Introduction
This article presents an overview of the basic characteristics of equity securities.
A corporate security, in its basic form, is a financial instrument that represents an ownership or creditor’s claim in a corporation. An equity security represents ownership in a corporation.
For investors, understanding equity securities is important because the legal, economic, and market characteristics of these securities affect both risk and return. Common stock, preferred stock, American Depositary Receipts, REITs, and master limited partnerships may all trade in public markets, but they do not all provide the same rights, claims, tax treatment, or risk profile.
The purpose of this article is to explain these securities in plain language so investors can better understand what they own, how ownership is recorded, how dividends are paid, and where equity securities stand in a company’s capital structure.
Common Stock
Common stock represents an ownership interest in a corporation.
Common stockholders generally have the residual claim on the company’s assets and earnings after the claims of creditors and preferred shareholders have been satisfied. This residual claim gives common stockholders the potential to benefit from increases in the company’s value, but it also exposes them to the greatest risk if the company performs poorly.
Share Count
A corporation’s authorized stock represents the maximum number of shares the company may issue. A company’s authorized number of shares is specified in the company’s governing documents, usually its articles or certificate 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, property, or other valid consideration. A company will typically issue only a fraction of its authorized shares, allowing it to issue additional shares as needed.
Shares issued to the public will generally be counted as issued shares, regardless of their current ownership or subsequent repurchase by the company.
A company’s outstanding stock is the number of common shares that have been issued to investors, net of any shares repurchased by the company and held as treasury shares.
Treasury stock refers to stock that has been issued to the investing public but has subsequently been repurchased by the company. Companies may repurchase shares for several reasons, including to reduce share count, offset dilution from stock-based compensation, return capital to shareholders, or take advantage of what management believes is a depressed share price.
Investors should pay close attention to share count because per-share value depends not only on the value of the whole company, but also on the number of shares among which that value is divided.
Preemptive Rights
Preemptive rights are rights given to shareholders that allow them to maintain their percentage ownership in the company. Specifically, preemptive rights give shareholders a right to participate in new share issuances before those shares are offered more broadly.
Companies can raise additional capital by issuing rights to existing shareholders in a rights offering. The rights give existing shareholders the ability to purchase additional shares, often at a discount to the market price or expected offering price, allowing existing shareholders to maintain their proportional ownership in the company.
Rights themselves may be transferable, depending on the terms of the offering, and thus can have value. Holders of rights may participate in the additional share issuance by exercising their rights and purchasing the additional shares. They may also sell their rights to other investors if the rights are transferable. Finally, rights holders may allow the rights to expire.
However, allowing a right to expire generally makes economic sense only when the current share price is below the subscription price, or when transaction costs and practical considerations make exercise unattractive.
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 stock begins trading without the rights. After that point, the stock is said to trade ex-rights, and the share price would be expected to decline by the value of the rights no longer attached to the stock.
Customarily, each common share is issued one right. The subscription price, which is the price at which the new stock may be purchased upon exercise of the rights, and the number of rights required to purchase an additional share will be detailed in the terms of the rights offering.
Number of Rights Needed to Purchase One New Share
To determine the number of rights needed to purchase one new share of stock, divide the number of existing shares outstanding by the number of new shares to be issued.
Number of Rights Needed = Existing Shares Outstanding ÷ New Shares to Be Issued
For example, if a company has 10 million shares outstanding and plans to issue 1 million new shares, then 10 rights would be required to purchase one new share.
The Value of a Right
To determine the value of a right, the investor must first determine the expected ex-rights share price, which is the share price that should result after the rights issue is complete and after reflecting the dilution from the new share issuance.
The ex-rights price can be estimated by multiplying the number of rights needed to purchase one new share by the cum-rights share price, adding the subscription price of the new share, and dividing the result by the new number of shares owned after exercise.
A simplified formula is:
Ex-Rights Price = [(Rights Needed × Cum-Rights Price) + Subscription Price] ÷ (Rights Needed + 1)
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.
Value of One Right = Cum-Rights Price – Ex-Rights Price
The relationship can be stated as:
Cum-Rights Price = Ex-Rights Price + Value of Right
In other words, on the ex-rights date, the share price would be expected to decline by the value of the rights. Since shareholders receive rights equal in value to the expected price adjustment, the rights offering should not, by itself, economically harm shareholders who properly exercise or sell their rights.
Voting Rights
Common stockholders are generally entitled to participate in the company’s governance process through voting rights.
