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Stocks

(The following is a Your Money Matters program brochure reproduction)

Corporations are usually organized under state laws. Each corporation is authorized by its charter to issue a specified amount of stock. Stock represents partial ownership (equity) in the corporation. The corporation may issue no more stock than the number of shares of stock authorized by its charter. Often a corporation will be authorized to issue more stock than it plans to sell immediately so that it may sell additional shares in the future without amending its charter.

Classes of Stock

Common Stock A corporation must issue at least one class of stock—common stock—sometimes referred to as common shares, capital shares, or capital stock. Purchasers of common stock are granted specific rights by the issuing corporation’s charter and by the chartering state’s business corporation law. These rights generally include the right to vote at stockholders’ meetings, the right to sell or otherwise dispose of their stock, the right of first opportunity to purchase any additional shares of common stock issued by the corporation, the right to share pro-rata with other common stockholders in any dividends distributed to common stockholders, the right to receive annual reports and to inspect the corporation’s books and records, and the right to share in any assets remaining after creditors are paid, if the corporation is liquidated. Common stocks sometimes have a par value, which is an arbitrary value assigned to them by the issuing companies. The stock may actually be bought and sold at prices greater or less than the par value.

A corporation may be authorized to issue more than one class of stock. A corporation may issue two or more classes of common stock which would then be distinguishable from each other by the rights granted to each class share. For example, one class of common stock might have enhanced voting rights; holders of this class would likely pay a higher price for their shares.

However, it is more likely that, if more than one class of stock is issued by a corporation, one of the classes will be common stock, with any additional classes being designated as preferred stock.

Preferred Stock Preferred stock gets its name from the preferences granted to its owners. These include a preference as to payment of dividends, and may include a preference in the distribution of assets (after creditors are paid) if the corporation is liquidated. However, preference as to dividends does not guarantee the payment of dividends. Rather, if dividends are declared, the preferred stockholders have the right to receive their preferred dividend before the common stockholders are paid any dividends. On the other hand, preferred stock normally carries no voting rights. Issuing preferred stock enables a corporation to raise additional capital without jeopardizing the controlling interests of the common stockholders. Like common stock, preferred stock may have a par value, and also like common stock, preferred stock may be bought and sold at prices greater or less than par.

Preferred stockholders may be granted some voting rights, but normally those voting rights are limited to matters directly affecting their special rights as preferred stockholders. If, for example, a company fails to pay dividends for a specified number of consecutive calendar quarters, preferred stockholders may then have the right to elect one or more members of the corporation’s board of directors.

Preferred stock may be participating or non-participating, cumulative or non-cumulative, callable, convertible, or some combination of these and other features.

If the company decides to issue non-participating preferred stock, the stockholder is entitled to dividend payments at regular intervals but will not receive any additional dividends, no matter how profitable the company may become.

In contrast, holders of participating preferred stock will receive a share of ordinary dividends distributed to common stockholders in addition to the regular preferred dividend.

If the stock is a cumulative preferred and the company fails to pay a dividend when due, the unpaid dividend obligation will accumulate for the benefit of the preferred stock owners. If the company does not make payments on the cumulative preferred stock for a number of years, the obligations continue to accumulate during the entire time and must be paid in full before common stockholders receive any dividend payments. In contrast, if a preferred stock is non-cumulative, unpaid dividends may never be received.

Callable preferred stock may be called in for redemption by the company at a price which is set by the company at the time of issuance. The call feature of a preferred stock enables the company to eliminate the high cost of dividends it may be paying on preferred stock. The call price of the preferred stock tends to put a ceiling on the market price of the stock because the company can redeem the stock at any time at the call price.

The stockholder may choose to exchange convertible preferred stock for shares of the company’s common stock at a predetermined rate. The conversion usually cannot take place within the first two or three years after issuance, and other conditions may apply. Convertible preferred stock offers the stability and fixed return of preferred stock with the potential to cash in on an increase in the value of the related common stock. However, once you have converted to common stock, you cannot switch back to the preferred.

