Stocks

Securities issued by a corporation are classified as debt, equity, or some hybrid of these two forms. Debt usually takes the form of a loan and must be repaid; equity usually takes the form of an ownership claim upon the corporation. The two main types of equity claims are common stock and preferred stock, although there are also related claims, such as rights, warrants, and convertible securities. Growing companies, which tend to lack the assets necessary to secure debt, often decide to issue equity securities. Although issuing common stock can be traumatic for a small business—because it can be costly, and because it causes a dramatic redistribution of ownership and control—it can also provide a solid foundation upon which to build a company. Preferred stock offers holders priority in receiving dividends and in claiming assets in the event of business liquidation, but it also lacks the voting rights afforded to common stockholders. Many venture capitalists require convertible preferred stock—which can be converted to common stock at some time in the future at a favorable price—as incentive to invest in start-up ventures.

COMMON STOCK

A share of common stock is quite literally a share in the business, a partial claim to ownership of the firm. Owning a share of common stock provides a number of rights and privileges. These include sharing in the income of the firm, exercising a voice in the management of the firm, and holding a claim on the assets of the firm.

Dividends

Sharing in the income of the firm is generally in the form of a cash dividend. The firm is not obligated to pay dividends, which must be declared by the board of directors. The size and timing of the dividends is uncertain. In a strictly rational economic environment, dividends would be considered as a "residual." In this view, the firm would weigh payment of dividends against other uses for the funds. Dividends would be paid only if the firm had no better use for the funds. In this case, declaring or increasing dividends would be a negative signal, since the firm would be admitting that it lacked possibilities for growth.

For widely held, publicly traded firms there are a number of indications that this is not the case, and that shareholders and investors like dividends and dividend increases. In these contexts, dividends are taken as a signal that the firm is financially healthy. A decrease in dividends would indicate inability to maintain the level of dividends, signaling a decline in prospects. An increase would signal an improvement in prospects. The signal from a dividend decrease is strong because management will wish to give only positive signals by at least maintaining the dividend, making cuts only when absolutely necessary. The signal from a dividend increase is also strong because management would be hesitant to increase dividends unless they could be maintained. The signaling nature of dividends is supported by cases in which the dividend is maintained in the face of declining earnings, sometimes even using borrowed funds. It is also supported by the occurrence of "extraordinary" or one-time-only dividends, a label by which management attempts to avoid increasing expectations.

This signaling approach is not applicable to closely held firms. In this situation, communication between management and shareholders is more direct and signals are not required. When owners are also the managers, sharing in earnings may take the indirect form of salaries and fringe benefits. In fact, shareholders in closely held firms may prefer that dividends be reinvested, even in relatively low return projects, as a form of tax protection. The investment is on a pretax (before personal tax) basis for the investor, avoiding immediate double taxation and converting the income to capital gains that will be paid at a later date.

Dividends are declared for stockholders at a particular date, called the date of record. Since stock transactions ordinarily take five business days for completion, the stock goes "ex-dividend" four days before the date of record, unless special arrangement is made for immediate delivery. Since the dividend removes funds from the firm, it can be expected that the per share price will decrease by the amount of the dividend on the ex-dividend date.

Stock dividends are quite different in form and nature from cash dividends. In a stock dividend, the investor is given more shares in proportion to the number already held. A stock split is similar, with a difference in accounting treatment and a greater increase in the number of shares. The use of the word "dividends" in stock dividends is actually a misuse of the word, since there is no flow of cash, and the proportional and absolute ownership of the investor is unchanged. The stockholder receives nothing more than a repackaging of ownership: the number of shares increases, but the price per share will drop. There are, however, some arguments in favor of stock dividends. One of these is the argument that investors will avoid stocks of unusually high price, possibly due to required size of investment and round lot (100 share) trading. On the other hand, stocks with unusually low price are also avoided, perhaps perceived as "cheap." The price drop accompanying stock dividends can be used to adjust price. Stock dividends have also been suggested as a way to make cash dividends elective while also providing tax-advantaged reinvestment.

With a cash dividend, an investor who wishes to reinvest must pay taxes and then reinvest the reduced amount. With a stock dividend, the entire amount is reinvested. Although taxes will ultimately be paid, in the interim a return is earned on the entire pretax amount. This is the same argument as that for low dividends in a closely held firm. Investors who wish cash dividends can simply sell the stock. Using stock dividends in this way faces restrictions from the Internal Revenue Service.

