Understanding The Types of Equity Securities

1.1 Common Stock

Common stock (also known as common shares, ordinary shares, or voting shares) is the main type of equity security issued by companies. A common share represents an ownership interest in a company. Common shares have an infinite life; in other words, they are issued without maturity dates. Common stock may or may not be issued with a par value. When common shares are issued with par values, companies typically set their par value extremely low, such as Rs.10 per share in India. It is important to note that the par value of a common share may have no connection to its market value, even at the time of issue.

For instance, a common share with a par value of Rs.10 may be issued to a shareholder for Rs.50. Common shares represent the largest proportion of equity securities by market value. Large companies often have many common shareholders, each of whom owns a portion of the company’s total shares. Investors may own common stock of public or private companies. Shares of public companies typically trade on stock exchanges that facilitate trading of shares between buyers and sellers. Private companies are typically much smaller than public companies, and their shares do not trade on stock exchanges. The ability to sell common shares of public companies on stock exchanges offers potential shareholders the ability to trade when they want to trade and at a fair price.

Common stock typically provides its owners with voting rights and cash flow rights in proportion to the size of their ownership stake. Common shareholders usually have the right to vote on certain matters. Companies often pay out a portion of their profits each year to their shareholders as dividends; the rights to such distributions are the shareholders’ cash flow rights. Dividends are typically declared by the board of directors and vary according to the company’s performance, its reinvestment needs, and the management’s view on paying dividends. As owners of the underlying company, common shareholders participate in the performance of the company and have a residual claim on the company’s liquidated assets after all liabilities (debts) and other claims with higher seniority have been paid.

Many companies have a single class of common stock and follow the rule of “one share, one vote”. But some companies may issue different classes of common stock that provide different cash flow and voting rights. In general, an arrangement in which a company offers two classes of common stock (e.g., Class A and Class B) typically provides one class of shareholders with superior voting and/or cash flow rights

The reason for having multiple share classes is usually that the company’s original owner wants to maintain control, as measured by voting power, while still offering cash flow rights to attract shareholders. In general, for large public companies in which nearly all shareholders hold small ownership positions, the difference in voting rights may not be important to shareholders.

1.2 Why Are Common Stock Issued?

The primary reason behind the issuance of common stocks is to raise capital.

The capital thus raised can be used for several purposes like

• Expansion

• Acquisition of a promising company

• Paying off debts

• Creation of a cash reserve for future use

Issuance of more common stocks in the market tends to dilute the holding power of existing stockholders. This is why company owners are often wary and tend to weigh the pros and cons of share issuance before making the final call.

1.3 What Type of Investors Are Common Stocks Best for?

Investors buy common stock for essentially two reasons:

• For income, via the steady trickle of dividends the shares pay

• For appreciation: the chance that they’ll be able to profit by reselling the stock later

Of the two, appreciation has the edge. People primarily invest in common stock because they want to share in a company’s growth. As its earnings and profits increase, so will the price of its stock shares.

In terms of risk, common stocks run the gamut, from blue-chip Stocks, which are highly stable and secure, to penny stocks, which are extremely volatile. You can find a stock to suit just about any investment need or time-frame.

In general, though, the less time you have to hold your stocks, the riskier they are. Compared to bonds and other investments, stocks are more secure over longer periods of time. Historically, the equities market has appreciated. But while stocks, in general, have tended to increase in value over the long term, the stock market may stay down for years. And shares in individual companies can always tumble or become worthless, even in robust markets.

So investors with a smaller window, such as those who are older or who need their money sooner, are better off investing elsewhere or at least diversifying their portfolios with other assets.

1.4 How common stock is created, sold, and traded

So how do companies create common stock? The first step is an initial public offering, which is usually done by partnering up with an investment bank, which helps price the stock and decides just how many shares will be made available.

By taking a company (and shares in it) “public,” those with early access to the stock – founders, employees, venture capitalists, and other private investors – can more easily sell their existing shares, hopefully at a profit. That’s because the world of potential buyers immediately grows so much larger once a stock is publicly available and starts trading on a stock exchange.

