Stocks are devices used since medieval times for public humiliation, corporal punishment, and torture. The stocks are similar to the pillory and the pranger, as each consists of large, hinged, wooden boards; the difference, however, is that when a person is placed in the stocks, their feet are locked in place, and sometimes as well their hands or head, or these may be chained. The victim is in a sitting position.
With stocks, boards are placed around the legs or the wrists, whereas in the pillory they are placed around the arms and neck and fixed to a pole, and the victim stands. However, the terms can be confused, and many people refer to the pillory as the stocks.
The practice of using stocks continues to be cited as an example of cruel and unusual punishment.
The Definition of a Stock
Plain and simple, stock is a share in the ownership of a company. Stock represents a claim on the company's assets and earnings. As you acquire more stock, your ownership stake in the company becomes greater. Whether you say shares, equity, or stock, it all means the same thing.
Being an Owner
Holding a company's stock means that you are one of the many owners (shareholders) of a company and, as such, you have a claim (albeit usually very small) to everything the company owns. Yes, this means that technically you own a tiny sliver of every piece of furniture, every trademark, and every contract of the company. As an owner, you are entitled to your share of the company's earnings as well as any voting rights attached to the stock.
A stock is represented by a stock certificate. This is a fancy piece of paper that is proof of your ownership. In today's computer age, you won't actually get to see this document because your brokerage keeps these records electronically, which is also known as holding shares "in street name". This is done to make the shares easier to trade. In the past, when a person wanted to sell his or her shares, that person physically took the certificates down to the brokerage. Now, trading with a click of the mouse or a phone call makes life easier for everybody.
Being a shareholder of a public company does not mean you have a say in the day-to-day running of the business. Instead, one vote per share to elect the board of directors at annual meetings is the extent to which you have a say in the company. For instance, being a Microsoft shareholder doesn't mean you can call up Bill Gates and tell him how you think the company should be run. In the same line of thinking, being a shareholder of Anheuser Busch doesn't mean you can walk into the factory and grab a free case of Bud Light!
The management of the company is supposed to increase the value of the firm for shareholders. If this doesn't happen, the shareholders can vote to have the management removed, at least in theory. In reality, individual investors like you and I don't own enough shares to have a material influence on the company. It's really the big boys like large institutional investors and billionaire entrepreneurs who make the decisions.
For ordinary shareholders, not being able to manage the company isn't such a big deal. After all, the idea is that you don't want to have to work to make money, right? The importance of being a shareholder is that you are entitled to a portion of the company’s profits and have a claim on assets. Profits are sometimes paid out in the form of dividends. The more shares you own, the larger the portion of the profits you get. Your claim on assets is only relevant if a company goes bankrupt. In case of liquidation, you'll receive what's left after all the creditors have been paid. This last point is worth repeating: the importance of stock ownership is your claim on assets and earnings. Without this, the stock wouldn't be worth the paper it's printed on.
Another extremely important feature of stock is its limited liability, which means that, as an owner of a stock, you are not personally liable if the company is not able to pay its debts. Other companies such as partnerships are set up so that if the partnership goes bankrupt the creditors can come after the partners (shareholders) personally and sell off their house, car, furniture, etc. Owning stock means that, no matter what, the maximum value you can lose is the value of your investment. Even if a company of which you are a shareholder goes bankrupt, you can never lose your personal assets.
Debt vs. Equity
Why does a company issue stock? Why would the founders share the profits with thousands of people when they could keep profits to themselves? The reason is that at some point every company needs to raise money. To do this, companies can either borrow it from somebody or raise it by selling part of the company, which is known as issuing stock. A company can borrow by taking a loan from a bank or by issuing bonds. Both methods fit under the umbrella of debt financing. On the other hand, issuing stock is called equity financing. Issuing stock is advantageous for the company because it does not require the company to pay back the money or make interest payments along the way. All that the shareholders get in return for their money is the hope that the shares will someday be worth more than what they paid for them. The first sale of a stock, which is issued by the private company itself, is called the initial public offering (IPO).
