Understanding Common Investments: Stock
Stocks and bonds are the staples of many investment portfolios. Stock represents a share of ownership in a corporation. A bond is a security that represents a debt owed by the corporation to the bondholder, but does not include the ownership privileges of a stockholder.
A share of stock is issued in a number of different ways -- following are descriptions of the most common forms:
Common stock - also called common shares, capital shares, or capital stock - represents units of ownership in a corporation. Purchasers of common stock are granted specific rights that may include the following:
- Voting at stockholder meetings.
- Selling or otherwise disposing of stock.
- Having the first opportunity to purchase additional shares of common stock issued by the corporation.
- Sharing dividends with other common stockholders.
- Receiving annual reports and inspecting the corporation's books and records.
- Sharing in assets (after creditors are paid) if the corporation is liquidated.
A corporation may be authorized to issue more than one class of stock. For example, a class of common stock might have enhanced voting rights. This stock may be more expensive than regular shares. Usually any additional classes of stock being offered are designated "preferred stock."
Preferred stock gets its name from the preferences granted to its owners, which may include dividends or a share in the distribution of assets should the company be liquidated. Preferred stock generally doesn't carry voting rights. It's issued by a company to raise capital without jeopardizing the controlling interests of the common stockholders.
The benefits of investing in this type of stock are often similar to those of bonds. Most preferred stock dividends offer a fixed rate of income.
Preferred stockholders have an ownership interest in a company's net worth. Such stock is subordinate to the company's debts to bondholders, but it is superior to common stock. Preferred stocks offer relative safety of income, but preferred stock prices usually have a more modest growth potential than common stock. Preferred stock is sometimes convertible to common stock.
How Stock is Valued
Stock is often referred to a having par value, book value, and market value.
Par Value: Par value is an arbitrary value set by the company at the time of issuance and is of little concern to most investors.
Book Value: Book value is calculated by dividing the total net assets of the company by the number of shares outstanding.
Market Value: The price at which shares of stock can be bought and sold is called the market value. Shares that are not publicly traded, however, will have no market value.
Dividends and Yields
Unlike interest on bonds or certificates of deposit that remains constant, dividends on stock can be reduced or eliminated in lean periods. Profits in good years, however, usually mean higher dividends, increased stock prices, and better returns for the stockholder.
Preferred stock dividends are usually paid at a fixed rate and before dividends are paid on common stock. In addition, most preferred stock dividends are cumulative, which means that if the company fails to pay a dividend when due, the unpaid dividend obligation will accumulate for the benefit of the preferred stock owners. These obligations must be paid in full before common stockholders receive any dividend payments.
Risks in Stocks
A company's stock could decline in price because the company's revenue declines or isn't being managed well. Or a perfectly well-managed and prosperous company's stock could
fall because lots of investors decide to sell millions of shares of stock of all kinds, or stocks of a certain kind. That's what happened when the dot-com bubble burst, and it drove the entire market down, without bothering to differentiate the good stocks from the bad.
A warrant is a type of security, usually issued together with a bond or preferred stock. The warrant entitles the holder to buy a proportionate amount of common stock at a specified price that is usually higher than the market price at the time the warrant is issued. A warrant is usually offered as a "sweetener" to enhance the marketability of accompanying fixed-income securities. Warrants for shares of publicly traded stocks are usually tradeable on exchanges and usually have a life of several years.
Similar to warrants, subscription rights to new issues are often sold to existing shareholders. These rights, known as options, are usually exercisable at a price below current market value of the stock in question. They usually expire within a short time.