Securities issued by a corporation are classified as debt, equity, or some hybrid of these two forms. Debt usually takes the form of a loan and must be repaid; equity usually takes the form of an ownership claim upon the corporation. The two main types of equity claims are common stock and preferred stock, although there are also related claims, such as rights, warrants, and convertible securities. Growing companies, which tend to lack the assets necessary to secure debt, often decide to issue equity securities. Although issuing common stock can be traumatic for a small business—because it can be costly, and because it causes a dramatic redistribution of ownership and control—it can also provide a solid foundation upon which to build a company. Preferred stock offers holders priority in receiving dividends and in claiming assets in the event of business liquidation, but it also lacks the voting rights afforded to common stockholders. Many venture capitalists require convertible preferred stock—which can be converted to common stock at some time in the future at a favorable price—as incentive to invest in start-up ventures.
A share of common stock is quite literally a share in the business, a partial claim to ownership of the firm. Owning a share of common stock provides a number of rights and privileges. These include sharing in the income of the firm, exercising a voice in the management of the firm, and holding a claim on the assets of the firm.
Sharing in the income of the firm is generally in the form of a cash dividend. The firm is not obligated to pay dividends, which must be declared by the board of directors. The size and timing of the dividends is uncertain. In a strictly rational economic environment, dividends would be considered as a "residual." In this view, the firm would weigh payment of dividends against other uses for the funds. Dividends would be paid only if the firm had no better use for the funds. In this case, declaring or increasing dividends would be a negative signal, since the firm would be admitting that it lacked possibilities for growth.
For widely held, publicly traded firms there are a number of indications that this is not the case, and that shareholders and investors like dividends and dividend increases. In these contexts, dividends are taken as a signal that the firm is financially healthy. A decrease in dividends would indicate inability to maintain the level of dividends, signaling a decline in prospects. An increase would signal an improvement in prospects. The signal from a dividend decrease is strong because management will wish to give only positive signals by at least maintaining the dividend, making cuts only when absolutely necessary. The signal from a dividend increase is also strong because management would be hesitant to increase dividends unless they could be maintained. The signaling nature of dividends is supported by cases in which the dividend is maintained in the face of declining earnings, sometimes even using borrowed funds. It is also supported by the occurrence of "extraordinary" or one-time-only dividends, a label by which management attempts to avoid increasing expectations.
This signaling approach is not applicable to closely held firms. In this situation, communication between management and shareholders is more direct and signals are not required. When owners are also the managers, sharing in earnings may take the indirect form of salaries and fringe benefits. In fact, shareholders in closely held firms may prefer that dividends be reinvested, even in relatively low return projects, as a form of tax protection. The investment is on a pretax (before personal tax) basis for the investor, avoiding immediate double taxation and converting the income to capital gains that will be paid at a later date.
Dividends are declared for stockholders at a particular date, called the date of record. Since stock transactions ordinarily take five business days for completion, the stock goes "ex-dividend" four days before the date of record, unless special arrangement is made for immediate delivery. Since the dividend removes funds from the firm, it can be expected that the per share price will decrease by the amount of the dividend on the ex-dividend date.
Stock dividends are quite different in form and nature from cash dividends. In a stock dividend, the investor is given more shares in proportion to the number already held. A stock split is similar, with a difference in accounting treatment and a greater increase in the number of shares. The use of the word "dividends" in stock dividends is actually a misuse of the word, since there is no flow of cash, and the proportional and absolute ownership of the investor is unchanged. The stockholder receives nothing more than a repackaging of ownership: the number of shares increases, but the price per share will drop. There are, however, some arguments in favor of stock dividends. One of these is the argument that investors will avoid stocks of unusually high price, possibly due to required size of investment and round lot (100 share) trading. On the other hand, stocks with unusually low price are also avoided, perhaps perceived as "cheap." The price drop accompanying stock dividends can be used to adjust price. Stock dividends have also been suggested as a way to make cash dividends elective while also providing tax-advantaged reinvestment.
With a cash dividend, an investor who wishes to reinvest must pay taxes and then reinvest the reduced amount. With a stock dividend, the entire amount is reinvested. Although taxes will ultimately be paid, in the interim a return is earned on the entire pretax amount. This is the same argument as that for low dividends in a closely held firm. Investors who wish cash dividends can simply sell the stock. Using stock dividends in this way faces restrictions from the Internal Revenue Service.
