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Introduction to Equity Securities
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When starting off a review of securities, it’s important to start off with a definition of what is a security. A great place to start would be a security is anything that can be exchanged for value and contains risk. Securities are divided into two main classes, or types– equity securities, or stock, and debt securities, or bonds.
Equity securities consist of common stock and preferred stock or common equity and preferred equity. The ownership of these securities creates an ownership relationship with the company. Debt or bonds creates a creditor relationship with the company, the United States government, a municipality, or a state as the case may be. You are indeed a creditor of the entity if you have purchased a debt security or a bond.
We should take a look at a list of some of the items that do meet the definition of a security and some of the items that do not meet the definition of a security. These first three terms most of you may be very familiar with or at least they are terms you have heard.
This next term, a variable annuity or a variable contract, this is also a security because it contains risk to the owner. Now, these next three terms– options, rights, and warrants– sometimes give test takers a little bit of a hesitation because they are concerned about what the question may contain, but we’re going to make it very easy for you as we progress through our review. Here, we just want you to know that they do indeed meet the definition of a security. An option, right, or warrant is a security.
Now, this next list gives you an idea of some of the things that don’t meet the definition of a security. Whole and term life insurance policies. They do not contain risk. They guarantee the payment to a beneficiary in the case of insured’s death.
A fixed annuity, or a fixed contract
This does not contain risk because it guarantees an individual a set payment for the term of their life. Since it guarantees individual a set payment for the term of their life, there is no risk. So therefore, it is an insurance product. It is not a security.
An IRA and a retirement plan
Now, these are accounts, or wrappers, that people make contributions into, and those contributions are often used to purchase securities like stocks, bonds, or mutual fund shares. But the account, or the wrapper, itself is not a security. They are used to hold the securities.
A prospectus and a confirmation
A prospectus is an offering document. It discloses the terms and conditions to an investor or a potential investor about the opportunity to purchase a security, and that offering document does not meet the definition of a security. It merely discloses the terms about an offering of securities.
A confirmation is a receipt for a transaction in securities. It merely tells an investor that he or she bought or sold the security as the case may be.
We need to take a look at how companies come to be in existence. Now we’re going to take a look at a corporate timeline because it’s an important part of a review of securities. Now, when a company wants to begin, or incorporate, it’s going to fill out some papers, and it is going to select a number of things at the time of incorporation.
One of the things it’s going to select is the maximum number of shares it can sell in an effort to raise cash, and that is known as authorized stock. Authorized stock is the maximum number of shares a company can sell to raise money to operate its business. It is arbitrarily determined at the time of incorporation, and the only thing that can change that number is a vote of the shareholders. It can only be changed with the approval of the existing shareholders.
Now, there is an entity you need to be familiar with here, and it’s known as the registrar. The registrar’s job is to ensure that the corporation does not sell more shares than it is authorized to. It is there to ensure that it doesn’t sell more than the maximum number of authorized shares.
Issued stock is stock that has actually been sold to investors. Issued stock comes from authorized stock, and it is used to fund the expansion of a business in most cases.
Outstanding stock is stock that has been sold to the investing public and remains in the hands of the investing public. So issued stock becomes outstanding stock.
Now, let’s take a look at a little bit of an example. We have XYZ, and XYZ is incorporated in its home state. And at that time of incorporation, it has set a maximum number of shares that it can sell to the investors at any given point of 10 million shares. Now, XYZ has been, perhaps, going along for a few years and decides it wants to build a really new manufacturing plant, and it needs the money to do so. So it sold 6 million shares to investors. So six million shares in this case have been issued, and six million shares are now outstanding because the people who bought those shares still have the ownership of those shares.
Now, from time to time, corporations will wish to repurchase their own shares, and there are many reasons. But the most likely reason is they want to maintain control of the corporation. Ownership of the common stock is ownership of the corporation and therefore control of the corporation. Maybe the officers and directors at XYZ are concerned that some company may want to come along and take them over. So in an effort to fend off a takeover, they may go into the marketplace and repurchase their own shares. Shares that have been issued to the investing public and subsequently repurchased by the corporation become known as treasury stock.
So the main reason the company would repurchase its own shares is to maintain control of the corporation, but there are several other reasons why the corporation may do it. Well, they may do it to increase earnings per share just to make the company look a little bit better to investors. They also may do it to fund an employee stock option plan or a stock purchase plan. Once stock becomes part of the treasury, it does not vote, it does not count in earnings per share, it does not receive dividends, it’s just sitting there idle, and the corporation may elect to reissue it in the future or sell it again to the public if they wish, or they may simply wish to retire it.