Control

The corporate form allows the separation of management and ownership, with the manager serving as the agent of the owner. Separation raises the problem of control, or what is termed the agency problem. Stockholders have only indirect control by voting for the directors. The directors in turn choose management and are responsible for monitoring and controlling management's conduct. In fact, the stockholders' ability to influence the conduct of the firm may be quite small, and management may have virtually total control within very broad limits.

Voting for the directors takes either of two forms. The first form is majority voting. In this form, each stockholder receives votes for each open position according to the number of shares held, and may cast those votes only for candidates for that position. The winning candidate is the candidate winning a majority of the votes cast. The second form is called cumulative voting. In this form, stockholders again receive votes for each open position according to the number of shares held, but may apportion the votes among the positions and candidates as desired. The candidates receiving the most votes are elected.

Excluding minority stockholders from representation on the board is more difficult under cumulative voting. For example, if there are four directors to be elected and one million shares eligible to vote at one vote per share, a stockholder with 500,001 shares would control the election. Under majority voting a dissident stockholder with 200,001 shares could cast only 200,001 votes apiece for candidates for each of the four positions, which would not be sufficient to ensure representation on the board. Under cumulative voting, a dissident stockholder with a minimum of 200,001 shares could be sure of representation by electing one candidate of choice, casting a cumulative 800,004 votes for that candidate. The remaining 799,999 shares could be sure of electing three chosen candidates, but could not command sufficient votes to exceed the cumulative dissident vote four times.

Although the board of directors is supposedly independent of management, the degree of independence is sometimes small. Typically, some members of the board are "insiders" drawn from management, while others are "outside" directors. Even the outside directors may not be completely independent of management for several reasons. One reason is that few shareholders can afford the time and expense to attend the annual meetings, so that voting is done through the mail. This usually takes the form of a "proxy" giving management the power to vote for the shareholder, as instructed. While the shareholder may instruct management on how to vote, the choices may be few and are controlled by management. Management will tend to nominate safe candidates for directorship, who will not be likely to challenge the status quo. As a result, directorship is at times an honor or sinecure, treated as having few real obligations.

Dissidents may mount opposition and seek the proxy votes, but such opposition is liable to face legal challenges and must overcome both psychological barriers and shareholder apathy. Many shareholders either do not vote or routinely vote for existing management. Further, dissidents must spend their own money, while management has the resources of the firm at its disposal.

In addition to controlling the proxy system, managements have instituted a number of other defensive mechanisms in the face of takeover threats. It is not unusual to find several "classes" of stock with different voting power, with some classes having no voting power at all. A number of firms have changed from cumulative to majority voting. Staggered boards, in which only a portion of the board terms expire in a given year, and supermajority voting policies have also been used. Takeover defenses include the golden parachute, or extremely generous severance compensation in the face of a takeover, and the poison pill, an action that is triggered by a takeover and has the effect of reducing the value of the firm. All of these measures act to make stockholder power appear more tenuous.

There has been some recent movement towards greater stockholder power. One factor in this movement is the increasing size of institutional investors such as pensions and mutual funds. This has led to a more activist stance, and a willingness to use the power of large stock positions to influence management. Another factor is a renewed emphasis on the duties of the directors, who may be personally liable for management's misconduct.

Residual Ownership

The common stockholder has a claim on the assets of the firm. This is an undifferentiated or general claim which does not apply to any specific asset. The claim cannot be exercised except at the breakup of the firm. The firm may be dissolved by a vote of the stockholders, or by bankruptcy. In either case, there is a well-defined priority in which the liabilities of the firm will be met. The common stockholders have the lowest priority, and receive a distribution only if prior claims are paid in full. For this reason the common stockholder is referred to as the residual owner of the firm.

Preemptive Right

The corporate charter will often provide common stockholders with the right to maintain their proportional ownership in the firm, called the preemptive right. For example, if a stockholder owns 10 percent of the stock outstanding and 100,000 new shares are to be issued, the stockholder has the right to purchase 10,000 shares (10 percent) of the new issue. This preemptive right can be honored in a rights offering. In a rights offering, each stockholder receives one right for each share held. Buying shares or subscribing to the issue then requires the surrender of a set number of rights, as well as payment of the offering price. The offering is often underpriced in order to assure its success. The rights are then valuable because possession of the rights allows subscription to the underpriced issue. The rights can be transferred, and are often traded.