The corporate form allows the separation of management and ownership, with the manager serving as the agent of the owner. Separation raises the problem of control, or what is termed the agency problem. Stockholders have only indirect control by voting for the directors. The directors in turn choose management and are responsible for monitoring and controlling management's conduct. In fact, the stockholders' ability to influence the conduct of the firm may be quite small, and management may have virtually total control within very broad limits.
Voting for the directors takes either of two forms. The first form is majority voting. In this form, each stockholder receives votes for each open position according to the number of shares held, and may cast those votes only for candidates for that position. The winning candidate is the candidate winning a majority of the votes cast. The second form is called cumulative voting. In this form, stockholders again receive votes for each open position according to the number of shares held, but may apportion the votes among the positions and candidates as desired. The candidates receiving the most votes are elected.
Excluding minority stockholders from representation on the board is more difficult under cumulative voting. For example, if there are four directors to be elected and one million shares eligible to vote at one vote per share, a stockholder with 500,001 shares would control the election. Under majority voting a dissident stockholder with 200,001 shares could cast only 200,001 votes apiece for candidates for each of the four positions, which would not be sufficient to ensure representation on the board. Under cumulative voting, a dissident stockholder with a minimum of 200,001 shares could be sure of representation by electing one candidate of choice, casting a cumulative 800,004 votes for that candidate. The remaining 799,999 shares could be sure of electing three chosen candidates, but could not command sufficient votes to exceed the cumulative dissident vote four times.
Although the board of directors is supposedly independent of management, the degree of independence is sometimes small. Typically, some members of the board are "insiders" drawn from management, while others are "outside" directors. Even the outside directors may not be completely independent of management for several reasons. One reason is that few shareholders can afford the time and expense to attend the annual meetings, so that voting is done through the mail. This usually takes the form of a "proxy" giving management the power to vote for the shareholder, as instructed. While the shareholder may instruct management on how to vote, the choices may be few and are controlled by management. Management will tend to nominate safe candidates for directorship, who will not be likely to challenge the status quo. As a result, directorship is at times an honor or sinecure, treated as having few real obligations.
Dissidents may mount opposition and seek the proxy votes, but such opposition is liable to face legal challenges and must overcome both psychological barriers and shareholder apathy. Many shareholders either do not vote or routinely vote for existing management. Further, dissidents must spend their own money, while management has the resources of the firm at its disposal.
In addition to controlling the proxy system, managements have instituted a number of other defensive mechanisms in the face of takeover threats. It is not unusual to find several "classes" of stock with different voting power, with some classes having no voting power at all. A number of firms have changed from cumulative to majority voting. Staggered boards, in which only a portion of the board terms expire in a given year, and supermajority voting policies have also been used. Takeover defenses include the golden parachute, or extremely generous severance compensation in the face of a takeover, and the poison pill, an action that is triggered by a takeover and has the effect of reducing the value of the firm. All of these measures act to make stockholder power appear more tenuous.
There has been some recent movement towards greater stockholder power. One factor in this movement is the increasing size of institutional investors such as pensions and mutual funds. This has led to a more activist stance, and a willingness to use the power of large stock positions to influence management. Another factor is a renewed emphasis on the duties of the directors, who may be personally liable for management's misconduct.
The common stockholder has a claim on the assets of the firm. This is an undifferentiated or general claim which does not apply to any specific asset. The claim cannot be exercised except at the breakup of the firm. The firm may be dissolved by a vote of the stockholders, or by bankruptcy. In either case, there is a well-defined priority in which the liabilities of the firm will be met. The common stockholders have the lowest priority, and receive a distribution only if prior claims are paid in full. For this reason the common stockholder is referred to as the residual owner of the firm.
The corporate charter will often provide common stockholders with the right to maintain their proportional ownership in the firm, called the preemptive right. For example, if a stockholder owns 10 percent of the stock outstanding and 100,000 new shares are to be issued, the stockholder has the right to purchase 10,000 shares (10 percent) of the new issue. This preemptive right can be honored in a rights offering. In a rights offering, each stockholder receives one right for each share held. Buying shares or subscribing to the issue then requires the surrender of a set number of rights, as well as payment of the offering price. The offering is often underpriced in order to assure its success. The rights are then valuable because possession of the rights allows subscription to the underpriced issue. The rights can be transferred, and are often traded.