1.5 Advantages of Issuing Common Stock

From Companies Point of View

1. Long Term Source of Fund- Common stock is the source of permanent capital. Funds raised from common stock is available for use as long as the company exists.

2. No Mandatory Payment- Common Stocks does not legally obligate the firm to pay dividends. If a company generates sufficient earnings, it can pay dividend to common shareholders. In contrast to bond interest, there is no legal obligation to pay dividends to common stockholders

3. Increase Borrowing Capacity- Common stock financing increases the borrowing capacity of the company. Because common stock provides cushion against losses of creditors, the sale of common stock generally increases the credit worthiness of the firm. Thus, business firm with strong equity base is capable of obtaining loan easily & common stock strengthen the equity base of the firm

Form Investors Perspective:

1. Performance- Common stocks, when compared to bonds and deposit certificates, perform better. However, there is no upper limit on the investor’s earnings from their common stock holdings. Therefore, common stocks are less expensive and more practical alternatives against debt investment.

2. Voting rights- One voting right is vested to an investor per share of each common stock held. These voting rights help investors to take part in business decisions and the creation of corporate policies. In some cases, investors have the right to elect the board of directors by exercising their voting rights. The more common stocks investor has the more power they will swing the policies in a company.

3. Liquidity- Due to their liquidity features, common stocks can be easily surrendered or invested by investors. Thus, these stocks help investors buy shares and walk away with all their funds if the company does not give results to their expectations. Liquidity offers the investors flexibility to do with their investments what they see fit without any hassle.

4. Limited Legal Liabilities- Beyond the financial investment events that occur within the company, the obligations of common shareholders still exist, and they need to be concerned with all legal liabilities. When the company is giving growing returns across time, common shareholders know passive recipients of a fixed income of sorts. Passive shareholders are not responsible in case the company liquidates or gets into legal trouble.

1.6 Disadvantages of Issuing Company Stock

From Companies Point of View:

1. Higher Risk & Cost- Common stock is expensive source of long term financing. Common shareholders expect a higher rate of return than other investors, since the risk involved is also high. Moreover, floatation costs that include underwriting commission, brokerage fees and other expenses usually are higher than those for debt & preferred stock.

2. Dilution of Ownership- The issuance/ issue of new common shares may dilute the ownership & control of the existing shareholders. Dilution of ownership assumes greater significance incase of closely-held companies

3. Dilution of EPS- Common stock dividends are not tax deductible payments. The impact of this factor is reflected in relatively higher cost of equity capital as compared with debt capital.

From Investors Point of View:

1. Market Risks- The major risk associated with the common share is the market risk. Market risk is the issue of the company underperforming over a period. A substantial decline in the company’s performance can lead to the profit being eaten by the shareholders and not getting the dividends they are looking for. This is an essential parameter to consider because common shareholders are not the only and the first ones to receive payout benefits even when the company is performing extremely well.

2. Uncertainty- Even though common shareholding can be considered a fixed-income option, there is no guarantee of payouts. However, the major difference here is that the income is not guaranteed when one expects it based on the fund’s availability in the company and how they are allocating those funds. When the company starts to allocate dividend payouts, investors and common stockholders are not the only ones to receive immediate payouts. They receive their dividends after shareholders and bondholders are entitled to receive full dividends. Hence there is a degree of uncertainty and lack of control when it comes to the profitability of common stocks.

3. Limited Rights & Ownership- While shareholders are company owners, they do not enjoy all the rights & privileges that the owner of privately held companies do. For eg- they cannot normally walk in & demand to review in details the company’s books.

1.7 Common Stocks and Balance Sheet

Typically, information regarding the common stocks of a company is recorded under the header of a stockholder’s equity section in its Balance Sheet. Individuals who intend to determine the book value, also known as the net worth of a company’s shares, would gain valuable insights from this section of the Balance Sheet. Notably, stockholder’s equity is the book value of a company’s stock and tends to highlight a company’s intrinsic value. Such an amount helps estimate the amount shareholders would receive in the case of a liquidation.

However, stocks don’t need to be traded at this amount. Growing companies often trade several times more than their book value. Conversely, companies that are struggling may opt to trade below their share’s book value.