Some governance decisions in which common stockholders may participate include:
- Election of board directors;
- Major corporate transactions, such as mergers;
- Amendments to governing documents;
- Certain share issuances; and
- The selection or ratification of outside auditors.
The specific voting rights depend on the company’s governing documents, exchange listing rules, corporate law, and the class of shares owned.
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 generally involves a seat-by-seat vote for directors, with each shareholder casting one vote per share in each election.
With cumulative voting, shareholders do not vote seat by seat but rather vote in a single at-large election. Each shareholder gets to multiply the number of shares owned by the number of directors to be elected. Cumulative voting allows shareholders to direct their voting rights to specific candidates rather than allocating their votes evenly among all candidates.
For example, under cumulative voting, if four 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.
Cumulative voting can benefit minority shareholders because it allows them to concentrate their votes on one candidate, providing a greater possibility of board representation than statutory voting might allow.
Since large publicly traded corporations may have thousands or millions of shareholders, nearly all shareholder voting in public companies occurs by proxy.
Proxy voting refers to an agency relationship in which the shareholder, as principal, authorizes another party, the proxy, to vote on her behalf. The designated party acting as agent may be another shareholder, a shareholder representative, or company management.
Publicly traded companies still hold shareholder meetings, but most shares are represented and voted by proxy rather than by shareholders appearing personally at the meeting.
Transferability of Common Shares
Common stock shares are generally homogeneous units that can be transferred to others.
Historically, common stock ownership was evidenced by a physical stock certificate. A stock certificate showed the number of shares, the name of the issuing corporation, par value, and certain rights of the shareholder. The certificate also displayed a CUSIP number, which is an identification code used for securities.
Today, most publicly traded shares are held electronically in book-entry form rather than through physical certificates. For publicly traded stock, most shares are held in street name, meaning the shares are held in the name of the broker or its nominee rather than directly in the customer’s name.
Since the securities are in the broker’s custody, transferring shares at the time of sale is much easier than if the shares were registered directly in the customer’s name and physical certificates had to be transferred.
The transfer agent is a company, often a trust company or commercial bank, appointed by a corporation to maintain records of stock and bond holders, issue and cancel certificates when certificates are used, process transfers, and resolve issues arising from lost, destroyed, or stolen certificates.
The registrar is responsible for maintaining or verifying records so that the transfer agent does not issue more shares than are authorized by the company. The registrar, working with the transfer agent, helps maintain current records of the owners of a bond issue and the stockholders in a corporation.
For investors, the practical point is simple: public stock ownership is usually recorded electronically through brokers and transfer systems, even though the underlying legal rights remain those of equity ownership.
Risks of Common Stock Ownership
Common stock returns are based on the sum of share price increases, known as capital appreciation, and dividends.
The risks inherent in common stock ownership are therefore the inverse of the components of stock returns: price declines and the reduction or termination of dividends.
Causes of Long-Term Price Declines
Over short periods of time, a stock’s price will fluctuate for many 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 tend to reflect fundamentals such as expected earnings, cash flow, asset values, financial strength, and the durability of the company’s business model.
Absent non-fundamental reasons for stock price fluctuations, such as tax selling or forced selling, a stock’s price reflects the collective and differing expectations of market participants regarding the amount, timing, and uncertainty of the company’s future earnings and cash flows.
In other words, a company’s stock price should, at any moment, reflect investors’ collective projection of future business results, discounted to present value.
Thus, a company’s stock price should reflect the company’s per-share intrinsic value, at least as estimated by the market. For our purposes, intrinsic value can be understood as the present value of expected future earnings or cash flows.
Long-term stock price declines often reflect changing expectations regarding a company’s future earnings ability. One risk of common stock ownership, therefore, is the impairment of a company’s future earning power and the stock price declines that would result.
The stock market is often described as a discounting mechanism. This means stock prices should reflect the present value of expected future earnings or cash flows. As such, stock price declines can also come from an increase in interest rates or required rates of return. Assuming no change in expected future earnings, those earnings discounted at a higher rate will have a lower present value.
Risk from Dividends
Common stock is the most junior security in a company’s capital structure.
In practical terms, common stockholders have a claim on a company’s earnings that is subordinate to the claims of debt holders and preferred stockholders. The junior status of common stockholders can also be seen in the event of liquidation, where the claims of debt holders and preferred stockholders must generally be satisfied before common stockholders receive anything.
Dividends are not guaranteed. A company’s board of directors may reduce, suspend, or eliminate dividends. In some industries, regulatory approval or regulatory capital considerations may also affect whether a company can pay dividends.