A rights offering may be attractive to management because the stockholders, who thought enough of the firm to buy its stock, are a pre-sold group. The value of the preemptive right to the common stockholders, however, is questionable. The preemptive right of proportional ownership is important only if proportional control is important to the stockholder. The stockholder may be quite willing to waive the preemptive right. If the funds are used properly, the price of the stock will increase, and all stockholders will benefit. Without buying part of the new issue, the stockholder may have a smaller proportional share, but the share will be worth more. While rights are usually valuable, this value arises from under-pricing of the issue rather than from an inherent value of rights. The value of the rights ultimately depends on the use of the funds and whether or not the market views that use as valuable.

Valuation

In investment practice, decisions are more often expressed and made in terms of the comparative expected rates of return, rather than on price. A number of models and techniques are used for valuation. A common approach to valuation of common stock is present value. This approach is based on an estimate of the future cash dividends. The present value is then the amount which, if invested at the required rate of return on the stock, could exactly recreate the estimated dividends. This required rate of return can be estimated from models such as the capital asset pricing model (CAPM), using the systematic risk of the stock, or from the estimated rate of return on stocks of similar risk. Another common approach is based on the price-earnings ratios, or P/E. In this approach, the estimated earnings of the firm are multiplied by the appropriate P/E to obtain the estimated price. This approach can be shown to be a special case of present value analysis, with restrictive assumptions. Since various models and minor differences in assumptions can produce widely different results, valuation is best applied as a comparative analysis.

In some cases, such as estate valuation, the dollar value of the stock must be estimated for legal purposes. For assets that are widely publicly traded, the market price is generally taken as an objective estimate of asset value for legal purposes, since this is sale value of the stock. For stock that is not widely traded, valuation is based on models such as present value, combined with a comparison with similar publicly traded stock. Often, however, a number of discounts are applied for various reasons. It is widely accepted that, compared to publicly traded stock, stock that is not publicly traded should be valued at a discount because of a lack of liquidity. This discount may be 60 percent or more. Another discount is applied for a minority position in a closely held stock or a family firm, since the minority position would have no control This discount does not apply if the value is estimated from the value of publicly traded stock, because the market price of a stock is traded already the price of a minority position. There is an inverse effect for publicly traded stock in the form of a control premium. A large block of stock which would give control of the firm might be priced above market.

Finally, it should be noted that the accounting book value is only rarely more than tangentially relevant to market value. This is due to the use of accounting assumptions such as historic cost. While accounting information may be useful in a careful valuation study, accounting definitions of value differ sharply from economic value.

PREFERRED STOCK

Preferred stock is sometimes called a hybrid, since it has some of the properties of equity and some of the properties of debt. Like debt, the cash flows to be received are specified in advance. Unlike debt, these specified flows are in the form of promises rather than of legal obligations. It is not unusual for firms to have several issues of preferred stock outstanding, with differing characteristics. Other differences arise in the areas of control and claims on assets.

Dividends

Because the specified payments on preferred stock are not obligations, they are referred to as dividends. Preferred dividends are not tax-deductible expenses for the firm, and consequently the cost to the firm of raising capital from this source is higher than for debt. The firm is unlikely to skip or fail to declare the dividend, however, for several reasons. One of the reasons is that the dividends are typically (but not always) cumulative. Any skipped dividend remains due and payable by the firm, although no interest is due. One source of the preferred designation is that all preferred dividends in arrears must be paid before any dividend can be paid to common stockholders (although bond payments have priority over all dividends). Failure to declare preferred dividends may also trigger restrictive conditions of the issue. A very important consideration is that, just as for common dividends, preferred dividends are a signal to stockholders, both actual and potential. A skipped preferred dividend would indicate that common dividends will also be skipped, and would be a very negative signal that the firm was encountering problems. This would also close off access to most lenders.

There is also a form of preferred stock, called participating preferred stock, in which there may be a share in earnings above the specified dividends. Such participation would typically only occur if earnings or common dividends rose over some threshold, and might be limited in other ways. A more recent innovation is adjustable-rate preferred stock, with a variable dividend based on prevailing interest rates.

Control

Under normal circumstances, preferred stockholders do not have any voting power. As a result, they have little control over or direct influence on the conduct of the firm. Some minimal control would be provided by the indenture under which the stock was issued, and would be exercised passively—i.e., the trustees for the issue would be responsible for assuring that all conditions were observed. In some circumstances, the conditions of the issue could result in increased control on the part of the preferred stockholders. For instance, it is not unusual for the preferred stockholders to be given voting rights if more than a specified number of preferred dividends are skipped. Other provisions may restrict the payment of common dividends if certain conditions are not met. Preferred stockholders also may have a preemptive right.

