In this article, I present an overview of the basic characteristics of equity securities. A corporate security, in its basic form, is a financial instrument which represents an ownership or creditor’s claim in a corporation. An equity security represents ownership in a corporation.
- COMMON STOCK
2.1. Share Count
A corporation’s authorized stock represents the maximum number of shares which a company may issue. A company’s authorized number of shares are specified in the company’s articles of incorporation. A company will generally need shareholder approval before increasing the number of authorized shares.
A company issues shares when it distributes shares to investors in consideration of cash, services, or property. A company will typically only issue a fraction of its authorized shares, thus allowing the company to issue additional shares as needed. Shares issued to the public will always be counted as issued shares, regardless of their ownership or subsequent repurchase by the company.
A company’s outstanding stock is the number of common shares which have been issued to investors, net of any shares repurchased by the company.
Treasury stock refers to stock that has been issued to the investing public but has been subsequently repurchased by the company. Companies will often repurchase their shares for several reasons, including to increase earnings-per-share (EPS), to reduce share-dilution from employee stock option issuance, or to take advantage of a depressed share price.
2.2. Preemptive Rights
Preemptive rights are rights given to shareholders that allow them to maintain their percentage ownership in the company. Specifically, preemptive rights grant shareholders right of first refusal on new share issuance.
Companies can raise additional capital by issuing rights to existing shareholders in a rights offering. The rights confer upon existing shareholders the ability to purchase shares at a discount from the price at which shares will be later offered to the public, thus allowing the existing shareholders to maintain their proportional ownership in the company. Rights themselves are freely transferable, and thus have value. Holders of rights will participate in the additional share issuance by exercising their rights and purchasing the additional shares. In addition, rights holders may also sell their rights to other investors. Finally, rights holders may allow the rights to expire. However, only when the current share price is below the subscription price will allowing a right to expire make economic sense.
The stock is said to trade “cum rights” when it trades with the rights attached. The cum-rights period is the time between the date the rights are declared and the date the rights expire. After the expiration date, the stock is said to trade “ex-rights”, and the ex-rights trading price will be reduced by the value of the rights which are no longer attached to the stock.
Customarily, each common share is issued one right. The subscription price (the price at which the new stock must be purchased upon execution of the rights) and the number of rights required to purchase an additional share will be detailed in the terms of the rights offering.
2.2.1. Number of Rights Needed to Buy a Share of Stock
To determine the number of rights needed to buy one new share of stock, divide the number of existing shares outstanding by the number of new shares to be issued.
2.2.2. The Value of a Right
To determine the value of a right, the investor must first determine the ex-rights share price, which is the share price that should result after the rights issue is complete and thus reflecting the dilution from the new share issuance. The ex-rights price can be found by multiplying the number of shares needed to purchase one new share by the cum-rights share price, then adding the subscription price of the new share, all divided by the new number of shares owned.
Once the ex-rights price is determined, the value of the right can be inferred by subtracting the ex-rights price from the cum-rights share price.
The relationship between the ex-rights price, the right’s value, and the cum-rights price can be seen through the following: Cum-rights price = (ex-rights price) + (Value of rights). In other words, at the ex-rights date – the first day at which the stock trades without the rights – the share price would be expected to decline by the value of the rights. Investors should note that because shareholders receive rights equal in value to the price drop ex-rights, the rights offering should not affect the shareholders.
2.3. Voting Rights
Common stock holders are entitled to participate in the company’s governance process through voting rights. Some of the governance decisions which a common stock holder may participate in via her voting rights are: election of board directors, decisions to merge or takeover another company, and the selection of outside auditors.
The most common form of voting is statutory voting (also called straight voting), where each share represents one vote. In the case of electing board members, statutory voting requires that the votes be evenly distributed among the candidates. In other words, there is a seat-by-seat vote for directors (a separate election for each seat), with each shareholder casting one vote per-share in each election.
