Equity Securities Common Stock as Ownership Shares

Common stocks, also known as equity securities, or equities, represent ownership shares in a corporation. Each share of common stock entitles its owners to one vote on any matters of corporate governance put to a vote at the corporation's annual meeting and to a share in the financial benefits of ownership1 (e.g., the right to any dividends that the corporation may choose to distribute).

A corporation is controlled by a board of directors elected by the shareholders.2 The board, which meets only a few times each year, selects managers who run the corporation on a day-to-day basis. Managers have the authority to make most business decisions without the board's approval. The board's mandate is to oversee management to ensure that it acts in the best interests of shareholders.

The members of the board are elected at the annual meeting. Shareholders who do not attend the annual meeting can vote by proxy, empowering another party to vote in their name. Management usually solicits the proxies of shareholders and normally gets a vast majority of these proxy votes. Thus, management usually has considerable discretion to run the firm as it sees fit, without daily oversight from the equityholders who actually own the firm.

We noted in Chapter 1 that there are several mechanisms to alleviate the potential agency problems that might arise from this arrangement. Among these are compensation schemes that link the success of the manager to that of the firm; oversight by the board of directors as well as outsiders such as security analysts, creditors, or large institutional investors; the threat of a proxy contest in which unhappy shareholders attempt to replace the current management team; or the threat of a takeover by another firm.

The common stock of most large corporations can be bought or sold freely on one or more of the stock exchanges. A corporation whose stock is not publicly traded is said to be closely held. In most closely held corporations, the owners of the firm also take an active role in its management. Takeovers generally are not an issue.

'Sometimes a corporation issues two classes of common stock, one bearing the right to vote, the other not. Because of their restricted rights, the nonvoting stocks sell for a lower price, reflecting the value of control. 2The voting system specified in the corporate articles determines the chances of affecting the elections to specific directorship seats. In a majority voting system, each shareholder can cast one vote per share for each seat. A cumulative voting system allows shareholders to concentrate all their votes in one seat, enabling minority shareholders to gain representation.

common stocks

Ownership shares in a publicly held corporation. Shareholders have voting rights and may receive dividends.

Characteristics of Common Stock

The two most important characteristics of common stock as an investment are its residual claim and its limited liability features.

Residual claim means stockholders are the last in line of all those who have a claim on the assets and income of the corporation. In a liquidation of the firm's assets, the shareholders have claim to what is left after paying all other claimants, such as the tax authorities, employees, suppliers, bondholders, and other creditors. In a going concern, shareholders have claim to the part of operating income left after interest and income taxes have been paid. Management either can pay this residual as cash dividends to shareholders or reinvest it in the business to increase the value of the shares.

Limited liability means that the most shareholders can lose in event of the failure of the corporation is their original investment. Shareholders are not like owners of unincorporated businesses, whose creditors can lay claim to the personal assets of the owner—such as houses, cars, and furniture. In the event of the firm's bankruptcy, corporate stockholders at worst have worthless stock. They are not personally liable for the firm's obligations: Their liability is limited.

3. a. If you buy 100 shares of IBM common stock, to what are you entitled?

b. What is the most money you can make over the next year?

c. If you pay $95 per share, what is the most money you could lose over the year?

Stock Market Listings

Figure 2.9 is a partial listing from The Wall Street Journal of stocks traded on the New York Stock Exchange. The NYSE is one of several markets in which investors may buy or sell shares of stock. We will examine issues of trading in these markets in the next chapter.

To interpret the information provided for each stock, consider the highlighted listing for General Electric. The first column is the percentage change in the stock price from the start of the year. GE shares have fallen 22.3% this year. The next two columns give the highest and lowest prices at which the stock has traded during the previous 52 weeks, $57.88 and $28.50, respectively. Until 1997, the minimum "tick size" on the New York Stock Exchange was $%, which meant that prices could be quoted only as dollars and eighths of dollars. In 1997, all U.S. exchanges began allowing price quotes in increments of $^6. By 2001, U.S. markets

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