Values of Stock In addition to the par value mentioned earlier, stocks have book value and may have a market value. While par value is an arbitrary value set by the company at the time of issuance, a better approximation of the value of a share of stock is its book value. A share’s book value is the total net assets of the company divided by the number of shares outstanding. For example, suppose a company with 1,000 shares of stock outstanding has total assets worth $10,000 and total liabilities of $4,000. Its net assets would then be $6,000. The book value of each of the 1,000 shares of stock therefore would be $6.

However, book value is usually not considered the most accurate measure of a stock’s value. Depending on how investors evaluate a company’s earnings prospects, they may be willing to pay more or less than book value for shares of the company’s stock. The price at which shares of stock can be bought and sold is called the market value. However, not all shares are publicly traded and therefore, some shares have no market value.

 

Investment Objectives

How Risky? As you contemplate any kind of investment, one of your primary considerations will be your overall investment objectives. Once you have determined that investing in stock is appropriate for you, you will want to keep your objectives in mind in order to chose the kinds of stock that are right for you.

Stocks are issued by all kinds of companies, from financially sound corporate giants, to established smaller companies looking for capital to expand, to speculative start-up companies with no track record and sometimes no product.

Blue chip stock is common stock of the largest, most financially stable corporations in America, considered leaders in their industries. These stocks have a history of stable or increased dividend payments. The "blue chip" reference comes directly from the poker table, where blue chips are more valuable than red or white ones. An investment in blue chip stocks is generally considered relatively conservative, but any investment in stock carries with it the risk of losing your entire investment.

Growth stocks are purchased by investors willing to take more risk for greater potential price appreciation. These stocks usually have what is referred to as a high price/earnings ratio (P/E). This ratio is obtained by dividing the current market price per share by the company’s most recent earnings per share. This ratio is an indication of the market’s current opinion about the growth potential of a stock or group of stocks: a high P/E ratio is based on anticipation that the company will do well.

Penny stocks are high risk, low-priced, highly speculative stocks usually issued by new companies. They are called "penny" stocks because they often sell for under $1 per share, although they may be priced up to $5 per share. They may be offered over the telephone or through the mail by high-pressure salespersons who hope to make substantial profits. These stocks are often issued by struggling companies. While some penny stocks have turned into profitable investments, the failures far outnumber the successes. An investor interested in penny stocks should be aware of the high risk of loss associated with them.

Growth or Income? As already noted, growth stock offers potential for price appreciation. Growth-stock companies typically invest all or most of their earnings in expansion. They are not likely to pay much in dividends. Price fluctuations for these stocks are often larger and more irregular than for income stocks. Other characteristics of growth stocks may include:

1 Earnings larger at each peak of the business cycle than they were at the previous peak;

2 Average growth rate of 10% or per year;

3 High product demand with competition not on overriding concern;

4 Earnings growth greater than that of the average business having favorable growth prospects;

5 Good potential for substantial price appreciation over the longer term.

Income stocks, on the other hand, are usually issued by well-established companies with steady earnings but lower potential for price appreciation. These companies are able to turn a large part of their earnings over to shareholders in the form of dividends because they do not choose to use the money for continued expansion.

Dividends and Yields

A company may distribute a portion of its profits or retained earnings, or both, to shareholders in the form of cash dividends. A company may use retained earnings to pay dividends despite the fact that it has not earned a profit from its operations—a practice which may adversely affect its future.

If you want regular income from stocks, you should look for a company that has a history of paying cash dividends on a regular basis. If you are more interested in capital gains (achieved by selling at a higher price than the purchase price), look for a growth stock. Firms with strong growth records generally pay smaller or no dividends because they retain their profits to keep the company growing.

A number of dates relate to payment of cash dividends. They are:

1 Declaration Date. This is the date on which a company’s board of directors declares that a dividend will b paid and specifies the amount.

2 Record Date. This is the date specified by the board of directors for determining shareholders who will be paid the dividend. All shareholders listed in the company’s records on that date will be paid the dividend whether or not they actually own the stock on that particular date.

