BUS601: Financial Management

Learning Objectives

• Explain the typical features of and differences between preferred stock and common stock.
• Contrast the key differences between equity and debt.
• Describe why managers care about a company's stock price.
  

Equity in a public corporation is divided into shares of stock. Typically, shares of stock have some key features. The first is the right to receive dividends, which are payouts (usually in cash) to the owners of a company proportional to their ownership of the company. Dividends are typically paid quarterly, though exceptions are not uncommon. The company's board of directors decides when dividends are to be issued and how much they are to be. The board of directors is elected by the shareholders, as determined by the company's corporate charter.

Shares of stock can be divided into different classes, and these can have different features. For example, one class of shares might have more voting power than a second class. Each class of stock will trade separately (or some might not trade at all) and, potentially, have a different price. The most common division of equity is between preferred shares of stock and common stock.

Preferred stock is equity, but behaves as almost a hybrid between bonds and common stock. In fact, at many investment banks, the fixed income traders handle bonds and preferred stock, and the equity traders only work with common stock. Preferred stock usually doesn't have a maturity date, and, like a bond, has a dividend that is at a fixed. Preferred stock has a nominal par value (typically $100 per share), and the annualized dividend is quoted as a percentage of this par value. Thus, one share of 5% preferred stock will pay $5 total in dividends over a year. Like a bond, if these dividends are insufficient to provide the required return to investors, the stock will trade at a price below the nominal par value. Unlike a bond, if the dividend isn't paid, stockholders can't send the company into bankruptcy. If, however, the full dividend isn't paid to the preferred shareholders, than no dividend is allowed to be paid to the owners of the common stock until all missed payments are paid in full. If the company is driven into bankruptcy and liquidation by the bondholders, the preferred shareholders have a superior claim to the assets compared to common shareholders (though both are subordinate to the bondholders). Typically, preferred shareholders get no votes for the board of directors.

Many corporations don't issue preferred stock, so the bulk of equity issues are called common stock. Common stock also has a nominal par value, but it is mostly an accounting/legal relic and has no bearing on the dividends or price of the stock. Since dividends on common stock are determined by the board, their cash flows are the most uncertain of the financial instruments discussed so far. Shareholders have a residual claim on the firm's assets, which is the value leftover after all other claims have been paid. Thus, any earnings remaining after all other obligations are met, are either paid out in dividends or retained by the firm, ostensibly to be used as capital for the firm's growth. These retained earnings increase the residual claim, potentially increasing the value of stock shares.

When a firm is doing poorly, and liabilities are larger than the value of the assets, the residual claim is zero and share prices understandably drop. If the company isn't driven into bankruptcy and can increase the assets to an amount more than liabilities, the residual claim grows and share prices rise. Since liabilities are relatively fixed but asset prices are potentially unbounded, the equity share similarly has unbounded growth potential.

From the company's perspective, it is important to note that equity only directly raises cash when the shares are issued. After the initial issue, trading occurs in the secondary markets, so any increase in value of the shares will be captured by the owners of the stock. If the company has positive earnings but chooses not to pay out all of those earnings as dividends, then the company is able to retain those earnings for use as capital. This is an indirect way of raising equity capital, though it does not come without a cost: the retained earnings should lead to an expectation of increased earnings in the future, allowing for an eventual increase in dividends. If this is the case, the share price should rise in anticipation of the expected higher future dividends.

Increasing the value of those outstanding shares is one of the primary goals of management, for a few key reasons. First, shareholders have voting power, and if they aren't receiving the returns they desire, they might replace the board with the intention of replacing senior management. Second, any additional offerings of equity will benefit from the increased share price, so the company will have access to a larger source of capital, if necessary. As an additional incentive, senior management will often receive a portion of their compensation tied to the value of equity, through stock grants, restricted shares, or stock options.

Key Takeaways

• Fundamentally, the value of stock is dependent on the value of the residual claim of the firm's assets.
• Preferred stock dividends are quoted as a percentage of their $100 par value. Common stock dividends are decided by the board and thus tend to fluctuate more.
• Managers care about stock prices because they can be replaced if shareholders are displeased, the company may need to raise equity financing in the future, and they may have been given shares themselves as compensation.

Exercises

1. What is the annual dividend on 6% preferred stock?
2. If a company is doing extremely well, would you rather own preferred stock or common stock in the company?

 This text was adapted by Saylor Academy under a Creative Commons Attribution-NonCommercial-ShareAlike 3.0 License without attribution as requested by the work's original creator or licensor.