This article will explain the financial security of common stock. The overview provides an introduction to the characteristics of common stock. These characteristics include the rights of common stockholders, dividend priority of a common stock shares, the role of common stockholders in corporate governance and the liability of common stockholder. In addition, other concepts that relate to factors that can affect the growth in value of common stock are explained, including supply and demand, earnings and market volatility. Explanations of corporate financial dealings in which the issuance or dividend payment of common stock shares is an important consideration, such as long-term financing, capital appreciation and liquidation, are included to help illustrate the ways that a corporation's board of directors, investors and shareholders make financial decisions about their common stock holdings.
Keywords Common Stock; Dividends; Liquidation; Par Value; Preferred Stock; Priority; Securities; Stockholders
Finance: Common Stock
Corporations are a form of business ownership in which the legal entity is created under state law so that it exists as a distinct enterprise from its owners. Once formed, corporations are generally managed by a board of directors, which elects officers to perform the day-to-day duties necessary to run the company. The articles of incorporation that are filed with the formation of the corporation typically set out the business purpose of the corporation. This statement of the business purpose may be specific, or it may simply allow the corporation to perform any lawful business. However, once the corporation is operative, it is ready to do business and grow successfully.
While some corporations may be financially self-sustaining, most companies need an influx of working capital at some point in order to grow in profitability. Some companies may need initial start-up funds to begin their operations. Other companies may be financially solvent for a period, only to arrive at a point where additional financing will be necessary to survive a time of reduced profits or to underwrite the purchase of major equipment to expand its operations.
Whatever the reason, a steady flow of profits and capital is the lifeblood of corporations. When a corporation faces the prospect of acquiring additional capital, the board of directors must decide what type of financing will be necessary to enable the corporation to profit and thrive. Most companies must choose between short-term financing and long-term financing options when weighing their cash flow needs against their corporate growth objectives. Short-term financing and long-term financing serve different purposes. Corporations typically choose short-term financing options to cover a periodic loss of funds or a sudden surge in expenses, such as when companies borrow funds to purchase a large quantity of goods in anticipation of a seasonal demand for the item. Short-term financing, then, is the best option for a corporation that needs to borrow funds to cover sudden expenses when an inflow of cash is anticipated at some future date that will enable the company to repay the funds in a relatively short amount of time. Most short-term borrowing is done with the help of financial intermediaries, such as banks, finance companies and money market funds.
Sometimes, however, corporations need a more substantial inflow of cash to finance the company's significant costs or future growth objectives. In this situation, most companies must look to long-term financing options to meet their fiscal needs. Long-term financing may be necessary to subsidize marketing and other supportive functions in order to generate more substantial future sales or to purchase more efficient equipment or finance ongoing research and development projects. Long-term financing is generated either from internal cash flow or from external sources of funds. As the company grows, it will generate income and it can spend, save or invest this income to generate internal cash flow. However, these internal sources of funds generally are insufficient to cover all of the long-term investments required by a company. Thus, corporations must look to external sources of funds to subsidize its more significant growth objectives.
Most long-term external financing is generated when a company issues stocks or bonds. If a firm decides to issue stocks to finance its long-term financing needs, it must then decide which types of stock it will issue. The most typical types of stocks are common stock and preferred stock. When a corporation is considering issuing stocks to generate long-term financing, the central question that the corporation must address is the likelihood of its ability to generate future earnings, which will be translated into dividends to common stockholders and capital appreciation. The greater the company's ability to assure potential investors of its growth opportunities, the better its chances of selling its stock to investors.
The following sections provide a more in-depth explanation of these concepts.
Basic Financial Concepts
Every corporation must finance its operations. Corporations typically generate long-term financing through external sources of funds, including stocks and bonds. The most common types of stock are common stock and preferred stock. Common stock carries certain rights and limitations that investors must understand before becoming shareholders in a corporation. This section provides an overview of the basic characteristics, privileges and limitations of common stock.
Characteristics of Common Stock
Common stock shares are traditionally conceived as ownership or equity interests in the corporation, so that the body of common shareholders is the corporation's owners. Stock is sometimes referred to as shares, securities or equity. The more shares you own, the larger the portion of the company (and profits) you own. The majority of stock is issued by corporations is common stock. The other type of shares that the public can hold in a corporation are known as preferred stock.
Basic Rights of Common Stockholders
When investors purchase shares of common stock, they are purchasing a security that represents ownership in a company. This ownership gives common stockholders some basic rights. The following sections will explain the fundamental rights of shareholders, including holders of common stock.
Shareholders, also called stockholders, are essentially part owners of any company in which they have invested by purchasing shares, or stock. A stock, represented by a stock certificate, is a share in the ownership of a company, and thus in the ownership of the company's assets and earnings. An investor's ownership in a company depends on the percentage of the company's total stock she owns. An investor who purchases 10 shares out of the 1,000 shares that a corporation issues would probably be a minor owner and thus would have a relatively small say in company policy. However, an investor who purchased 300 shares would own a much larger share of the company and thus would likely be a more influential decision maker on the future of the company's growth. Corporate ownership is beneficial because it allows investors to participate in steering the direction of a company and it allows investors to profit as the company grows through the increase in the value of their shares and through the distribution of any corporate dividends. Dividend distribution will be discussed in more detail in the next section.