Claim on Assets and Other Features

Another source of the preferred designation is that preferred stock has a prior claim on assets over that of common stock. The claim of bondholders is prior to that of the preferred stockholders. Although preferred stock typically has no maturity date, there is often some provision for retirement. One such provision is the call provision, under which the firm may buy back or recall the stock at a stated price. This price may vary over time, normally dropping as time passes. Another provision is the sinking fund, under which the firm will recall and retire a set number of shares each year. Alternately, the firm may repurchase the shares for retirement on the open market, and would prefer to do so if the market price of the preferred is below the call price. Preferred stock is sometimes convertible, i.e., it can be exchanged for common stock at the discretion of the holder. The conversion takes place at a set rate, but this rate may vary over time.

Valuation

The par value of a preferred stock is not related to market value, except that it is often used to define the dividend. Since the cash flow of dividends to preferred stockholders is specified, valuation of preferred stock is much simpler than for common stock. The valuation techniques are actually similar to those used for bonds, drawing heavily on the present value concept. The required rate of return on preferred stock is closely correlated with interest rates, but is above that of bonds because the bond payments are contractual obligations. As a result, preferred stock prices fluctuate with interest rates. The introduction of adjustable-rate preferred stock is an attempt to reduce this price sensitivity to interest rates.

FOREIGN STOCK

Purchases of foreign stock have greatly increased in recent years. One motivation behind this increase is that national economies are not perfectly correlated, so that greater diversification is possible than with a purely domestic portfolio. Another reason is that a number of foreign economies are growing, or are expected to grow, rapidly. Additionally, a number of developing countries have consciously promoted the development of secondary markets as an aid to economic development. Finally, developments in communications and an increasing familiarity with international affairs and opportunities has reduced the hesitance of investors to venture into what once was unfamiliar territory.

Foreign investment is not without problems. International communication is still more expensive and sometimes slower than domestic communication. Social and business customs often vary greatly between countries. Trading practices on some foreign exchanges are different than in the United States. Accounting differs not only in procedures, but often in degree of information disclosed. Although double taxation is generally avoided by international treaties, procedures are cumbersome. Political instability can be a consideration, particularly in developing countries. Finally, the investor faces exchange rate risk. A handsome gain in a foreign currency can be diminished, or even turned into a loss, by shifting exchange rates. These difficulties are felt less by professional managers of large institutions, and much of the foreign investment is through this channel.

An alternative vehicle for foreign investing is the American Depositary Receipt (ADR). This is simply a certificate of ownership of foreign stock that is deposited with a U.S. trustee. The depository institution also exchanges and distributes any dividends, and provides other administrative chores. ADRs are appealing to individual investors. It has also been suggested that the benefits of international investing can be obtained by investing in international firms.

INVESTMENT CHARACTERISTICS

Stocks are diverse in nature and can be classified many ways for investment purposes. For example, stocks can be classified according to the level of risk. Risky stocks are sometimes referred to as aggressive or speculative. They may also be growth stocks, which are expected to experience high rates of growth in size and earnings. If risk is measured by the beta (systematic or nondiversifiable risk), then the term applies to a stock with a beta greater than one. These stocks are quite sensitive to economic cycles, and are also called cyclical. Contrasted are the blue-chip stocks—high-quality stocks of major firms that have long and stable records of earnings and dividends. Stocks with low risk, or a beta of less than one, are referred to as defensive. One form of investment strategy, called timing, is to switch among cyclical and defensive stocks according to expected evolution of the economic cycle. This strategy is sometimes refined to movement among various types of stock or sectors of the economy. Another stock category is income stocks—stocks that have a long and stable record of comparatively high dividends.

Common stock has been suggested as a hedge against inflation. This suggestion arises from two lines of thought. The first is that stocks ultimately are claims to real assets and productivity, and the prices of such claims should rise with inflation. The second line of thought is that the total returns to common stock are high enough to overcome inflation. While this is apparently true over longer periods, it has not held true over shorter periods.

Preferred stock is generally not considered a desirable investment for individuals. While the junior position of preferred stockholders as compared to bondholders indicates that the required rate of return on preferred will be above that of bonds, observation indicates that the yield on bonds has generally been above that of preferred stock of similar quality. The reason for this is a provision of the tax codes that 70 percent of the preferred dividends received by a corporation are tax exempt. This provision is intended to avoid double taxation. Because of the tax exemption, the effective after-tax yield on preferred stock is higher for corporations, and buying of preferred stock by corporations drives the yields down. The resulting realized return for individuals, who cannot take advantage of this tax treatment, would generally be below acceptable levels.