Investors should therefore analyze not only whether a company currently pays a dividend, but also whether the dividend is supported by earnings, free cash flow, balance sheet strength, and business durability.
Mechanics of Public Stock Ownership
Most stock transactions occur in the secondary market, which is the market where securities are traded among investors. In a secondary market transaction, the company itself is not a party to the transaction.
This differs from the primary market, where securities are first sold and issuers receive the proceeds.
Most U.S. stock transactions now follow a T+1 settlement cycle, meaning the transaction generally settles one business day after the trade date. This is a major update from the older T+3 settlement cycle described in many legacy investing texts.
Important Dates
The trade date is the day on which a securities trade takes place. It is the day the order is executed. An order may not be executed on the same day it is placed, depending on the type of order and market conditions.
The settlement date is the day on which the buyer pays for the securities and the seller delivers the securities. For most U.S. stock transactions, regular-way settlement is now T+1, meaning one business day after the trade date.
For example, if an investor’s stock trade executes on Monday, settlement generally occurs on Tuesday, assuming Tuesday is a business day.
Settlement matters because it affects when cash proceeds become available, when securities are delivered, when ownership is recorded for certain purposes, and how brokerage account balances are treated.
Investors should understand their broker’s policies regarding unsettled funds, cash accounts, margin accounts, and settlement-related restrictions.
Preferred Stock
Preferred stock is a class of capital stock that has a claim senior to common stock with respect to the payment of dividends and the distribution of liquidation proceeds.
However, preferred stockholders generally do not share fully in the company’s operating performance and usually do not have the same voting rights as common stockholders.
Preferred stock has characteristics of both debt securities and common stock. Similar to interest payments on debt securities, dividends on preferred stock are often fixed. However, unlike interest payments, preferred dividends are generally not contractual obligations of the company unless the terms of the security or applicable law provide otherwise.
This hybrid nature is what makes preferred stock different from common stock. It may provide more income stability than common stock, but it generally provides less upside participation.
Types of Preferred Stock
Straight Preferred Stock
Straight preferred stock is non-cumulative, meaning that if a company suspends the dividend, current and subsequent missed preferred dividends are forfeited permanently.
However, the company generally cannot pay dividends to common shareholders for the same period unless preferred dividends have been paid first, depending on the preferred stock terms.
Cumulative Preferred Stock
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 accumulate and must be paid in full before dividends on common shares can be paid.
These unpaid dividends are often referred to as dividends in arrears.
Participating Preferred Stock
Participating preferred shares entitle the holders to receive the standard preferred dividend plus the opportunity to receive an additional dividend if the company’s profits exceed a specified level.
In this sense, the preferred holders participate, to a limited extent, in favorable company performance. Participating preferred shares may also contain provisions entitling shareholders to an additional distribution, above the par value of the shares, upon liquidation.
Convertible Preferred Stock
Convertible preferred shares entitle shareholders to convert their preferred shares into a specified number of common shares, with the conversion ratio determined at issuance.
Convertible preferred shares may allow investors to receive a preferred dividend while also participating in potential appreciation of the underlying common shares through the conversion option.
The number of common shares that the holder of convertible preferred may receive upon conversion is generally determined by dividing the value or par amount of the preferred shares by the conversion price.
Callable Preferred Stock
Callable preferred shares are issued with a call feature that gives the issuing company the option to redeem the shares from investors at a specified call price.
Callable preferred stock is often issued with call protection, meaning the issuer cannot redeem the stock within a specified period.
Call features are important because they may limit the investor’s upside if interest rates decline or if the issuer can refinance the preferred stock at a lower cost.
Dividends
A dividend is a distribution paid to shareholders based on the number of shares owned.
Dividends are one way a company can distribute cash to its shareholders. Share repurchases are another. Dividends are declared by a corporation’s board of directors. The payment of dividends is discretionary rather than a legal obligation in the same way interest payments on debt are contractual obligations.
For investors, dividends should be analyzed as part of a company’s broader capital allocation policy. A company may create value by paying dividends, repurchasing shares, reducing debt, reinvesting in the business, or making acquisitions. The important question is whether management is allocating capital in a way that improves long-term per-share value.
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 generally distributes cash to shareholders of record. For stock held in street name, which represents most publicly held stock, dividend payments are generally sent through the brokerage and credited to the investor’s account.
With a stock dividend, a company distributes additional shares of its common stock instead of cash.