A rights offering may be attractive to management because the stockholders, who thought enough of the firm to buy its stock, are a pre-sold group. The value of the preemptive right to the common stockholders, however, is questionable. The preemptive right of proportional ownership is important only if proportional control is important to the stockholder. The stockholder may be quite willing to waive the preemptive right. If the funds are used properly, the price of the stock will increase, and all stockholders will benefit. Without buying part of the new issue, the stockholder may have a smaller proportional share, but the share will be worth more. While rights are usually valuable, this value arises from under-pricing of the issue rather than from an inherent value of rights. The value of the rights ultimately depends on the use of the funds and whether or not the market views that use as valuable.
In investment practice, decisions are more often expressed and made in terms of the comparative expected rates of return, rather than on price. A number of models and techniques are used for valuation. A common approach to valuation of common stock is present value. This approach is based on an estimate of the future cash dividends. The present value is then the amount which, if invested at the required rate of return on the stock, could exactly recreate the estimated dividends. This required rate of return can be estimated from models such as the capital asset pricing model (CAPM), using the systematic risk of the stock, or from the estimated rate of return on stocks of similar risk. Another common approach is based on the price-earnings ratios, or P/E. In this approach, the estimated earnings of the firm are multiplied by the appropriate P/E to obtain the estimated price. This approach can be shown to be a special case of present value analysis, with restrictive assumptions. Since various models and minor differences in assumptions can produce widely different results, valuation is best applied as a comparative analysis.
In some cases, such as estate valuation, the dollar value of the stock must be estimated for legal purposes. For assets that are widely publicly traded, the market price is generally taken as an objective estimate of asset value for legal purposes, since this is sale value of the stock. For stock that is not widely traded, valuation is based on models such as present value, combined with a comparison with similar publicly traded stock. Often, however, a number of discounts are applied for various reasons. It is widely accepted that, compared to publicly traded stock, stock that is not publicly traded should be valued at a discount because of a lack of liquidity. This discount may be 60 percent or more. Another discount is applied for a minority position in a closely held stock or a family firm, since the minority position would have no control This discount does not apply if the value is estimated from the value of publicly traded stock, because the market price of a stock is traded already the price of a minority position. There is an inverse effect for publicly traded stock in the form of a control premium. A large block of stock which would give control of the firm might be priced above market.
Finally, it should be noted that the accounting book value is only rarely more than tangentially relevant to market value. This is due to the use of accounting assumptions such as historic cost. While accounting information may be useful in a careful valuation study, accounting definitions of value differ sharply from economic value.
Preferred stock is sometimes called a hybrid, since it has some of the properties of equity and some of the properties of debt. Like debt, the cash flows to be received are specified in advance. Unlike debt, these specified flows are in the form of promises rather than of legal obligations. It is not unusual for firms to have several issues of preferred stock outstanding, with differing characteristics. Other differences arise in the areas of control and claims on assets.
Because the specified payments on preferred stock are not obligations, they are referred to as dividends. Preferred dividends are not tax-deductible expenses for the firm, and consequently the cost to the firm of raising capital from this source is higher than for debt. The firm is unlikely to skip or fail to declare the dividend, however, for several reasons. One of the reasons is that the dividends are typically (but not always) cumulative. Any skipped dividend remains due and payable by the firm, although no interest is due. One source of the preferred designation is that all preferred dividends in arrears must be paid before any dividend can be paid to common stockholders (although bond payments have priority over all dividends). Failure to declare preferred dividends may also trigger restrictive conditions of the issue. A very important consideration is that, just as for common dividends, preferred dividends are a signal to stockholders, both actual and potential. A skipped preferred dividend would indicate that common dividends will also be skipped, and would be a very negative signal that the firm was encountering problems. This would also close off access to most lenders.
There is also a form of preferred stock, called participating preferred stock, in which there may be a share in earnings above the specified dividends. Such participation would typically only occur if earnings or common dividends rose over some threshold, and might be limited in other ways. A more recent innovation is adjustable-rate preferred stock, with a variable dividend based on prevailing interest rates.
Under normal circumstances, preferred stockholders do not have any voting power. As a result, they have little control over or direct influence on the conduct of the firm. Some minimal control would be provided by the indenture under which the stock was issued, and would be exercised passively—i.e., the trustees for the issue would be responsible for assuring that all conditions were observed. In some circumstances, the conditions of the issue could result in increased control on the part of the preferred stockholders. For instance, it is not unusual for the preferred stockholders to be given voting rights if more than a specified number of preferred dividends are skipped. Other provisions may restrict the payment of common dividends if certain conditions are not met. Preferred stockholders also may have a preemptive right.