It is important that you understand the distinction between a company financing through debt and financing through equity. When you buy a debt investment such as a bond, you are guaranteed the return of your money (the principal) along with promised interest payments. This isn't the case with an equity investment. By becoming an owner, you assume the risk of the company not being successful - just as a small business owner isn't guaranteed a return, neither is a shareholder. As an owner, your claim on assets is less than that of creditors. This means that if a company goes bankrupt and liquidates, you, as a shareholder, don't get any money until the banks and bondholders have been paid out; we call this absolute priority. Shareholders earn a lot if a company is successful, but they also stand to lose their entire investment if the company isn't successful.
It must be emphasized that there are no guarantees when it comes to individual stocks. Some companies pay out dividends, but many others do not. And there is no obligation to pay out dividends even for those firms that have traditionally given them. Without dividends, an investor can make money on a stock only through its appreciation in the open market. On the downside, any stock may go bankrupt, in which case your investment is worth nothing.
Although risk might sound all negative, there is also a bright side. Taking on greater risk demands a greater return on your investment. This is the reason why stocks have historically outperformed other investments such as bonds or savings accounts. Over the long term, an investment in stocks has historically had an average return of around 10-12%.
Types of Stock
Common stock is, well, common. When people talk about stocks they are usually referring to this type. In fact, the majority of stock is issued is in this form. We basically went over features of common stock in the last section. Common shares represent ownership in a company and a claim (dividends) on a portion of profits. Investors get one vote per share to elect the board members, who oversee the major decisions made by management.
Over the long term, common stock, by means of capital growth, yields higher returns than almost every other investment. This higher return comes at a cost since common stocks entail the most risk. If a company goes bankrupt and liquidates, the common shareholders will not receive money until the creditors, bondholders and preferred shareholders are paid.
Advantages and Disadvantages
Every share of common stock represents a proportional ownership, or equity, in a company. If a company has only one share of common stock and an investor owns it, the investor owns the entire company and is entitled to one hundred percent of the company’s profits. If a company has 100,000 shares of common stock and an investor owns one of them, then the investor owns 1/100,000th of the company, and as such, has an interest in 1/100,000th of the company’s profits.
Common stock has a number of advantages which make it a desirable investment vehicle, some of which are listed below:
- Common stock has the potential for delivering very large gains, unlike bonds, Certificates of Deposit, or some other alternatives. Annual returns-on-investment (ROIs) of over 100% have occurred on a somewhat regular basis.
- The potential loss from stock purchased with cash is limited to the total amount of the initial investment. This is considerably better than that of some leveraged transactions, where the maximum loss can well exceed the total of the funds invested.
- Stocks offer limited legal liability. Passive stockholders (those who take no active part in the running of the company) are protected against any liability stemming from the company’s actions beyond their financial investment in the company.
- Most stocks are very liquid; in other words, they can be bought and sold quickly at a fair price.
- Although past performance is not a guarantee of future performance, stocks have historically offered very high returns in relation to other investments.
- Stocks offer two ways for their owners to benefit, by capital gains and with dividends. As previously stated, each share of stock represents partial ownership in a company. If the company becomes more valuable, so will the ownership interest represented by each share of stock. This appreciation of the stock’s value is known as a capital gain. In addition, if the company earns more profits than it needs to support its maintenance and growth, it may elect to distribute the excess to its owners, the shareholders. The periodic distributions of profits are called dividend payments.
- Since common stock represents ownership of a business, stockholders are the last to get paid, like all other owners. A company must first pay its employees, suppliers, creditors, maintain its facilities and pay its taxes. Any money left can then be distributed among its owners.
- While shareholders are company owners, they do not enjoy all of the rights and privileges that the owners of privately held companies do. For example, they cannot normally walk in and demand to review in detail the company’s books.
- Investors in a company may not know all that there is to know about the company. This limited information can sometimes cause investment decision-making to be difficult.
