Understanding a stockholder’s voting rights

One of the most basic rights that most common stockholders receive is voting rights — although rarely corporations issue nonvoting common stock. Nonvoting stock may be issued by corporations to protect their board of directors, but it’s not as attractive to investors who like to have some control over who’s running the company. Most preferred stock is nonvoting.

When investors have voting rights, every so often a corporation may have those investors vote to change members on the board of directors. Although investors may be able to vote on other issues, the Series 7 focuses on voting to change board members.

Because having all stockholders actually attend the annual corporate meeting to vote would be difficult, stockholders usually vote by proxy, or absentee ballot.

Categorizing shares corporations can sell

All publicly held corporations have a certain quantity of shares that they can sell based on their corporate charter. These shares are broken down into a few categories depending on whether the issuer or investors hold the shares:

• Authorized shares: Authorized shares are the number of shares of stock that a corporation can issue. The issuer’s bylaws or corporate charter (a document filed with the state that identifies the names of the founders of the corporation, the company’s objectives, and so on) states the number of shares the company is authorized to sell. However, the issuer usually holds back a large percentage of the authorized stock (which it can sell later through a primary offering — see Chapter 5 for details on offerings).
• Issued shares: Issued shares are the portion of authorized shares that the issuer has sold to the public to raise money.

• Outstanding shares: Outstanding shares are the number of shares that are in investors’ hands. This quantity may or may not be the same number as the issued shares. At times, an issuer may decide to repurchase its stock in the market to either help increase the demand (and the price) of the stock trading in the market or to avoid a hostile takeover (when another company is trying to gain control of the issuer). Stock that the issuer repurchases is called treasury stock.

  The standard formula for outstanding shares follows:

  

The following question tests your understanding of outstanding shares.

ZZZ Bedding Corp. is authorized to issue 2,000,000 shares of common stock. However, ZZZ issues only 800,000 shares to the public. One year later, ZZZ repurchases 150,000 shares to increase the demand on the outstanding shares. How many shares does ZZZ have outstanding?

(A) 650,000

(B) 800,000

(C) 1,200,000

(D) 1,850,000

The right answer is Choice (A). You probably didn’t have too much difficulty with this one. All the question is asking is how many shares are still outstanding in the market. Check out the following equation:

Because ZZZ issued only 800,000 shares of the 2,000,000 that it’s authorized to issue, the most ZZZ ever had in the market was 800,000. However, a year after issuing those shares, ZZZ repurchased 150,000 shares, giving the company treasury stock. Therefore, the amount of outstanding shares is 650,000.

Considering the par value of common stock

Par value (stated or face value) for common stock is not as important to investors as it is to bondholders and preferred stockholders (see the later section “Considering characteristics of preferred stock”). Par value for common stock is more or less a bookkeeping value for the issuer. Although issuers may set the par value at $1 (or $5, $10, or whatever), the selling price is usually much more. A stock’s par value has no relation to the market price of the stock.

The amount over par value that an issuer receives for selling stock is called paid-in capital, paid-in surplus, or capital surplus.

The stated par value is printed on the stock certificate; it changes if the issuer splits its stock. An issuer can also issue no par value stock (stock issued without a stated par value); in this case, the stock has a stated value that the corporation uses for bookkeeping purposes. A lack of par value doesn’t affect investors.

Splitting common stock was covered on the Securities Industry Essentials Exam. So, you won't have to know the math related to splitting common stock on the Series 7. However, you should remember that forward stock splits lower the par value and market value as well as increasing the number of shares held by existing stockholders. Reverse splits increase the par value and market value while decreasing the number of shares held by existing stockholders.

Sharing corporate profits through dividends

If a corporation is profitable (and the board of directors is in a good mood), the board of directors may decide to issue a dividend to investors. Dividends are just a way for corporations to distribute cash, stock, product, or whatever, out of its earnings and profits. If and/or when the corporation declares a dividend, each shareholder is entitled to a pro rata share of dividends, meaning that every shareholder receives an equal proportion for each share that she owns. The Series 7 exam expects you to know the forms of dividends an investor can receive and how the dividends affect both the market price of the stock and an investor’s position. Although the investor can receive dividends in cash, stock, or property forms (stock of a subsidiary company or sample products made by the issuer), I focus on cash and stock dividends because those scenarios are more likely.

Investors can’t vote on dividends; instead, the board of directors decides dividend payouts. You can imagine that if this decision were left in the investors’ hands, they’d vote for dividends weekly! For more info on voting, see “Understanding a stockholder’s voting rights,” earlier in this chapter.

Cash dividends

Cash dividends are a way for a corporation to share its profits with shareholders. When an investor receives cash dividends, it’s a taxable event. Corporations aren’t required to pay dividends; however, dividends provide a good incentive for investors to hold onto stock that isn’t experiencing much growth. Although cash dividends are nice, the market price of the stock falls on the ex-dividend date (the first day the stock trades without a dividend) to reflect the dividend paid:

Try your hand at answering a cash dividend question.