Claim on Assets and Other Features
Another source of the preferred designation is that preferred stock has a prior claim on assets over that of common stock. The claim of bondholders is prior to that of the preferred stockholders. Although preferred stock typically has no maturity date, there is often some provision for retirement. One such provision is the call provision, under which the firm may buy back or recall the stock at a stated price. This price may vary over time, normally dropping as time passes. Another provision is the sinking fund, under which the firm will recall and retire a set number of shares each year. Alternately, the firm may repurchase the shares for retirement on the open market, and would prefer to do so if the market price of the preferred is below the call price. Preferred stock is sometimes convertible, i.e., it can be exchanged for common stock at the discretion of the holder. The conversion takes place at a set rate, but this rate may vary over time.
The par value of a preferred stock is not related to market value, except that it is often used to define the dividend. Since the cash flow of dividends to preferred stockholders is specified, valuation of preferred stock is much simpler than for common stock. The valuation techniques are actually similar to those used for bonds, drawing heavily on the present value concept. The required rate of return on preferred stock is closely correlated with interest rates, but is above that of bonds because the bond payments are contractual obligations. As a result, preferred stock prices fluctuate with interest rates. The introduction of adjustable-rate preferred stock is an attempt to reduce this price sensitivity to interest rates.
Purchases of foreign stock have greatly increased in recent years. One motivation behind this increase is that national economies are not perfectly correlated, so that greater diversification is possible than with a purely domestic portfolio. Another reason is that a number of foreign economies are growing, or are expected to grow, rapidly. Additionally, a number of developing countries have consciously promoted the development of secondary markets as an aid to economic development. Finally, developments in communications and an increasing familiarity with international affairs and opportunities has reduced the hesitance of investors to venture into what once was unfamiliar territory.
Foreign investment is not without problems. International communication is still more expensive and sometimes slower than domestic communication. Social and business customs often vary greatly between countries. Trading practices on some foreign exchanges are different than in the United States. Accounting differs not only in procedures, but often in degree of information disclosed. Although double taxation is generally avoided by international treaties, procedures are cumbersome. Political instability can be a consideration, particularly in developing countries. Finally, the investor faces exchange rate risk. A handsome gain in a foreign currency can be diminished, or even turned into a loss, by shifting exchange rates. These difficulties are felt less by professional managers of large institutions, and much of the foreign investment is through this channel.
An alternative vehicle for foreign investing is the American Depositary Receipt (ADR). This is simply a certificate of ownership of foreign stock that is deposited with a U.S. trustee. The depository institution also exchanges and distributes any dividends, and provides other administrative chores. ADRs are appealing to individual investors. It has also been suggested that the benefits of international investing can be obtained by investing in international firms.
Stocks are diverse in nature and can be classified many ways for investment purposes. For example, stocks can be classified according to the level of risk. Risky stocks are sometimes referred to as aggressive or speculative. They may also be growth stocks, which are expected to experience high rates of growth in size and earnings. If risk is measured by the beta (systematic or nondiversifiable risk), then the term applies to a stock with a beta greater than one. These stocks are quite sensitive to economic cycles, and are also called cyclical. Contrasted are the blue-chip stocks—high-quality stocks of major firms that have long and stable records of earnings and dividends. Stocks with low risk, or a beta of less than one, are referred to as defensive. One form of investment strategy, called timing, is to switch among cyclical and defensive stocks according to expected evolution of the economic cycle. This strategy is sometimes refined to movement among various types of stock or sectors of the economy. Another stock category is income stocks—stocks that have a long and stable record of comparatively high dividends.
Common stock has been suggested as a hedge against inflation. This suggestion arises from two lines of thought. The first is that stocks ultimately are claims to real assets and productivity, and the prices of such claims should rise with inflation. The second line of thought is that the total returns to common stock are high enough to overcome inflation. While this is apparently true over longer periods, it has not held true over shorter periods.
Preferred stock is generally not considered a desirable investment for individuals. While the junior position of preferred stockholders as compared to bondholders indicates that the required rate of return on preferred will be above that of bonds, observation indicates that the yield on bonds has generally been above that of preferred stock of similar quality. The reason for this is a provision of the tax codes that 70 percent of the preferred dividends received by a corporation are tax exempt. This provision is intended to avoid double taxation. Because of the tax exemption, the effective after-tax yield on preferred stock is higher for corporations, and buying of preferred stock by corporations drives the yields down. The resulting realized return for individuals, who cannot take advantage of this tax treatment, would generally be below acceptable levels.
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updated by Magee, ECDI