With cumulative voting, the shareholders do not vote seat-by-seat but rather vote in a single at-large election. In such an election, each shareholder gets to multiply the number of shares owned by the number of directors to be elected. Cumulative voting thus allows shareholders to direct their voting rights to specific candidates, as opposed to having to allocate their voting rights evenly among all candidates. For example, under cumulative voting, if four board directors are to be elected, a shareholder who owns 100 shares is entitled to cast 400 votes in favor of a single candidate or spread the votes across the candidates in any proportion. In contrast, under statutory voting, a shareholder would be to cast only a minimum of 100 votes for each candidate. Cumulative voting is beneficial to minority shareholders as it allows them to apply all their votes to one candidate, thus providing the opportunity for a higher level of representation on the board than would be allowed under statutory voting.
Since large corporations with thousands of shareholders and millions of outstanding shares would find it impossible to get enough shareholders together to constitute a quorum, nearly all shareholder voting in publicly-traded corporations is by proxy. Proxy voting refers to an agency relationship by which the shareholder, as principal, engages an agent, the “proxy”, to vote for her. The designated party acting as agent may be another shareholder, a shareholder representative, or company management. Of course, publicly-traded companies hold meetings; but at those meetings, the majority of shares are counted as present for quorum purposes and voting is by proxy.
2.4. Transferability of Common Shares
Common stock shares are homogenous units which can be easily traded to others.
Common stock ownership is evidenced by a stock certificate. A stock certificate shows the number of shares, name of the issuing corporation, par value, and rights of the shareholder. The stock certificate also shows a CUSIP number, which is an identification code issued by the Committee on Uniform Securities Identification Procedures (CUSIP numbers must also appear on trade confirmations).
To transfer or sell shares, the owner must endorse the stock certificate. The owner may also sign a stock power, which is a power of attorney that transfers ownership of the security to another party. The stock power is separate from the stock certificate and is attached to the certificate when the stock is sold or pledged. The stock power effectively gives the owner’s permission to another party (the transfer agent) to transfer ownership of the certificate to a third part.
For publicly-traded stock, most shares are held in “street name”, which means the shares are held in the name of the broker instead of a customer. Since the securities are in the broker’s custody, transfer of the shares at the time of sale is easier than if the stock were registered in the customer’s name and physical certificates had to be transferred.
The transfer agent is a company, usually a commercial bank, appointed by a corporation to maintain records of stock and bond holders, cancel and issue certificates, and to resolve problems arising from lost, destroyed, or stolen certificates. A corporation may also serve as its own transfer agent.
The registrar is the agency responsible for auditing the transfer agent to ensure that the transfer agent does not issue more shares than are authorized by the company. The registrar, working with the transfer agent, keeps current files of the owners of a bond issue and the stockholders in a corporation. The roles of registrar and transfer agent must be separated (not performed by a single department of any one company).
2.5. Risks of Common Stock Ownership
Common stock returns are based on the sum of share price increases (capital appreciation) and dividends. The risks inherent in common stock ownership are thus the inverse of the components of stock returns, i.e., price declines and a termination of dividends.
2.5.1. Causes of Long-Term Price Declines
Over short periods of time, a stock’s price will fluctuate for a variety of reasons not all of which are related to the expected fundamentals of the underlying business. Over longer periods of time, however, a stock’s price will reflect fundamentals such as expected earnings and asset values of the underlying business.
Absent non-fundamental reasons for stock price fluctuations (tax selling, for example), a stock’s price will reflect the collective and differing expectations of market participants in the amount, timing, and uncertainty of the company’s future discretionary earnings. In other words, a company’s stock price should, at any moment, reflect investors’ collective projection of future discretionary earnings, discounted to present value. Thus, a company’s stock price should reflect the company’s per share “intrinsic value”i. Stock prices declines should thus reflect changing expectations (pessimistic) regarding a company’s expected future earnings. One risk of stock ownership, therefore, reflects the potential of impairment to a company’s future earnings ability, and the stock price declines which would result.
The stock market is a “discounting mechanism”, meaning stock prices should reflect the present value of expected future earnings. As such, stock price declines can also come from an increase in interest rate. In other words, assuming no change in expected future earnings, those earnings discounted at a higher rate will have a lower present value.