Participation in Dividend Distribution
When a company grows and makes money, the management of the company can do one of two things with the profit: they can reinvest the profit back into the firm to give the company extra cash for use on new equipment or some other type of venture, or the money can be paid out to the corporation's shareholders in the form of a dividend. Thus, as a company grows and builds its earnings, stockholders are entitled to participate in the distribution of corporate earnings, called dividends. However, corporations do not have to pay dividends, and thus common stockholders are not guaranteed an annual distribution. While many corporations do pay dividends, they are distributed only upon the approval of the corporation's board of directors, which also sets the amount of dividends. In addition, common stock has a lower priority than the claims of a corporation's creditors and other forms of stock. Thus, even if a distribution is approved, there may not be sufficient corporate funds for distribution to all common stockholders. However, when a corporation is growing and profitable and its board of directors approves the distribution of dividends, common stockholders can receive a return on their investment in the company stock in the form of dividends.
While at first glance, common stock may seem to be a less than ideal investment, common stockholders may protect their investment and exercise some control over the direction of a company's growth through their voting power. The voting rights of investors are typically determined by one vote per share. Shareholders may exercise their voting power by electing a board of directors. The board of directors sets corporate policy and hires managers to run the firm. In addition, common stockholders may vote on important corporate matters, including any proposals that would effect fundamental changes on the company, such as mergers or liquidation. Shareholders vote on these issues at the company's annual meeting. If shareholders are unable to attend the annual meeting in person, they may choose to vote by proxies, which allow someone else to vote at the meeting, or by mailing in their vote.
The principle of absolute priority of a security establishes rules that dictate each place in line that a company's creditors or investors have for the distribution of dividends or the collection of assets in the event of a corporate default and liquidation. While common shareholders are considered owners of a company, the priority of common stock is beneath the claims of a company's creditors and the holders of other forms of corporate securities. This means that if a company liquidates, the creditors get the first chance to settle their debts from a company's assets during the insolvency proceedings. After the creditors, the holders of other types of corporate securities, including bondholders and preferred shareholders, are next in line. Only once these debts are settled may common shareholders look to recover their investment from what remains of a company's liquidated assets.
In addition to the rules of absolute priority, there are other rights that govern the distribution of dividends for each class of shareholder. For example, usually a company's charter states that preferred stockholders must receive dividends before common stockholders. Thus, while common stock generally yields higher returns over the long term than almost every other investment by means of capital growth, this higher return comes at a cost because common stocks entail the most risk. If a company goes bankrupt and liquidates, the common shareholders will not receive money until the creditors, bondholders and preferred shareholders are paid.
While common stockholders do face limited priority in dividend distribution and in insolvency proceedings, their liability is limited in that owners of stock are not personally liable if the company becomes insolvent. While some business entities, such as partnerships, allow for creditors to look to the personal assets of partners to recover the partnership's expenses, an important characteristic of corporate ownership as a stockholder is that the most a shareholder could lose is the value of his original investment in a company. Thus, even if a stockholder owns a significant percentage of shares in a corporation, a company creditor could never seek to pursue a stockholder's personal assets to settle a corporate debt. And, if a company ultimately goes bankrupt, shareholders never face losing their personal assets along with their business assets. Limited liability, therefore, means that stockholders are not responsible for the corporate debts and their maximum loss would be their original investment.
Some corporate investors choose to buy a significant percentage of a company's shares so that they posses a stronger voting power. However, their power could be undermined if the corporation simply issued more stock as it grew and profited, thus diluting the ownership percentage of current shareholders. To prevent this from happening, shareholders generally possess the right to buy new shares of stock before others so that they can maintain the same proportion of ownership they originally had. This is known as their preemptive right. Today, the preemptive rights of shareholders, if they exist, are typically expressed in the articles of incorporation that are filed when a corporation is formed.
In addition to preemptive rights, stockholders also possess the ability to transfer ownership of their shares to another investor. Basically, this allows investors to trade stocks on an exchange. The right to transfer ownership may not seem to be an important feature of stock, but the ease with which securities such as common stock can be bought and sold, also known as their liquidity, is one of the primary reasons for their popularity. Liquidity means that investors can buy and sell investments within minutes rather than having their money tied up in investments such as equipment or land that may take weeks or months to sell.
Originally, when a shareholder bought or sold a share, the shareholder had to physically transfer the stock certificates, which represent the number of shares the stockholder owned, to a broker. But with the advent of online trading, stocks are traded over the Internet without any actual transfer of documents. Thus, since most stockholders do not actually retain stock certificates, the certificates are held in an electronic format by brokerage firms. This is known as holding shares "in street name." This allows shares to be bought and sold on exchanges without the physical presence of either the seller or the buyer.
Shareholders may not only assert power over a corporation through their election of the board of directors and voting rights, shareholders may also enforce a corporation's lawful cause of action through a derivative action. In a derivative action, a shareholder is essentially enforcing the rights of the corporation where the directors have not done so, and any recovery gained from such an action goes back to the corporation, not the shareholder. However, before a shareholder may...
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