BIBLIOGRAPHY

Geddes, Ross. IPOs and Equity Offerings. Elsevier, 2003.

Goodman, Jordan Elliott. Everyone's Money Book on Stocks, Bonds, and Mutual Funds. Dearborn, 2002.

Madular, Jeff. Financial Markets and Institutions. Thomson South-Western, 2006.

Scott, David Logan. David Scott's Guide to Investing in Common Stocks. Houghton-Mifflin, 2005.

Sincere, Michael. Understanding Stocks. McGraw-Hill, 2004.

Williams, Ellie. The McGraw-Hill Investor's Desk Reference. McGraw-Hill, 2001.

                                  Hillstrom, Northern Lights

                                   updated by Magee, ECDI

STOCKS

There is no doubt that investing in the stock market can be one of the most exciting ways of making money. It is rewarding to see the little-known stock one chose become a hot property, perhaps doubling in price—and then doubling again and again. But as with any investment, the potential risks are equal to the rewards, so investors who want to participate in the stock market owe it to themselves to become fully informed before getting involved.

HOW DOES THE STOCK MARKET WORK?

A share of stock represents a unit of ownership in a corporation. When one buys stock, one is becoming a part owner of the business. Therefore, one benefits from any increase in the value of the corporation and one suffers when the corporation performs badly. One is also entitled to share in the profits earned by the corporation.

Stocks are bought and sold in marketplaces known as stock exchanges. The exchange itself does not buy or sell stock, nor does it set the price of stock; the exchange is simply a forum in which individuals and institutions may trade in stocks. Stock exchanges play a vital role in a capitalist economy. They provide a way for individuals to purchase shares in thousands of businesses, and they provide businesses with an important source of capital for expansion, research, and other purposes.

HOW ARE STOCKS TRADED?

Here, in two steps, is what happens when an investor decides to buy or sell a particular stock.

Step 1

An account executive at the brokerage house receives the buy or sell order, which may take any of several forms:

• Round-lot order: An order to buy or sell 100 shares, considered the standard trading unit
• Odd-lot order: An order to buy or sell fewer than 100 shares
• Market order: An order to buy or sell at the best available price

• Limit order: An order to buy or sell at a specified price
• Stop order: An order designated to protect profits or limit losses by calling for sale of the stock should its price fall to a specified level
• Good till canceled (GTC) order: An order that remains open until it is executed or canceled by the investor

Step 2

After the order is received, it is sent to the floor of the stock exchange. The brokerage firm's floor broker receives the order and executes it at the appropriate trading post. Confirmation of the transaction is reported back to the account executive at the local office, who notifies the investor. Remarkably, the entire process may take as little as two or three minutes.

Not all stocks are traded on any of the fourteen organized exchanges. Those that are not are traded "over the counter" in the so-called unorganized exchange. Not a physical place, the unorganized exchange consists of thousands of brokers and dealers who trade in about 50,000 different unlisted stocks through telephone, facsimile, or electronic communication.

In the over-the-counter market, transactions are negotiated privately rather than on an auction basis. An investor wishing to purchase a particular unlisted security consults a broker, who contacts other brokers dealing in that stock. The broker offering the stock for sale at the lowest price receives the offer.

Prices of over-the-counter stocks are quoted as both bid and asked prices. The bid price is the final price offered by a buyer, while the asked price is the final price requested by a seller. Trades are normally made when the bid and asked prices approach one another. Note the listing in Figure 1.

Increasingly, investors are buying and selling stocks online. There are many firms specializing in providing online services.

WHAT KINDS OF STOCKS ARE AVAILABLE?

The two basic kinds of stocks are common and preferred.

Common Stock

Each year, hundreds of new issues of stock, known as initial public offerings (IPOs), are sold to the public. In an initial offering of common stock, an underwriter is the seller. The underwriter sells the initial issue of stock at a fixed price to a group of initial buyers

who in turn "farm out" the investment until it reaches the "street," which is the investor. IPOs are appealing to some investors. Some IPOs offer "immediate profit opportunity," although determining when this will happen is not easily predicted, since for some IPOs, there is a quick realization—after the initial sale—that the issue was "overpriced."

A share of common stock represents a unit of ownership, or equity, in the issuing corporation. Each share of common stock usually has a par value, which is a more or less arbitrary value established by the board of directors and which bears little relation to the stock's actual market value. The market value is influenced by many factors, including the corporation's potential earning power, its financial condition, its earnings record, its record for paying dividends, and general business conditions.

