Common stock

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Common stock is a the mechanism used for ownership of a company. For every share of stock which someone owns in a company, they effectively have an ownership share in everything owned by the company. The more shares of stock that are owned, the more ownership the owner has in the profits of the company. 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 all the profits of that company. If there a 100,000 shares outstanding that shareholder would be entitled to (1/100,000) of the company and its profit.

The majority of stocks traded presently are common stock. Common Stock represents ownership in a company as well as a share of the company’s dividends. Investors are further granted voting rights in electing the board of directors, who are overseers of major decisions made by management. Looking at the long term, common stock is more likely to yield higher rewards/returns than other investment securities in its class. However, this higher return comes with increased risk. In general, over the long run, no other investment provides higher returns at a reasonable risk like common stock. History shows that common stock generally outperforms bonds and preferred stock put together.

History

Interest in common stock began in the first four decades of the twentieth century. Growth of common stock began with the development of the New York Stock Exchange, the foremost market for these securities. Investors became intrigued by the idea of capital gains and dividend payments. The transition to broader common stock ownership in the United States is the result of “managerial capitalism”. Large scale businesses owned by professional managers became the source of great economic efficiency in both the manufacturing and utilities industry. This increase in corporate wealth led investors to seek profit in these developments by purchasing corporate equity securities.

The rise of managerial capitalism had a significant impact on the role of investors. Instead of family controlled industries there was a rise in separation of controls between management and owners of corporations. Professional managers who usually owned very small percentages of equity in businesses, flourished into major power holding and main decision makers. With the stock market crash of 1929 shifted institution building from the private to the public sector. Greater governmental action led to changes in the level of Standard and Poor’s Composite Stock Index. This led to great government action. The fist and most successful was the effort of the government to use federal to strengthen the functioning of the stock market. This resulted in greater creation of legal safeguards preventing form misleading financial data and deliberate fraud against shareholders. Such actions helped restore public confidence in the stock market without diminishing the financial market’s ability to offer investment liquidity and a reasonable price. The second and less popular regulation by the federal government was reform involved attempts to restore stability and prosperity by using federal power to place constraints on free operation of marketing forces.

Characteristics

Stock Rights:

The owner of a common stock gets many rights and powers in the workings and management of the company. They include:

Dividend Payments – Upon authorization from the board of directors of the company, the share holder has the right to receive dividend payments. The payments are mostly made from earnings of the company.

Liquidity rights – The share holder has the power to sell their stake in the company to realize capital gains on public trading markets or in private transactions, provided there are buyers willing to buy the stock being sold.

Consideration in mergers – Stock holders have a right to receive consideration in a merger or other fundamental transactions of the company, provided it is approved by the board of directors and shareholders

Voting rights – Share holders also have the right to vote to elect directors and to approve fundamental transactions such as mergers, sale of assets, amendments to articles and dissolutions.

Distributions of assets - Shareholders hold the right to receive a proportionate distribution of assets upon the liquidation of a corporation, if the board of directors and shareholders approve dissolution.Shareholders have a residual claim to the income and assets of the business. To get paid from the sale of assets of a firm, financially, they stand last in line behind corporate creditors (bond holders, short-term lenders, banks, and trade creditors). When company is unable to pay its debts, and the company is forced into bankruptcy, shareholders receive nothing.

Uncertain Returns: The realizable returns on common stock are uncertain. The returns depend on a number of factors including but not limited to- declaration of dividends, demand for the stock in the market, undervaluation or overvaluation of a stock by the market, decisions made by the board of directors that affect the stock prices and returns. The above mentioned factors are constantly changing, and therefore make the returns on common stock uncertain.

Value based on cash returns:

Dividend based - Professional stock valuators concentrate on cash dividends to value a common stock. This is because some companies do not pay dividends, and most companies pay less dividends than have been earned.

Merger based - Many shareholders realize returns when they sell the stock (capital gains) or receive a higher price in a fundamental corporate transaction, such as a merger.

In the end, stock has value because of the possibility of cash returns:

Earnings - Even if current earnings are retained and reinvested, the reinvested earnings should produce future earnings that eventually will be paid as dividends.

Capital gains - If a shareholder sells stock on the market, it is because the buyer values the potential for future returns - that is, dividends.

Merger - If a company is acquired in a merger, and its shareholders paid for their stock, the acquirer values the company's potential for creating returns - dividends.

Advantages

  1. Common Stock has the possibility of delivering very large gains at a reasonable risk. Annual returns of investments of more than 1005 have occurred on an almost regular basis.
  2. The potential loss from purchased stock with cash is limited to the total amount of the initial investment.
  3. Stockholders of common stock have a limited liability and are protected from any liability stemming from the company’s actions not pertaining to the stockholder’s investment.
  4. Stock can be sold or bought very quickly, meaning they are highly liquid assets.
  5. Stocks have historically offered much better returns than other investments. (Note: this advantage is not always a guarantee.)
  6. Stock offer two ways for their owners to benefit, by capital gains and with dividends.

Disadvantages of Common Stock

  1. In the event of a bankruptcy, common stockholders are the last to get paid, since common stock represents ownership in a company. Bondholders are considered creditors, and holders of preferred stock have priority over owners of common stock in the distribution of assets.
  2. While shareholders are owners of the company they do not hold the same rights as actual company owners. For example, they can walk in and demand to see in detail the book’s maintained by the company.
  3. Investors are not always guaranteed to know everything about the company they are investing in.
  4. Stock prices tend to be unpredictable rising and falling frequently.