A stock dividend does not alter the total market value of the company. The decrease in the share price should be offset by the increase in the number of shares outstanding. In other words, a stock dividend does not change the size of the pie, meaning the market value of shareholder equity. It merely divides the pie into more pieces.
From the issuing company’s perspective, the key difference between a stock dividend and a cash dividend is that a cash dividend reduces assets because cash is paid out and reduces shareholders’ equity by reducing retained earnings. A stock dividend does not reduce cash, although it may result in reclassifications within shareholders’ equity depending on accounting treatment and the size of the stock dividend.
Investors should not assume that a stock dividend creates economic value by itself. Like a stock split, it changes the number of shares held and the price per share, but not the underlying economics of the business.
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 dividend process. It is the day the corporation announces that it has declared a dividend. On the declaration date, the company will also announce the record date and payment date.
The record date, sometimes called the holder-of-record date, is the date on which a shareholder listed in the corporation’s records will be considered the owner of the shares for purposes of receiving the upcoming dividend.
The ex-dividend date is the first day when purchasers of the security are no longer entitled to receive the dividend.
Under the current T+1 settlement cycle, the ex-dividend date for regular-way dividends is generally the same business day as the record date. This differs from the older T+3 framework, under which the ex-dividend date was typically two business days before the record date.
The payment date is the date the company pays the dividend through mail, electronic transfer, brokerage credit, or another applicable process.
The relationship among these dates matters because an investor must own the shares before the ex-dividend date to receive the dividend. If the investor purchases shares on or after the ex-dividend date, the seller, not the buyer, generally receives the upcoming dividend.
Stock Price and the Ex-Dividend Date
The price of a stock before the ex-dividend date reflects the value of the stock with the dividend rights attached.
All else equal, the price of the stock would be expected to decline on the ex-dividend date by approximately the amount of the dividend. This price adjustment occurs because new purchasers no longer receive the upcoming dividend.
It is important to note that, all else equal, an investor purchasing the stock shortly before the ex-dividend date should not expect to create value merely by receiving the dividend. The dividend is reflected in the purchase price and the expected price adjustment.
Taxes may also matter. Dividends can be taxable to the recipient, although the tax treatment depends on the type of dividend, the investor’s holding period, the investor’s tax status, and applicable law. Some dividends may qualify for favorable tax rates, while others may be taxed differently. Investors should consult a tax professional regarding their own circumstances.
Dividend Disbursement Process
The corporation will designate a disbursement agent responsible for sending the dividend payment to shareholders of record on the record date.
Since most investors have their shares held in street name, most dividend payments are processed through brokers or depositories and then credited to the investor’s brokerage account.
This process is largely invisible to individual investors, but it matters because the investor’s account records, record date ownership, and broker processing determine when the dividend appears in the account.
Special Types of Equity Securities
In addition to common and preferred stock, investors may encounter several other equity-related securities, including American Depositary Receipts, REITs, limited partnerships, and master limited partnerships.
Each has distinct legal, tax, and economic characteristics.
American Depositary Receipts and American Depositary Shares
In general, a depositary receipt is a security that trades like an ordinary share on an exchange but represents an economic interest in a foreign company. Depositary receipts allow publicly listed shares of a foreign company to trade on an exchange outside the company’s domestic market.
An American Depositary Receipt, or ADR, is a negotiable certificate that evidences ownership of American Depositary Shares, or ADSs. The ADSs represent an interest in shares of a non-U.S. company that have been deposited with a depositary bank.
Although ADR and ADS are often used interchangeably by market participants, there is a technical distinction. The ADR is the receipt or certificate, while the ADS represents the underlying share interest.
An ADR may represent one share, multiple shares, or a fraction of a share of the foreign company. ADRs are typically denominated in U.S. dollars and may trade in U.S. markets.
A depositary receipt is created when the equity shares of a foreign company are deposited with a depositary bank or custodian. The depositary then issues receipts that represent the deposited shares.
The price of each ADR should generally track the price of the underlying shares, adjusted for exchange rates and the ADR ratio. Short-term valuation discrepancies may create arbitrage opportunities, but investors should not assume the relationship is riskless. Currency, liquidity, tax, regulatory, and market-access issues can all affect ADR pricing and returns.
The responsibilities of the depositary bank may include acting as custodian, maintaining records, handling dividend payments, processing corporate actions, distributing shareholder materials, and facilitating conversion between ADRs and the underlying foreign shares.