Now, the test could ask you at some point to determine the number of outstanding shares or the number of treasury stock given several transactions with the corporation. Now, to determine treasury stock, you take issued stock, you subtract the number of shares that are outstanding, and that will tell you what the number of treasury shares are.
Or they could do it in the reverse order, ask you to determine which shares are outstanding and which shares are treasury. So issued stock minus treasury stock would give you outstanding stock, and we have an example up on the board here for you.
If XYZ has sold 6 million shares in an effort to raise cash, and it’s getting a little bit worried that some corporation might want to come over and take the company over, and it’s repurchased 2 million shares of stock. That 2 million shares now comes into the treasury. If a company has sold or issued 6 million shares and subsequently repurchased 2 million, well then 4 million remain outstanding. An important test point to note– once stock has become issued, it always remains issued. It doesn’t matter if it’s in the hands of the investing public or if it has been repurchased by the company and becomes part of the treasury.
Let’s take a look at a little bit of a real world example to help you wrap your head around that concept. If you go to a car dealer and you purchase a car, and then three years later, you go and you trade in that car. Even though you surrendered that car to the same car dealer, it’s still a used car. That’s kind of the concept of issued stock. Issued stock always remains issued. The only difference is, is it in the hands of the investing public and counted towards outstanding stock, or has it been repurchased by the corporation, and now it’s part of the treasury?
Let’s take a look at some values of common stock. The market value of a common stock is determined by supply and demand, whatever someone’s willing to pay for it and wherever someone is willing to sell it. It may or may or may not be reflective of the actual value of the corporation. Sometimes, investors are paying way too high a price for a corporation relative to its value. Sometimes, investors are selling shares of stock too cheaply relative to its value. It is arbitrarily determined by the forces of economics and supply and demand.
The book value of a corporation
The book value of a company is its theoretical liquidation value. It’s its assets minus liabilities, or its net worth. It’s, in theory, what someone may be willing to pay for the corporation based on its net worth.
Par value is a term we’re going to see many times throughout the course of this review. But here, in a discussion of common stock, it is not really relevant unless you’re an accountant looking at the balance sheet. Par value in a review of common stock is not indicative of any value of those shares. It’s only used by accountants to credit the sale of the stock to the balance sheet.
As a common stockholder, investors have a large number of rights, and we need to take a review of those right here. And one of the main rights you have is your right to maintain your percentage ownership of the company. This is known as a shareholder’s preemptive right. If a group of shareholders has purchased shares in a corporation, and the company subsequently wants to issue new shares or additional shares, they must first offer those shares for sale to investors under the shareholder’s preemptive right. We’ll take a look at that in just a moment.
As an owner of the corporation, you have a right to vote. You have the right to say what the corporation does. You have the right to vote on the main issues of the corporation, and your test is going to focus on the election of the board of directors and the way voting is conducted. Likely, that’s what you’ll see. The vote is for the board of directors.
Things you don’t have the right to vote for– executive compensation– and you don’t have the right to vote for bankruptcy those are two testable points that sometimes trip up students.
You also have the right to sell your shares when you want, or to freely transfer them. If you want to sell your shares tomorrow? The company cannot tell you no. You can sell those shares to whomever you wish whenever you wish. And the right to inspect the company’s books and records.
Now let’s say you have $1 million in Google. Well, that’s a lot of money. But , you can’t go down to the office of Google and ask them to take a look at their books and records. They’ll throw you out of their corporate office. A shareholder’s right to inspect the company’s books and records is insured through the issuance of annual and quarterly reports.
This is where the financial performance of the company, or its books and records, are disclosed to the investors. The annual report is a 10-K. There is one annual report. A quarterly report is a 10-Q. There are three 10-Qs and one 10K. The last quarter is contained in that annual report. A little bit of a test point there for you. You may see that on your exam. Three quarterly reports, one annual report issued to ensure the shareholder’s right to inspect their books and records.
Now, the pre-emptive right, your right to maintain your percentage ownership in the company. This is going to be granted through a pre-emptive rights offering or through a rights offering. And the investor is going to have the right to buy additional shares for up to 45 days. Maximum duration of this right is indeed 45 days. And when they issue those rights, those rights are going to come with the subscription price. The subscription price is the price at which you may buy the additional shares, and that subscription price is always below the current market value of the stock when the rights are issued.