Types

Categorization based on Risk of the investment

Blue Chips- Stock offerings in a countries most largest prestigious companies. Considered to be low risk, low reward investments, since they don’t have much potential for more growth. They do not normally need to acquire additional capital, and as a result tent to have excess cash. For this reason, they are more likely to pay out dividends.

Utilities- Stocks issued by water and power companies. Very limited competition. They are low risk investments and offer fairly low rewards. However, they are very safe investments.

Established growth- these are companies that are well known ad big in size, but they are still having room for growth and expansion. Earnings are usually invested into further growth of the company, so they do not always pay dividends to their shareholders. However, shareholders are able to benefit through capital gains.

Emerging Growth- these are small companies with significant potential for growth. They do not pay dividends. They may offer very good returns but they are also very risky investments.

Penny Stocks- These are the most speculative/risky companies. They represent investment in companies that may still be in the research and development stages of their time. Generally, have a high failure rate.

Categorization based Company size

Stocks are often categorized by size, specifically by the issuer's market capitalization or the number of shares outstanding times the share price.

Micro-caps - Less than $500 million

Small caps - $500 million to $2 billion

Mid-caps - $2 billion to $10 billion

Large caps - $10 billion to $100 billion

Mega caps - More than $100 billion

Categorization based on Sectors of the economy

Consumer Discretionary - e.g. GM, Home Depot, Walt Disney

Consumer Staple - e.g. Pepsi Co, RJR, Sara Lee

Energy - e.g. Exxon/Mobil, Noble Drilling, Halliburton

Financials - e.g. Wachovia, Bank of America, Goldman Sachs

Health Care - e.g. Merck, Pfizer, Aetna

Industrials - e.g. Boeing, UPS, Delta

Information Technology - e.g. Microsoft, Yahoo, Intel

Materials - e.g. Alcoa, International Paper, U.S. Steel

Telecommunications - e.g. AT&T, Bellsouth, Verizon

Utilities - e.g. Duke Energy, Southern Co., Calpine

Valuation methods

Common stock is usually issued with a par value, often $1 per share, although this usually has no relationship to the sale price of the stock. Companies are valued based on a number of factors including ratios such as Earnings Per Share (EPS), and Debt to Income ratio.

Common stock valuation is difficult for two reasons. First, not even the promised cash flows are known in advance. Second, the life of the investment is forever. Finally, it is difficult to determine rate of return required by the market.

Cash Flows

Let Po =(D1 + P1) / (1+R)

Po= current price of the stock

P1 = price in one period

D1= cash divided paid

R= required rate of return.


Furthermore, one can push the problem of coming up with the stock price off into the future for an infinite period of time. The current price of the stock can be written as the present value of the dividends from the beginning to an infinite amount of periods by:

Po = [D1/(1+R)^1] + [D2/(1+R)^2] + [D3/(1+R)^3] + [D4/(1+R)^4] + [D5/(1+R)^5]+ ...

Constant Dividends Model

In cases where the dividend has zero growth, the stock can be viewed as an ordinary perpetuity. In this case Po= D/R, where R is the required rate of return.

Constant Dividend Growth Model


If we know that the dividend will grow at a steady rate , we can call the growth g, and the value of the stock becomes. Do will be the dividend just paid, and D1 will be the value of the next dividend. D1 =D1/ (1+g) or (D0 X (1+g))/R-g

An asset with cash flows growing forever is called a growing perpetuity. Most companies strive to maintain a constant growth in their dividends. When the dividend grows at a steady rate, then we have replaced the problem of coming up with a infinite number of future dividends to a problem of coming up with a single growth rate. As long as the growth rate growth rae g is less then the discount rate of R, the present value of this series of cash flows can be written as

P0= D1/ R-g

This in turn is called the Dividend Growth Model

Non Constant Dividend Growth Model

Finally, to value non constant growth rate we would

Po = Po = [D1/(1+R)^1] + [D2/(1+R)^2] + [D3/(1+R)^3] + [P3/(1+R)^3]


The dividend growth model calculates the total return as:

R= Dividend yield + Capital Gains Yield

R= (D1 + Po) + g

Equity Risk involved

The total risk of a security can be thought of as the sum of two types of risk: systematic risk and unsystematic risk.

Unsystematic risk

Unsystematic risk is company or industry specific. It is the risk of investing in a particular company or an industry. Unsystematic risk can be averted by diversification of a portfolio. Diversification works because unsystematic risks of different stocks tend to partially offset one another in a portfolio. This occurs when the price of one stock in the portfolio goes down; the price of another tends to go up, at least partially offsetting the loss. As long as the returns of two stocks are not perfectly, positively correlated, one can reduce total risk by combining the securities in a portfolio. By adding enough securities to a portfolio, it is possible to eliminate unsystematic risk. Unsystematic risk is therefore, also called diversifiable risk.

Systematic risk and Beta

Systematic risk is the risk of investing in the stock market. No matter how many stocks we add to the portfolio, systematic risk cannot be averted. Therefore, it is often called non-diversifiable risk. Systematic risk is usually measured by how closely a security’s returns are correlated with the returns of the entire market. The extent to which a stock’s returns are related to general market changes is measured with beta (β). The β of the market as a whole is 1. Suppose a stock has the β of 2 relative to the market. This means that the stock is expected to be twice as volatile as the market. Stocks with betas less than 1 are defensive stocks because they carry less systematic risk than the market and tend to subdue the effects of market movements on the returns of a portfolio.