ABC stock is trading for $49.50 on the day prior to the ex-dividend date. If ABC previously announced a $0.75 dividend, what will be the next day’s opening price?

(A) $48.25

(B) $48.75

(C) $49.50

(D) $50.25

The correct answer is Choice (B). Check your work:

The math’s as simple as that. Because stocks are now trading in pennies instead of eighths like they used to, calculating the price on the ex-dividend date is a snap.

Stock dividends

Stock dividends are just like forward stock splits in that the investor receives more shares of stock, only the corporation gives a percentage dividend (5 percent, 10 percent, and so on) instead of splitting the stock 2-for-1, 3-for-1, or whatever. Unlike cash dividends, stock dividends aren’t taxable to the stockholder because the investor’s overall value of investment doesn’t change.

The primary reason for a company to give investors a stock dividend is to make the market price more attractive to investors (if the market price gets too high, it limits the number of investors who can purchase the stock), thus adding liquidity (ease of trading) to the stock.

The following question tests your expertise in answering stock dividend questions.

Terry Trader owns 400 shares of OXX common stock at $33 per share. OXX previously declared a 10 percent stock dividend. Assuming no change in the market price of OXX prior to the dividend, what is Terry’s position after the dividend?

(A) 400 shares at $30

(B) 440 shares at $33

(C) 400 shares at $36.30

(D) 440 shares at $30

The answer you want is Choice (D). In this case, you can find the answer without doing any math. Because the number of shares increases, the price of the stock has to decrease. Therefore, the only answer that works is Choice (D). I can’t guarantee that you’ll get a question where you don’t have to do the math, but don’t rule it out; scan the answer choices before pulling out your calculator.

Anyway, here’s how the numbers work. You have to remember that the investor’s overall value of investment doesn’t change. Terry gets a 10 percent stock dividend, so she receives 10 percent more shares. Now Terry has 440 shares of OXX (400 shares + 40 shares [10 percent of 400]). Next, you need to determine her overall value of investment:

Because the overall value of investment doesn’t change, Terry needs to have $13,200 worth of OXX after the dividend:

Terry’s position after the split is 440 shares at $30 per share.

Penny stocks

Penny stocks are low-priced equity securities issued by corporations. Penny stocks are non-NASDAQ equity securities that trade OTC at less than $5 per share. Penny stocks are considered extremely speculative in nature and aren't for everyone. Prior to even contacting a client about the purchase of penny stocks, you must determine the investor's suitability based on information about his objectives and financial situation.

All broker-dealers must provide a penny stock disclosure document, which outlines the risks of investing in penny stocks (lack of liquidity, quick price changes, and so on) to investors prior to effecting any penny stock transactions. The broker-dealer must receive a signed and dated acknowledgement of receipt of the document from the customer. (Certain established customers are exempt from having to receive and sign the disclosure document.) The broker-dealer must wait at least 2 business days after sending the document to the customer prior to any penny-stock transaction. Broker-dealers must maintain the customer's signed acknowledgement. In addition, if requested by the customer, the broker-dealer must provide the penny stock information provided at the SEC's website at www.sec.gov/investor/pubs/microcapstock.htm.

Considering characteristics of preferred stock

One advantage of purchasing preferred stock over common stock is that preferred shareholders receive money back (if there’s any left) before common stockholders do if the issuer declares bankruptcy. However, the main difference between preferred stock and common stock has to do with dividends. Issuers of common stock pay a cash dividend only if the company’s in a position to share corporate profits. By contrast, issuers of preferred stock are required to pay consistent cash dividends. Preferred stock generally has a par value of $100 per share and tends to trade in the market somewhere close to that par value.

Some of the drawbacks of investing in preferred stock over common stock are the lack of voting rights, the higher cost per share (usually), and limited growth. You can assume for Series 7 exam purposes that preferred stockholders don’t receive voting rights unless they fail to receive their expected dividends (a few other exceptions exist, but you don’t need to worry about them now). Also, because the price of preferred stock remains relatively stable, preferred stockholders may miss out on potential gains that common stockholders may realize.

If the issuer can’t make a payment because earnings are low, then in most cases, owners of preferred stock are still owed the missing dividend payment(s). The dividend (sharing of profits) that preferred stockholders receive is based on par value. Thus, although par value may be nothing more than a bookkeeping value when you’re dealing with common stock, par value is definitely important to preferred stockholders.

To calculate the annual dividend, multiply the percentage of the dividend by the par value. For instance, if a customer owns a preferred stock that pays an 8 percent dividend and the par value is $100, you set up the following equation:

If the issuer were to pay this dividend quarterly (once every three months), an investor would receive $2 every three months.