Well, what can happen during the terms of a rights offering? Well, the investor could say, this is a great idea. You know, what? I love this company. I’ve owned this stock for years. I’m happy to be able to buy some more of it at a discount to the marketplace. So an investor could exercise their rights. They could send in their rights, along with their check, to the rights agent, and they will be issued the additional shares, therefore maintaining their proportional ownership of the company.
A shareholder can sell their rights. If an investor gets a notice of their rights offering the same day they get a tuition bill for their triplets in college, they may have to choose which bill is going to get paid, and they’ll probably pay the kids’ tuition bill. But the right has value. So this investor may indeed sell those rights to a third party or to another investor.
The rights could expire. The subscription price of the right is fixed at the time of issuance. But what’s happening with the market price of this stock during the term of the 45 days? That stock price is going up and down as the case may be. Should the market price of this stock fall below the subscription price of the right, and the 45 day term has expired, that right is going to indeed expire worthless.
Let’s take a look at a practical example of that. Let’s say we have XYZ trading in the marketplace at $40 a share. And the right gives the holder the opportunity to buy the stock at $38 per share. Well, that is a $2 winning proposition for that investor. Now, they have the right to buy this stock at $38 for 45 days. But during the term of the 45 days, XYZ is going up and down in price. And let’s say the market goes through a little bit of a downturn, and the stock falls to $35 per share. And we are at the end of our 45 day term. Well, nobody in their right mind is going to buy a stock at $38 when it’s trading in the marketplace at 35. This is an example of when the rights would expire worthless.
So that’s a good recap of the preemptive rights offering that could be exercised. These individual purchases the shares. They could be sold to another investor because they do have value, and they could expire worthless if the share price falls below the subscription price and remains there at the end of the 45 days.
All right, we already have taken a look at some of the rights of shareholders, and we’ve discussed a shareholder’s right to elect the board of directors or to vote for the board of directors. We need to take a closer look at how voting is conducted and how a shareholder may indeed cast their votes.
There are two methods by which voting may be conducted– the statutory method and the cumulative method. These methods tell the investor how they may cast their votes during the election process. The statutory method requires that the investor cast their votes evenly among the candidates they wish to elect, or even distribution of votes between the candidates. The cumulative method allows the investor to put the weight of all their votes behind a single candidate.
If the test asks you which method of voting benefits smaller investors, your answer is always going to be the cumulative method because they perceive it as giving the smaller investor more of a say in the election process. Now, let’s move ahead and take a look at a practical application of the shareholders’ vote.
Now, let’s say in our example here we have an individual who owns 200 shares of stock. And in this particular election, there are two people to be elected to the board of directors. This candidate will now have 400 votes. To determine how many votes a shareholder has, you take the number of shares they own, you multiply it by the number of people to be elected to the board of directors, and that will give you the number of votes that they are allowed to cast in the election process.
The statutory and cumulative method of voting tell the investor how they may cast their votes or distribute their votes. So if we have two people to be elected to the board of directors, and we have four candidates running, the investor can cast their 400 votes pursuant to the statutory or cumulative method, and the proxy, or the voting material the individual receives, will detail the voting is conducted.
Under the statutory method, if this individual wanted to elect candidate one, well, they could give him or her 200 votes. If they wanted to elect candidate four, they can give 200 votes to that candidate as well. So even distribution of votes among the candidates they wish to elect.
The cumulative method allows the individual to put all of their weight of their votes behind one particular individual. So if this person wanted to give all of the votes to candidate one because they’re their brother-in-law, they could do so. If the test asks you again which benefits a small investor, it is indeed the cumulative method because they can put all of their votes behind one particular candidate.
All right, we just did a really good review of the voting process and the shareholder’s right to cast their votes. Now, let’s take a look at a couple of additional rights of shareholders. I think we did a good job covering freely transferring their shares. They have the right to buy and sell their shares as they so choose without any restrictions from the corporation. We discussed the inspection of books and records ensured through the issuance of 10-Ks and 10-Qs, annual and quarterly reports. And remember, there are three quarterly reports and one annual report. That fourth quarter is indeed contained in that final 10-K, or the annual report.
One other shareholder’s right that you never ever want to exercise, and it is your right to claim residual assets. If the corporation goes bankrupt, after every single other investor has been paid and every creditor has been paid, as a common stockholder, you have the right to your proportional ownership of whatever it may be left. You may, if you’re lucky, get the paperclips and the typewriters.
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