ADRs can make foreign companies more accessible to U.S. investors, but they also introduce additional risks. These may include currency risk, foreign political and regulatory risk, different accounting standards, different disclosure practices, depositary fees, and liquidity differences.
Real Estate Investment Trusts
A real estate investment trust, or REIT, is a company that owns or finances real estate assets for the purpose of generating income for investors.
REITs may be one of several types:
- Equity REITs, which own real estate and collect rental income;
- Mortgage REITs, which invest in mortgages and other real estate debt; and
- Hybrid REITs, which combine elements of equity and mortgage REITs.
Equity REITs own commercial real estate and seek to collect rental income and participate in any appreciation of the underlying properties. Mortgage REITs invest in loans secured by real estate. Hybrid REITs both own real estate and invest in real estate-related debt.
A characteristic feature of REITs is that they may receive special tax treatment if they satisfy detailed requirements under the Internal Revenue Code. These requirements generally include income, asset, ownership, and distribution tests. One important requirement is that a REIT generally must distribute at least 90% of its taxable income to shareholders each year.
Because REIT shares are homogeneous and divisible, in contrast with the real assets REITs hold, they may provide investors with a more liquid and accessible way to gain exposure to real estate than direct ownership of individual properties.
However, REITs are not risk-free. Investors should analyze leverage, property quality, tenant concentration, lease duration, interest rate sensitivity, management quality, and valuation.
Limited Partnerships
A limited partnership, or 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 generally have at least two partners: one general partner and one limited partner. The general partner manages the business and accepts unlimited liability. The limited partner contributes capital and generally has limited liability, provided the limited partner does not participate in management beyond what is permitted by law.
An LP is formed with organizational documents, such as a limited partnership agreement.
The limited partnership agreement is a written agreement among partners specifying the conduct of the partnership, including the division of earnings, management authority, transfer restrictions, and procedures for dividing assets if the partnership is dissolved.
In an LP, the death or incapacity of a limited partner generally will not affect the existence of the limited partnership. However, the death, incapacity, or withdrawal of the general partner may cause dissolution unless the LP agreement specifies procedures for admitting a successor general partner.
A limited partnership is typically a pass-through entity for tax purposes, meaning items of income, gain, loss, deduction, and credit are passed through to each partner and reported on the partners’ individual tax returns.
The tax rules for limited partnerships can be complex. Investors should understand that partnership investments may involve Schedule K-1 reporting, state tax considerations, passive activity limitations, basis limitations, and other tax issues.
Master Limited Partnerships
Master limited partnerships, or MLPs, are partnerships in which a secondary market exists for the partnership units.
MLPs offer investors the income potential of traditional partnerships with the liquidity benefits of publicly traded securities. MLPs have often been associated with energy infrastructure, natural resources, and similar income-oriented assets.
MLPs are usually purchased by investors who are primarily interested in income, since many traditional common stocks may offer greater capital appreciation potential.
However, MLPs are not the same as ordinary common stocks. Investors should consider tax reporting complexity, commodity exposure, leverage, distribution coverage, capital expenditure needs, and the incentives of the general partner or sponsor.
Another document central to partnerships is the subscription agreement. This agreement is the application submitted by an investor seeking to join a limited partnership. All prospective investors must generally be approved by the general partner before they can become limited partners.
Conclusion
Equity securities represent ownership interests, but not all equity securities are the same.
Common stock generally provides voting rights, residual ownership, and participation in the company’s long-term success or failure. Preferred stock provides a senior claim to common stock with respect to dividends and liquidation proceeds but usually offers less upside participation. ADRs provide exposure to foreign companies through U.S.-traded securities. REITs provide exposure to real estate assets. Limited partnerships and MLPs provide partnership interests with distinct tax and legal characteristics.
Investors should understand these differences before evaluating any equity security.
At the most basic level, an equity security should be analyzed by asking several questions:
- What does the security legally represent?
- Where does it stand in the capital structure?
- What rights does the investor receive?
- How are dividends or distributions paid?
- How is ownership recorded and transferred?
- What risks are specific to this security type?
- How does the security’s price compare with underlying value?
Understanding the structure of an equity security is not a substitute for valuation, business analysis, or risk assessment. But it is an essential starting point.
Investors should know what they own.
Sources
Bodie, Zvi, Alex Kane, and Alan J. Marcus. Investments, 8th ed. New York: McGraw-Hill, 2009.
Reilly, Frank K., and Edgar A. Norton. Investments, 6th ed. Mason: South-Western, 2003.
