firm’s management.
Preferred stock is an equity investment, however. The firm retains discretion to make the dividend payments to the preferred stockholders: It has no contractual obligation to pay those dividends. Instead, preferred dividends are usually cumulative; that is, unpaid dividends cumulate and must be paid in full before any dividends may be paid to holders of common stock.
In contrast, the firm does have a contractual obligation to make the interest payments on the debt. Failure to make these payments sets off corporate bankruptcy proceedings. Preferred stock also differs from bonds in terms of its tax treatment for the firm. Because preferred stock payments are treated as dividends rather than as interest on debt, they are not tax-deductible expenses for the firm. This disadvantage is largely offset by the fact that corporations may exclude 70% of dividends received from domestic corporations in the computation
of their taxable income. Preferred stocks, therefore, make desirable fixed-income investments for some corporations.
Even though preferred stock ranks after bonds in terms of the priority of its claim to the assets of the firm in the event of corporate bankruptcy, preferred stock often sells at lower yields than corporate bonds. Presumably this reflects the value of the dividend exclusion, for risk considerations alone indicate that preferred stock ought to offer higher yields than bonds. Individual investors, who cannot use the 70% exclusion, generally will find preferred stock yields unattractive relative to those on other available assets.
Corporations issue preferred stock in variations similar to those of corporate bonds. Preferred stock can be callable by the issuing firm, in which case it is said to be redeemable. It also can be convertible into common stock at some specified conversion ratio. Arelatively recent innovation in the market is adjustable-rate preferred stock, which, like adjustable-rate mortgages, ties the dividend rate to current market interest rates.
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