Monday, May 9, 2016

Stock Basics

Plenty of people talk about stocks. You know the things Uber drivers and your favorite uncle always give you the hottest tip on. You hear how one stock went from zero to hero, or another from hero to darn it! Some talk about how it made them rich, and no one talks about how it made them poor. So it's time we had a little discussion.

Since some readers are well versed in these valuable financial instruments, and others are not, I'll start with a basic summary for the types of stocks. I'll give a little detail as to what it actually means you are buying, and the reasons why you are buying it.

At it's roots stocks are the equity interest you are buying in a company.  When you buy "shares" you are actually buying a piece(equity) of the company.  Stocks are a cornerstone of wealth building. As the company earns more money your shares usually(but not always) become more valuable. Shares are generally sliced into two categories with important distinctions.

  • Common Stocks 
This equity class is what most investors are referring to when speaking of companies such as Coca-Cola, Facebook, and IBM. Common equity can be diced up a few ways. You might own common stock that has regular voting rights, special voting rights, or no voting rights. All common stock entitles you to a share of the company profits, but not necessarily dividends. Dividends are elective and do not have to paid on common stock if the company chooses so. Many times dividends on common stock take a back seat to preferred stock which we will discuss next. Generally investors buy common stock for price appreciation and dividend increases if they are paid. The more shares you own, the larger the portion of the company(and profits) you are entitled to.

Price appreciation is the result of higher profits per share. An example would be something like this. Imagine a company has 1,000,000 shares available and has reported income for the last 3 years.

EarningsEarnings Per ShareStock PriceP/E ratio
Year 1$5,000,000$5.00$60.0012.00
Year 2$7,500,000$7.50$90.0012.00
Year 3$10,000,000$10.00$100.0010.00

Included is a basic Price/Earnings ratio which is a widely followed valuation metric. In this example the stock trades for exactly 12 times earnings except for year 3 where it trades for 10 times earnings. 
  • Preferred Stocks
Preferred stocks are normally one step up in the ownership structure. So in the case of bankruptcy preferred share owners will get any crumbs left before common equity holders.  Usually preferred shares have a feature that give them a special advantage over common equity.  This can be in the form of increased voting rights such as 10 votes per share compared to 1 vote per share with common equity. Also preferred shares are usually paid a higher dividend amount. The dividends on preferred shares are usually set at a standard rate higher than the common. If the company is running through tough times it might cut the dividend on common equity, but not preferred equity. 

Preferred shares may also be "called". A company might issue preferred shares with the option of redeeming(buying back) the shares at a specific point in time. It is up to the company to redeem the shares based on a variety of factors. Also preferred shares may be "convertible" into common shares.  Normally in this scenario a preferred share owner can after a set time convert their preferred shares into common shares. Normally this provision allows the preferred share holder to receive a ratio of common shares for each preferred share. An example would be you receive 10 common shares for 1 preferred share. This could be beneficial if the preferred share owner expects greater price appreciation in the common shares.  On a side note generally preferred shares trade less frequently since they are normally not issued in the same amounts as common shares.

In summary common and preferred equity can be any combination of voting, non voting, dividend paying, non dividend paying. So it's important to pay close attention to what type of equity you are buying in an individual company.  In an upcoming post we will begin to discuss other nuances and information regarding this asset.

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