When working on a dividend question on preferred stock, you need to look for the par value in the problem. It’s normally $100, but it could be $25, $50, and so on.

Getting familiar with types of preferred stock

You need to be aware of several types of preferred stock for the Series 7. This section gives you a brief explanation of the types and some of their characteristics. Some preferred stock may be a combination of the different types, as in cumulative convertible preferred stock. Here are the distinctions between noncumulative and cumulative preferred stock:

• Noncumulative (straight) preferred: This type of preferred stock is rare. The main feature of preferred stock is that investors receive a consistent cash dividend. In the event that the issuer doesn’t pay the dividend, the company usually still owes it to investors. This isn’t the case for noncumulative preferred stock. If the preferred stock is noncumulative and the issuer fails to pay a dividend, the issuer doesn’t owe it to investors. An investor may choose noncumulative preferred stock over common stock because the company is still supposed to pay a consistent cash dividend.
• Cumulative preferred: Cumulative preferred stock is more common. If an investor owns cumulative preferred stock and doesn’t receive an expected dividend, the issuer still owes that dividend. If the issuer declares a common dividend, the issuer first has to make up all delinquent payments to cumulative preferred stockholders.

The following question tests your understanding of cumulative preferred stock.

An investor owns ABC 8 percent cumulative preferred stock ($100 par). In the first year, ABC paid $6 in dividends. In the second year, it paid $4 in dividends. If a common dividend is declared the following year, how much must the preferred shareholders receive?

(A) $6

(B) $8

(C) $12

(D) $14

The right answer is Choice (D). Because ABC is cumulative preferred stock, issuers have to catch up preferred stockholders on all outstanding dividends before common shareholders receive a dividend. In this example, the investor is supposed to receive $8 per year in dividends (8% × $100 par). In the first year, the issuer shorted the investor $2; in the second year, $4. The investor hasn’t yet received payment for the following year, so she is owed $8. Add up these debts:

All preferred stock has to be either cumulative or noncumulative. Both types may have other features, including the ability to turn into other kinds of stock, offerings of extra dividends, and other VIP treatment. I run through some of these traits in the list that follows:

• Convertible preferred: Convertible preferred stock allows investors to trade their preferred stock for common stock of the same company at any time. Because the issuers are providing investors with another way to make money, investors usually receive a lower dividend payment than with regular preferred stock.

  The conversion price is the dollar price at which a convertible preferred stock par value can be exchanged into a share of common stock. When the convertible preferred stock is first issued, the conversion price is specified and is based on par value. The conversion ratio tells you the number of shares of common stock that an investor receives for converting one share of preferred stock.

  You can use the following conversion ratio formula for convertible preferred stock and also for convertible bonds (see Chapter 7 for info on convertible bonds):

  

• The conversion ratio helps you determine a parity price where the convertible preferred stock and common stock would be trading equally. For example, say you have a convertible preferred stock that’s exchangeable for four shares of common stock. If the convertible preferred stock is trading at $100 and the common stock is trading at $25, they’re on parity because four shares of stock at $25 equal $100. However, if there’s a disparity in the exchange values, converting may be profitable. If the convertible preferred stock is trading at $100 and the common stock is trading at $28, the common stock is trading above parity; converting makes sense because investors are exchanging $100 worth of securities for $112 worth of securities ($28 × 4).

• Callable preferred: Callable preferred stock allows the issuer to buy back the preferred stock at any time at a price on the certificate. This stock is a little riskier for investors because they don’t have control over how long they can hold the stock, so corporations usually pay a higher dividend on callable preferred stock than on regular preferred stock. Issuers will issue callable preferred stock with a sinking fund provision, which means that the issuer will set aside money in an account (custodial account) to repurchase the shares (if he decides to) sometime in the future.
• Participating preferred: Although rarely issued, participating preferred stock allows the investors to receive common dividends in addition to the usual preferred dividends. Most preferred stock is non-participating, meaning that they don't receive common dividends, only preferred dividends.
• Prior (senior) preferred: Preferred stockholders receive compensation before common stockholders in the event of corporate bankruptcy. In this case, senior preferred stockholders receive compensation even before other preferred stockholders. Because of the extra safety factor, senior preferred stock pays a slightly lower dividend than other preferred stock from the same issuer.
• Adjustable (variable or floating rate) preferred: Holders of adjustable preferred stock receive a dividend that’s reset every three months to match movements in the prevailing interest rates. Because the dividend adjusts to changing interest rates (usually based off of a certain benchmark such as the T-bill rate or London Interbank Offered Rate [LIBOR]), the stock price remains more stable.

The following example gives you an idea of how to determine the conversion ratio.

If ABC preferred stock ($100 par) is convertible into common stock for $25, what is the conversion ratio?