- Stock prices tend to be volatile. Prices can be erratic, rising and declining quickly. Such declines often cause investors to panic and sell, which actually only serves to lock in their losses.
- Stock values can sometimes change for no apparent reason, which can be quite frustrating for the investor who is trying to anticipate the stock’s behavior based on the actual performance of the company.
Types of Common Stocks
- Blue Chips:Blue chips refers to the stock offerings of the country’s largest and most prestigious companies. Due to their already large size and market share, these companies sometimes don’t have the potential for further substantial internal growth. On the other hand, they won’t be going out of business anytime soon. They are considered to be relatively low-risk, low-reward investments. They rarely have to raise additional capital, and they usually generate excess cash. As a result, blue chip companies generally pay dividends to their shareholders.
- Utilities:These are the stocks issued by power and water companies. They usually have limited competition, and as such, enjoy somewhat monopolistic conditions. For example, most homeowners have only one choice from which to purchase their power services. Because of these prevailing conditions, utilities are considered low-risk investments. They’re also closely regulated with regard to the prices that they are allowed to charge for their services and the return which they are allowed to earn. Thus, they also offer a fairly low reward. But like blue chip companies, they are generally considered to be very stable and safe investments. Most utilities distribute a relatively high percentage of their earnings in the form of dividends.
- Established Growth:These companies are large enough to be well-established and even well-known, but are small enough to still have the possibility of substantial future growth. They’re usually currently profitable, but may need to raise additional capital to sustain their growth. The earnings that these companies generate are usually reinvested for further expansion and, as a result, they don’t usually pay dividends to their shareholders. However, the shareholders do often reap benefits in the form of capital gains.
- Emerging Growth: Emerging growth companies are relatively small and have the potential for substantial future growth. These companies will generally need to raise additional capital to support their growth and expansion. They, therefore, will not pay dividends. Many times they can offer very attractive returns but they also have additional risk. This can often be attributed to the fact that successful management of rapid corporate growth and its inherent risks can be very challenging and complicated, and many management teams may not quite be suited for the task.
- Penny Stocks:These are by far the most speculative. They generally trade for less than $5 per share. These stocks represent ownership in companies which may still be in the research and development stage of their first product. They may also be offerings of companies that have suffered severe financial setbacks and are barely surviving. While almost always losing money, they carry a great deal of risk, and they tend to be very illiquid. There is generally a high failure rate among these companies.
Preferred stock represents some degree of ownership in a company but usually doesn't come with the same voting rights. (This may vary depending on the company.) With preferred shares, investors are usually guaranteed a fixed dividend forever. This is different than common stock, which has variable dividends that are never guaranteed. Another advantage is that in the event of liquidation, preferred shareholders are paid off before the common shareholder (but still after debt holders). Preferred stock may also be callable, meaning that the company has the option to purchase the shares from shareholders at anytime for any reason (usually for a premium).
Some people consider preferred stock to be more like debt than equity. A good way to think of these kinds of shares is to see them as being in between bonds and common shares.Preferred stock is a specific type of stock which has very different characteristics from common stock. Like common stock, proceeds from the sale of preferred stock are recorded by the company on its balance sheet as equity; or, an ownership interest. For all practical purposes, however, investors consider preferred stocks to be another type of debt security; specifically, one which normally pays a fixed return in the form of quarterly dividends instead of semi-annual interest payments, as some bonds do.
Because preferred stocks are, in fact, equity instruments, they have three important differences from bonds. First, they are junior to the company’s debt obligations. Every security that a company issues has a specific ranking order, from the most senior to the most junior. In the event that the company doesn’t generate enough cash to service all of its debts, this ranking order will determine who receives payment first. Interest payments are made first to the most senior debt holder, then to the next, and so on until the available cash is exhausted. Being company ownership, common stocks are always the most junior securities, with preferred stocks ranking between the most junior debt security and the company’s common stock.