3 Payment Date. As the name suggests, this is the date on which the dividend payment is made.

4 Ex-dividend Date. This date comes after the declaration date and is usually two business days before the record date. From the ex-dividend date until the payment date, the stock is traded without the declared but unpaid dividend. This means if a sale is made after the ex-dividend date, the seller rather than the buyer is entitled to the dividend.

Because of the lag in recordkeeping, a person who purchases a stock just prior to the ex-dividend date does not always have the shares issued in his or her name in time to receive the dividend directly from the company. This may result in the seller actually receiving a dividend check the seller is not entitled to. In that case, the brokerage firm will charge the seller’s account for the amount of the dividend and pay it to the buyer.

A dividend is said to be passed when it is expected but not declared. Dividends are passed or omitted when, in the opinion of the company’s board of directors, the company’s financial condition does not warrant payment or the money is needed for other business purposes. Even the largest firms may pass dividends.

A company may choose to pay a stock dividend, which is a dividend paid in shares or fractions of shares, instead of cash. A stock dividend merely lowers the cost per share of your holdings; it does not change the total value of your holdings. For example, if you owned 100 shares of stock worth $1,000, each share would be worth $10. If a 25% stock dividend were paid, you would then own 125 shares whose total value would still be $1,000. However, each share would then be worth $8.

A stock dividend is usually nontaxable at the time paid unless the company offers the stockholder the option of receiving the dividend in the form of either stock or cash.

The yield on a stock is the percentage of return on the market value of the stock. It is calculated by dividing the yearly dividend paid by the current market price of the stock—not the purchase price. While your dividend payments on a stock may remain the same very quarter, the yield may change dramatically with changes in the stock’s market price. Remember, however, that a company may be paying dividends even though it is not making a profit, and that a company making a profit may elect not to pay dividends. Therefore, you may wish to pay attention to the P/E ratio, discussed earlier, as well.

Stock Splits

When a company believes that investors are shying away from purchasing or holding its stock because the market price is too high or too low, the board of directors may approve a stock split. A stock split is similar to a stock dividend in that new shares of stock are issued to current stockholders.

Stock splits are expressed as ratios such as "2 for 1" or "3 for 2." In a 3 for 2 split, for example, for every 2 shares you currently own, you would receive one additional share so that after the split was paid, you would have 3 "new" shares for every 2 "old" shares you previously held.

As with a stock dividend, while the total value of your holdings remains the same, the value per share will change according to the split ratio. When a stock split takes place, the market price per share will generally be adjusted by the same ratio. Most stock splits result in additional shares being issued and the market price per share being reduced to a more attractive trading level for investors.

In contrast, when the market price of a stock is unusually low, a reverse stock split may be declared. In a reverse split, shareholders are required to send their certificates to the company to be exchanged for new certificates representing a small number of shares. Again, the split is expressed as a ratio, such as "1 for 10" reverse split. In that example, for every 10 shares you currently own, you would receive a certificate for 1 new share. A reverse split will increase the market price per share by approximately the same ratio. Thus, the total value of your holdings will remain the same, but the market price per share will be approximately 10 times higher.

The four dividend dates previously discussed also apply to stock splits, with one exception: the ex-dividend date normally is the day after payment date. Because market prices are usually adjusted for dividends and stock splits on the ex-date, placing the ex-date after the payment date discourages speculative trading in the stock between the declaration date and the payment date. It does mean, however, that if you sell your stock any time on or before the payment date, you will not be entitled to the split shares.

Stocks vs. Bonds

A brief mention of bonds as contrasted with stocks is relevant before concluding. Whereas a stock represents partial ownership (equity) in a company, bonds represent debt payable by a company to the bondholders.

As part owners, stockholders take on added risk for their investment. If a company must liquidate, stockholders cannot receive anything for their shares until all debts, including bonds, are paid in full. Also, interest on bonds must be paid in good times or bad, like any other debt. In contrast, dividends on stock can be reduced or even eliminated in lean periods. Profits in good years, however, usually mean higher dividends, increased stock prices, and better returns for the stockholder, while interest on bonds remains constant.

Of course, when considering investing in stock, you should carefully evaluate all aspects of a company, weigh your objectives carefully, and investigate before you invest.