2.5.2. Risk from Dividends
Common stock is the most junior security in a company’s capital structure. In practical terms, common stock holders have a claim on a company’s earnings that is superseded by the claims of debt and preferred stock holders. The junior status of common stockholders can also be seen in the event of a company liquidation, whereby the claims of debt holders (and preferred stock holders) must be satisfied in full before the common stock holders receive anything. And in some industries, approval must be obtained from certain regulatory agencies before a company can pay dividends.
- MECHANICS OF PUBLIC STOCK OWNERSHIP
Most stock purchases occur in the secondary market, which is the market where securities are traded among investors (the company itself is not a party in the transaction). In contrast, the primary market is the market where securities are first sold and issuers, not other investors, receive the proceeds.
Most transactions in the stock market follow regular way delivery and settlement, which refers to the completion of a securities transaction at the office of the purchasing broker on (but not before) the third full business day after the date of the transaction.
3.2. Important Dates
The trade date is the day on which a security trade takes place (day the order is executed). An order may not be executed on the same day that an order is placed, depending on the type of order.
The settlement date is the day on which a buyer of a security becomes the owner of record. On this date, the executed order must be settled, either by a buyer paying for the securities with cash or by a seller delivering the securities and receiving the proceeds of the sale for them. In a regular way delivery of stocks and bonds, the settlement date is three business days after the trade was executed (trade date).
The payment date is the absolute last day that a buyer of a security must have the money in their account with the brokerage firm to pay for the purchase. Under industry rules, the payment date for common and preferred stock and corporate and municipal bonds is five business days after the trade date (known as T+5). The Federal Reserve Board regulated payment dates under Regulation T.
The brokerage customer is in violation of Regulation T when she fails to pay for the purchase of the securities within the five business days allowed. A broker may “sell out” a customer’s account by selling the securities received from the selling broker to cover the customer’s transaction, and the customer is responsible for any decline in the value of the securities. The broker may also sell out any other securities in the customer’s account to cover any losses. The failure to pay will also trigger a freeze on the customer’s account, meaning that for 90 days the customer can only purchase securities through the broker if the money for the purchase is in the customer’s brokerage account. After the 90 day freeze period, the customer is considered to have reestablished credit and may purchase securities the “regular way”, thus having up to five days from the trade date to fund the purchase.
- PREFERRED STOCK
Preferred stock is a class of capital stock that has a claim senior to that of common stock with respect to the payment of dividends and the distribution of the company’s liquidation proceeds. However, preferred stock holders do not share in the company’s operating performance and generally do not have any voting rights. Preferred stock has characteristics of both debt securities and common stock. Similar to the interest payments on debt securities, the dividends on preferred stock are fixed and generally higher than the dividends on common shares. However, unlike interest payments preferred dividends are not contractual obligations of the company.
4.2. Types of Preferred Stock
Straight preferred stock is non-cumulative, meaning that if a company suspends the dividend, current and subsequent preferred dividends are forfeited permanently. However, the company is still not permitted to pay any dividends to common shareholders in the current period unless preferred dividends have been paid first.
Dividends on cumulative preferred stock accrue so that if the company decides not to pay a dividend in one or more periods, the unpaid dividends accrue and must be paid in full before dividends on common shares can be paid.
Participating preferred shares entitle the holders of such securities to receive the standard preferred dividends plus the opportunity to receive an additional dividend if the company’s profits exceed a pre-specified level. In this sense the preferred holders are participating, to a limited extend, in any favorable operations of the company. In addition, participating preferred shares contain provisions that entitle shareholders to an additional distribution, above the par value of the shares, upon the company’s liquidation.
Convertible preferred shares entitle shareholders to convert their shares into a specified number of common shares, with the conversion ratio being determined at issuance. Convertible preferred shares have the following advantages: (1) they allow investors to earn a higher dividend than if they invested in the company’s common shares, (2) they allow investors the opportunity to share in the profits of the company, (3) they allow investors to benefit from a rise in the price of the common shares through the exercise of the conversion option, and (4) their price is less volatile than the underlying common shares because the dividends are known and more stable. The number of shares that the holder of convertible preferred may receive upon conversion is determined by dividing the value of the preferred shares by the conversion price.