Ownership of a share of common stock carries certain privileges:

A share in earnings

Each year, the board of directors of the corporation meets to determine the amount of the corporation's earnings that will be distributed to stockholders. This distribution, known as the dividend, will vary depending on the company's current profitability and accumulated earnings. A dividend may be omitted altogether if the company is earning no current profits or if the board elects to plow back profits into growth.

A share in control

Holders of common stock are invited to attend annual meetings of stockholders and they have the right to vote on matters of corporate policy on the basis of one vote per share held. However, the small investor with only a few shares of stock has little or no practical influence on corporate decisions.

A claim on assets

In the event of the company's liquidation, holders of common stock have the right to share in the firm's assets after all debts and prior claims have been satisfied.

There are four main categories of common stock, each of which is best for a particular investment strategy and purpose.

1. Blue-chip stocks. High-grade, or blue-chip, stocks are issued by well-established corporations with many years of proven success, earnings growth, and consistent dividend payments. Blue-chip stocks tend to be relatively high priced and offer a relatively low-income yield. They are a relatively safe investment when compared with other categories of stock.
2. Income stocks. Income stocks pay a higher-than-average return on investment. They are generally issued by firms in stable businesses that have no need to reinvest a large percentage of profits each year.
3. Growth stocks. Issued by firms expected to grow rapidly during the years to come, growth stocks have a current income that is often low, since the company plows back most of its earnings into company research and expansion. The value of the stock, however, may rise quickly if the company performs in accordance with company expectations.
4. Speculative stocks. Speculative stocks are backed by no proven corporate track record or lengthy dividend history. Stocks issued by little-known companies or newly formed corporations, high-flying "glamour" stocks issued by companies in new business areas, and low-priced "penny stocks" all may be considered speculative stocks. As with any speculative investment, there is a slight possibility of tremendous profit—but a substantial risk of losing all as well.

Preferred Stock

Preferred stock, like common stock, represents ownership of a share in a corporation. Holders of preferred stock, however, have a prior claim on the company's earnings as compared with holders of common stock; hence the name preferred stock. Similarly, holders of preferred stock have a prior claim in the company's assets in the event of a liquidation, but they have no voting privileges.

Preferred stock also has certain distinctive features related to dividend payments. A fixed, specified annual dividend is usually paid for each share of preferred stock. This fixed dividend may be expressed in dollars (for example, $10 per share) or as a percentage of the stock's par value. The dividend must be paid before dividends are issued to holders of common stock.

Preferred stock dividends, however, are not considered a debt of the corporation—unlike, for example, the interest due on corporate bonds—because the firm is not obligated to meet its dividend payments. The board of directors may decide to withhold the dividend payment for a given year because of limited earnings or other reasons. To protect stockholders against undue losses in dividends, most preferred stock is issued with a cumulative feature. If a dividend is not paid on cumulative preferred stock, the amount is carried over to the following period, and both current and past unpaid dividends must be paid before holders of common stock can receive any dividend.

WHAT ARE THE ADVANTAGES AND DISADVANTAGES OF STOCKS?

Like any investment, stocks have distinct advantages and disadvantages.

Advantages

Growth potential

When a company has the potential for growth in value and earnings, so does its stock. If the investor chooses the right stock—in a company that is highly profitable and continues to be—or a group of such stocks, significant profit can be realized, possibly, in a relatively short time. History reveals that, as a whole, the stock market has had an upward trend in values, with years of gain outnumbering those of decline by better than three to one.

Liquidity

Stocks traded on the major exchanges can be bought and sold quickly and easily at readily ascertainable prices.

Possible tax benefits

Growth stocks, which pay low or no dividends so that company profits can be reinvested, provide an effective tax shelter. As the corporation's value grows, so does the value of the stock, which is a form of tax-deferred income, since no taxes need to be paid on these gains until the stock is sold.

Disadvantages

Risks

There can be no guarantee of making money by investing in stocks. Companies may fail, stock prices may drop, and investors may lose their investments. Remember the saying of one concerned investor: "I am not so concerned with the return on my investment as I am with the return of my investment."

Brokerage commissions

Most investors need the help and advice of a stockbroker when they become involved in the market. High broker commissions, however, can largely erode profits. Since one fee is charged when the stocks are bought and another when stocks are sold, investors are, in effect, paying twice. Well-informed investors should look into the use of a discount broker, who provides little or no investment counseling but charges greatly reduced commissions when trading stocks.

Complexity

The stock market is complicated, and the amount of knowledge needed to be consistently successful is considerable. Investors who lack the patience, time, or skill to inform themselves about the market often buy and sell on impulse, thereby minimizing their profits and maximizing their losses.