Second, unlike debt instruments, the company isn’t legally obligated to make dividend payments to its preferred stockholders. Missing an interest payment on a bond will cause a default because it is a debt. Bondholders can then claim breach of contract and force the company into involuntary bankruptcy. They can also have the company’s board of directors or management team replaced. Missing a dividend payment, however, is not a breach of contract and, thus, will not cause a default. A company will usually strive to make its dividend payments to preferred stockholders nonetheless, because generally, the company is prohibited from making dividend payments to its common stockholders as well as to company managers until its preferred stockholders have been paid.
The third difference between preferred stocks and bonds is that dividends don’t accrue between dividend payment dates. When bonds trade, they trade with accrued interest. An investor who buys a bond between interest payment dates must pay the seller not only the price of the bond, but also the interest that the bond has earned since the last interest payment date. Preferred stocks do not trade with accrued dividends. When an investor buys a preferred stock between dividend payment dates, the seller is not entitled to receive a partial or prorated dividend amount. Whoever owns the stock on the ownership day of record, known as the ex-dividend day, is entitled to receive any dividend payment, regardless of how long that investor has owned the stock.
Companies issue preferred stocks in order to strengthen their balance sheets. Since the proceeds from preferred stock sales are considered equity, they also improve the issuing company’s debt-to-equity ratio. Companies need to enhance their balance sheets for several reasons: to avoid violating the covenants of their loan agreements; to meet legally mandated debt-to-equity ratios (for regulated industries such as banking or insurance); and to provide the capital that’s necessary to support their expansion plans. While the issuance of either preferred or common stock will strengthen the balance sheet, preferred stocks must provide their investors higher dividends than common stocks because preferred stocks don’t offer the opportunity to share in the company’s growth. This is so that the company doesn’t dilute the ownership interest of the current common stockholders by the issuance of preferred stock.
Types of Preferred Stock
In addition to the straight preferred, as just described, there is great diversity in the preferred stock market. Additional types of preferred stock include:
Prior Preferred Stock
Many companies have different issues of preferred stock outstanding at the same time and one of them is usually designated to be the one with the highest priority. If the company has only enough money to meet the dividend schedule on one of the preferred issues, it makes the dividend payments on the prior preferred. Therefore, prior preferred have less credit risk than the other preferred stocks but it usually offers a lower yield than the others. Preference Preferred Stock
Ranked behind the company's prior preferred stock ( on a seniority basis, are the company's various preference issues. These issues receive preference over all other classes of the company's preferred except for the prior preferred. If the company issues more than one issue of preference preferred, then the various issues are ranked by their relative seniority. One issue is designated first preference, the next senior issue is the second and so on.
Convertile Preferred Stock
These are preferred stock that the stockholders can exchange for a predetermined number of the company's common stock. This exchange can occur at any time the investor chooses regardless of the current market price of the common stock. It is a one tie deal so you cannot convert the common stock back to preferred stock. Participating Preferred Stock
These stocks offer the investors the opportunity to receive extra dividends if the compnay achieves some pretedetermined financial goals. The investors who purchased these stocks receive their regular dividend regardless of how well or how poorly the company performs, assuming of course, the company does well enough to make the annual dividend payments. If the company achieves predetermined sales, earnins or profitability goals, the investors receive an additional dividend. Cumulative Preferred Stock
If a dividend on a cumulative preferred is missed, it is not forgotten. Instead, it accumulates and must be paid off before any dividend payments are made to the common stockholders. A company can issue cumulative prior preferred, participating preference preferred or any other combination of preferred stock.
Different Classes of Stock
Common and preferred are the two main forms of stock; however, it's also possible for companies to customize different classes of stock in any way they want. The most common reason for this is the company wanting the voting power to remain with a certain group; therefore, different classes of shares are given different voting rights. For example, one class of shares would be held by a select group who are given ten votes per share while a second class would be issued to the majority of investors who are given one vote per share.
When there is more than one class of stock, the classes are traditionally designated as Class A and Class B.