Callable preferred shares are issued with a call feature which gives the issuing company the option to buy back shares from investors at a call price that is specified when the shares are issued. Callable preferred stock is often issued with call protection, meaning the issuer cannot redeem the stock within a specified period.
A dividend is a distribution paid to shareholders based on the number of shares owned. Dividends are one of two ways a company can distribute cash to its shareholders (share repurchases being the other). Dividends are declared by a corporation’s board of directors. The payments of dividends is discretionary rather than a legal obligation (such as with interest payments).
5.2. Types of Dividends
Generally, dividends may be paid in cash or stock. Regular cash dividends are the most common form of dividends. For cash dividends, a company will send out a check to shareholders of record. For stock held in street name (which is most publicly held stock), the checks are sent to the brokerage, which then credits the investor’s account accordingly.
With a stock dividend, a company distributes additional shares of its common stock instead of cash. With a stock dividend, the shareholder’s total cost basis remains the same but the cost per share held is reduced. A stock dividend does not alter the total market value of the company, as the decrease in the share price will be offset by the increase in the number of shares outstanding. In other words, the stock dividend does not change the size of the “pie” (market value of shareholder’s equity), but merely divides it into smaller pieces.
From the issuing company’s perspective, the key difference between a stock dividend and a cash dividend is that a cash dividend affects a company’s capital structure. Specifically, cash dividends reduce assets (because cash is being paid out) and shareholder’s equity (by reducing retained earnings). Stock dividends, on the other hand, do not affect assets or shareholder’s equity.
5.3. Dividend Payment Chronology
The board of directors sets in motion a standard dividend chronology when it votes to pay a dividend.
The declaration date is the starting point of the entire dividend process, as it is the day that the corporation issues a statement declaring a dividend. On the declaration date, the company will also announce the holder-of-record date and the payment date.
The ex-dividend date is the first day when purchasers of the security are no longer entitled to receive the dividend. The amount of time between the ex-date and the holder-of record-date is linked to the trade settlement cycle of the exchange on which the shares are traded. Generally, trades take three days to settle, so someone purchasing the stock on the ex-dividend date will not be a shareholder as of the holder-of-record date (which is two days after the ex-dividend date). The ex-dividend date is set by the exchange on which the stock trades.
The holder-of-record date is two days after the ex-dividend date (this time interval is fixed). The holder-of-record date is the date that a shareholder listed in the corporation’s records will be considered to have ownership of the shares for the purposes of receiving the upcoming dividend. The relationship between the ex-dividend date and the holder-of-record date is that an investor would have to have purchased the stock before the ex-dividend date to be an owner of record on the record date.
The payment date is the final critical date in the dividend chronology. It is the date that the company pays (via mail or electronic transfer) the dividend payment. Note that unlike other dates in the dividend chronology, such as the ex-date and the record date, which occur only on business days, the payment date can occur on a weekend or holiday.
5.4. Stock Price and the Ex-Dividend Date
The price of the stock prior to the ex-dividend date reflects the value of the stock with the dividend rights. All else equal, the price of the stock would decline on the ex-dividend date by the amount of the dividend. It is important to note that, all else equal, an investor purchasing the stock shortly before the ex-dividend date thinking that they would benefit from receiving the dividend, would actually be worse off as the dividend would merely be a return of the investor’s capital (since the dividend would be reflected in the purchase price) while also generating a tax liability when the dividend is received (dividend income is fully taxable).
5.5. Dividend Disbursement Process
The corporation will designate a disbursement agent who is responsible for sending the dividend payment (via mail or electronic transfer) to the shareholders of record on the record date. Since most investors have their shares held in their broker’s name (street name), most dividend payments will be sent to the broker’s dividend department, which will then collect and distribute (via crediting the investor’s account) the dividends to the shareholders who hold accounts at their firm.