SUMMARY

The only way to approach the stock market is to maintain good, old-fashioned common sense. Here are some points to keep in mind:

• Avoid hot tips: If a friend knows about a hot tip, so do hundreds of other people. Remember, hot tips can get one burned.
• Do not become attached to a company and its stock: Be objective in viewing a stock even if it is the stock of one's employer, accumulated over the years. Weed out stocks that are not meeting one's objectives, even if it is the first stock ever bought as an investor.
• Do some portfolio comparisons: Check on the total return by adding up the stock's price change and dividends for a specific period and divide the total by the price at the start of that period. Then multiply the result by 100. This will result in a percentage that can be compared to what the return in other types of investments would have been.
• Have some patience: Except for wild speculation, investors should take their time. Stocks should not be sold on the basis of performance over a short time, but rather on the concept of the long run. Remember that the longer the holding period, the more likely a profit will be gained in spite of the inevitable interim ups and downs. On the buy side, the same rule applies. Do not get bullied into purchasing something that "can't wait." Good investments can wait.

Never forget that whenever a stock is bought, someone else is selling it. Stock may be bought because of a belief that the investment is good and the price will rise. Nevertheless, the person selling that same stock believes the opposite, so only one of these people will be correct. Thinking of it in these terms will make an investor a realistic and conservative player.

see also Investments ; Securities and Exchange Commission ; Stock Exchanges ; Stock Indexes

bibliography

Campbell, Allan B. (2004). Conquering stock market hype. New York: McGraw-Hill.

Dalton, John M. (2001). How the stock market works (3rd ed.). New York: New York Institute of Finance.

Fontanills, George A., and Gentile, Tom (2001). Stock market course. New York: Wiley.

Kelly, Jason (2003). The neatest little guide to stock market investments. New York: Penguin.

Stav, Julie, and Adamson, Deborah (2000). Get your share: The everyday woman's guide to striking it rich in the stock market. New York: Berkeley Books.

Joel Lerner

stock / stäk/ • n. 1. the goods or merchandise kept on the premises of a business or warehouse and available for sale or distribution. ∎  a supply or quantity of something accumulated or available for future use: my stock of wine. ∎  farm animals such as cattle, pigs, and sheep, bred and kept for their meat or milk; livestock. ∎ short for rolling stock. ∎  (also film stock) photographic film that has not been exposed or processed. ∎  the undealt cards of the deck, left on the table to be drawn from in some card games. 2. the capital raised by a business or corporation through the issue and subscription of shares: the company's stock rose by 86%. ∎  (also stocks) a portion of this as held by an individual or group as an investment. ∎  (also stocks) the shares of a particular company, type of company, or industry: blue-chip stocks. ∎  securities issued by the government in fixed units with a fixed rate of interest. ∎ fig. a person's reputation or popularity. 3. liquid made by cooking bones, meat, fish, or vegetables slowly in water, used as a basis for the preparation of soup, gravy, or sauces. ∎  the raw material from which a specified commodity can be manufactured. 4. a person's ancestry or line of descent: her mother was of French stock. ∎  a breed, variety, or population of an animal or plant. 5. the trunk or woody stem of a living tree or shrub, esp. one into which a graft (scion) is inserted. ∎  the perennial part of a herbaceous plant, esp. a rhizome. 6. a herbaceous European plant (genus Matthiola) of the cabbage family, widely cultivated for its fragrant flowers, which are typically lilac, pink, or white. 7. (the stocks) [treated as sing. or pl.] hist. an instrument of punishment consisting of an adjustable wooden structure with holes for securing a person's feet and hands, in which criminals were locked and exposed to public ridicule or assault. 8. the part of a rifle or other firearm to which the barrel and firing mechanism are attached, held against one's shoulder when firing the gun. ∎  the crosspiece of an anchor. ∎  the handle of something such as a whip or fishing rod. ∎ short for headstock (sense 1). ∎ short for tailstock. 9. a band of white material tied like a cravat and worn as a part of formal horse-riding dress. ∎  a piece of black material worn under a clerical collar. 10. (stocks) a frame used to support a ship or boat out of water, esp. when under construction. • adj. 1. (of a product or type of product) usually kept in stock and thus regularly available for sale: 25 percent off stock items. 2. (of a phrase or expression) so regularly used as to be automatic or hackneyed: their stock response was “We can't take everyone.” ∎  denoting a conventional character type or situation that recurs in a particular genre of literature, theater, or film. ∎  denoting or relating to cinematic footage that can be regularly used in different productions, typically that of outdoor scenes used to add realism to a production shot in an indoor set.• v. [tr.] 1. have or keep a supply of (a particular product or type or product) available for sale. ∎  provide or fill with goods, items, or a supply of something. ∎  [intr.] (stock up) amass supplies of something, typically for a particular occasion or purpose. 2. fit (a rifle or other firearm) with a stock.PHRASES: in (or out of) stock (of goods) available (or unavailable) for immediate sale in a store.put stock in have a specified amount of belief or faith in: I don't put much stock in modern medicine.take stock review or make an overall assessment of a particular situation, typically as a prelude to making a decision: he needed to take stock of his life.