(A) 1 share

(B) 4 shares

(C) 25 shares

(D) 100 shares

The answer you want is Choice (B). This equation is about as simple as the math gets on the Series 7 exam. Because the $100 par value preferred stock is convertible into common stock for $25, it’s convertible into four shares:

If you’d like to have more fun (and I use that term loosely) with convertible securities, please visit the convertible bond section in Chapter 7.

Opening national borders: ADRs

American Depositary Receipts (ADRs) are receipts for foreign securities traded in the United States. ADRs are negotiable certificates (they can be sold or transferred to another party) that represent a specific number of shares (usually one to ten) of a foreign stock. ADR investors may or may not have voting privileges. U.S. banks issue them; therefore, investors receive dividends in U.S. dollars. The stock certificates are held in a foreign branch of a U.S. bank (the custodian bank) and, to exchange their ADRs for the actual shares, investors return the ADRs to the bank that’s holding the shares. In addition to the risks associated with stock ownership in general, ADR owners are subject to currency risk (the risk that the value of the security may decline because the value of the currency of the issuing corporation may fall in relation to the U.S. dollar). For information on how the strength of the dollar affects the relative prices of goods in the international market, flip to Chapter 13.

Rights: The right to buy new shares at a discount

Corporations offer rights (subscription or preemptive rights) to their common stockholders. To maintain their proportionate ownership of the corporation, rights allow existing stockholders to purchase new shares of the corporation at a discount directly from the issuer, before the shares are offered to the public. Stockholders receive one right for each share owned. The rights are short-term (usually 30 to 45 days). The rights are marketable and may be sold by the stockholders to other investors. If existing stockholders don’t purchase all the shares, the issuer offers any unsold shares to a standby underwriter. A standby underwriter is a broker-dealer that purchases any stock that wasn’t sold in the rights offering and then resells the shares to other investors.

For the Series 7, you can assume that common stockholders automatically receive rights.

Because rights allow investors to purchase the shares at a discount, rights have a theoretical value. The board of directors determines that value when they decide how many rights investors need to purchase a share, as well as the discounted price offered to investors. To determine the value of a right, you can use one of two basic formulas: the cum rights formula or the ex-rights formula. Look closely at the question to determine which one you need. The following sections explore each.

Using the cum rights formula

You may have to find the value of a right while shares are still trading with rights attached. To find out how much of a discount each right provides, you can simply take the difference between the market price and the subscription price, divide that by the number of rights, and come up with a nice, round number. But not so fast! On the ex-date (the first day the stock trades without rights), the market price will drop by the value of the right. Before the ex-date, you can find the value of a right by using the cum (Latin for with) rights formula:

The +1 in the denominator accounts for the later drop in the market price. Try out the following rights question.

DEF Corp. is issuing new shares through a rights offering. If a new share costs $16 plus four rights and the stock trades at $20, what is the theoretical value of a right prior to the ex-date?

(A) $0.20

(B) $0.80

(C) $1.00

(D) $1.20

The right answer is Choice (B). The stock is trading with (cum) rights (the words prior to the ex-date in the problem tip you off), so you need to use the cum rights formula to figure out the value of a right:

The theoretical value of a right is $0.80.

Using the ex-rights formula

When you calculate the value of a right on the ex-date (the first day the stock trades without rights), the market price has already fallen by the value of the right. You simply have to use the new market price and the subscription price to figure out the discount per right. If the stock is trading ex-rights, use the following formula to figure out the value of a right:

The cum rights and ex-rights formulas are the same except for the +1 in the denominator. Because ex means without, remember that the ex formula is without the +1.

Warrants: The right to buy stock at a fixed price

Warrants are certificates that entitle the holder to buy a specific amount of stock at a fixed price; they’re usually issued along with a new bond or stock offering. Warrant holders have no voting rights and receive no dividends. Bundled bonds and warrants or bundled stock and warrants are called units. They are long term and sometimes perpetual (without an expiration date). Warrants are sweeteners because they’re something that the issuer throws into the new offering to make the deal more appealing; however, warrants can also be sold separately on the market. When warrants are originally issued, the warrant’s exercise price is set well above the underlying stock’s market price.

For example, suppose QRS warrants give investors the right to buy QRS common stock at $20 per share when QRS common stock is trading at $12. Certainly, exercising their warrants to purchase QRS stock at $20 wouldn’t make sense for investors when they can buy QRS stock in the market at $12. However, if QRS rises above $20 per share, holders of warrants can exercise their warrants and purchase the stock from the issuer at $20 per share.

When a corporation offers new stock through a rights offering or by issuing warrants, the corporation includes an anti-dilution agreement or anti-dilution provision in its corporate charter and prospectus. The anti-dilution agreement states that if the issuer offers new securities to the public, it must offer them to its current stockholders first. This allows its existing stockholders to keep the same proportionate ownership of the issuing corporation.