- SPECIAL TYPES OF EQUITY SECURITIES
6.1. American Depository Receipts (ADR) and American Depository Shares (ADS)
In general, a depository receipt is a security that traded like an ordinary share on an exchange, but represents an economic interest in a foreign company. The depository receipt thus allows publicly listed shares of a foreign company to be traded on an exchange outside its domestic market.
A depository receipt is created when the equity shares of a foreign company are deposited in a bank (the “depository”) in the country on whose exchange the shares will trade. The depository then issues receipts that represent the shares that were deposited. The price of each ADR should track the price of the underlying shares, as any short-term valuation discrepancies between shares traded on multiple exchanges would represent a quick arbitrage (riskless profit) for astute traders to exploit.
The responsibilities of the depository bank that issues the receipts include acting as custodian and as a registrar for the securities. These custodial responsibilities entail handling dividend payment and stock splits, and serving as the transfer agent for the foreign company whose securities the depository receipt represents.
An American Depository Receipt (ADR) is a U.S. dollar denominated security that trades like a common share on U.S. exchanges. ADRs are the oldest (created in 1927) and most commonly traded depository receipt. ADRs enable foreign companies to raise capital from U.S. investors while avoiding the long and costly registration process associated with conventional public securities offering in the U.S.
American Depository Shares (ADS) are the actual underlying shares on which ADR are based. ADS are traded in the issuing company’s domestic market.
6.2. Real Estate Investment Trusts
A real estate investment trust (REIT) is a company that owns and manages real estate assets (or the associated debt) for generating income for its investors. REITs may be one of three types: Equity REIT, Mortgage REIT, or Hybrid REIT.
Equity REITs own commercial real estate to collect rental income and participate in any appreciation of the underlying properties. Mortgage REITs invest in loans which are secured by commercial real estate. These mortgages may be originated and underwritten by the REIT or the REIT may purchase preexisting mortgages. Hybrid REITs are REITs that both take equity stakes in real estate and invest in commercial mortgages.
A characteristic feature of REITs is they are entitled to special tax treatment under internal revenue code Subchapter M, and thus will not have to pay taxes at the corporate level if (1) 75% of its income came from rents, mortgage interest, or property sales and (2) pay at least 90% of its taxable income to shareholders as dividends each year. Since REIT shares are homogenous and divisible, in contrast with the real assets which REITs hold, they are generally more suitable for small investors than direct ownership of real assets.
6.3. Limited Partnerships
A limited partnership (LP) is a form of business organization in which certain partners restrict their involvement in the management of the business in exchange for limited liability. LPs must comprise at least two partners, one of which must be a general partner who manages the business and the other a limited partner. The general partner accepts unlimited liability.
A LP is formed with certain organizational documents, such as a limited partnership agreement. The limited partnership agreement is a written agreement among partners in a LP which specifies the conduct of the partnership, including the division of earnings and procedures for dividing up assets if the partnership is dissolved.
In a LP, the death or incapacity of a limited partner will not affect the existence of the limited partnership. However, the death or incapacity of the general partner will cause a dissolution of the partnership, unless the LP agreement has specified procedures for admitting a successor general partner.
A limited partnership is a “pass-through” entity for tax purposes, meaning that items of income or loss are passed through to each partner and included in the partners’ individual tax returns. However, since limited partners are not liable for the debts of a LP, general partners receive the entire tax basis derived from recourse liabilities.
Master limited partnerships (MLP) are partnerships in which a secondary market exists for the partnerships units. MLPs thus offer investors the income potential of traditional partnerships with the liquidity benefits offered by traditional stocks. MLPs are usually purchased by investors who are primarily interested in income, since traditional stocks will generally offer higher capital appreciation potential.
Another document central to partnerships is the subscription agreement. This agreement is the application that is submitted by an investor seeking to join a limited partnership. All prospective investors must be approved by the general partner before they can become limited partners.
i For our purposes, intrinsic value is defined as the present value of expected future earnings. Cash flow may also be used in lieu of earnings, but the valuation mechanics are the same.