Stocks

BIBLIOGRAPHY

Stocks are a type of financial instrument that represent ownership in a business organization. Ideally, the price of any stock is equal to the present value of expected future cash payments to the stockholder. Stocks perform specific and important functions in financial markets and in the economy generally. From the perspective of private investors stocks are a form of financial investment. Ownership of stock in a business entitles a person to part of the profits generated by the operation of that business. When a corporation realizes profits, it pays a dividend to its stockholders, though it will often retain some profits to finance additional business operations.

Stocks differ from other financial instruments mainly in terms of risk. For example, bond owners are paid interest according to their bond’s annual yield. Companies that issue bonds enter into a contract with bondholders to pay a specific amount of money over a specific time period. Once a bond matures, the company that issued the bond returns the money that it borrowed to the bondholders. Stockholders, in contrast, are the owners of that company. Since corporations are legally obligated to pay bondholders interest, bondholders risk default if the issuing company goes bankrupt. Since the dividend paid by the company varies with the performance of that company, stockholders can realize a poor rate of return without the company actually going bankrupt.

Economists view stocks as a particular type of institution that performs specific social functions. Stocks, and other financial instruments, play an important role in the functioning of capitalist societies. Stocks, bonds, and other types of loans are alternative means of financing the operations of a business. Stocks represent a means of raising financial capital for business investment. Anytime a business sells new shares of stock, the investors who buy them provide funding for new entrepreneurial business projects. Investors who buy new shares of stock in a company are speculating about the future profits of that company. If the projects that a company undertakes realize or exceed expected profits, its stockholders (unlike bondholders) will earn high dividends and capital gains. So the capitalists who buy shares of stock are speculators who attempt to predict future trends in the economy. Efficient businesses produce products that consumers want most urgently at a low cost. Efficient businesses will earn the most profits for their stockholders.

Capitalists who speculate accurately concerning different businesses can earn new fortunes for themselves by providing finance to efficient businesses. Capitalists who err in predicting future economic trends can lose previously accumulated fortunes. In this way stock ownership can work as a regulating mechanism to direct money into efficient businesses that need additional funding to expand and away from inefficient businesses whose operations should be curtailed.

Most stock trading involves previously owned shares of stock rather than newly issued shares. Trading of existing shares of stock is also important to the functioning of businesses. The price of existing shares of stock tells a company how much money it can raise by issuing new shares. Of course, businesses need not use this method of finance, and many businesses buy up existing shares of stock to increase the value of the remaining shares. Yet stock ownership still affects the business’s performance.

It is important to note that stock ownership implies a separation of ownership and control. Stockholders own a corporation, but the chief executive officer (CEO) or president actually manages the daily operations and plans the future operations of any corporation. Separation of ownership and control in a corporation, though, poses a potential problem. The CEO and other top executives may abuse their authority at the expense of stockholders. Both bondholders and stockholders have an interest in the efficient operation of the corporation in which they have invested. Under specific circumstances, bonds and stocks are virtually identical. If investors have perfect information on the activities of corporate officers, if taxes affect bonds and stocks equally, and if the costs of transacting for stocks and bonds are equal, then stocks and bonds will be perfect substitutes as far as investors are concerned. The logic behind this proposition is simple. If people have perfect information about the activities of corporate officers, then they will know exactly what the future stream of dividends will be. If a stock will pay more than a bond with certainty, then investors will buy more of that stock. When investors own more shares of a stock, its price will rise, and its dividend will fall. The rate of return of a stock will therefore be equal to the interest rate on bonds—if investors have perfect information on the operation of that corporation by its top executive officers. Investors might prefer stocks or bonds for tax reasons or because of differences in transactions costs. But given our three assumptions, bonds and stocks will appear identical to investors.

The idea that investors have perfect information is completely unrealistic, but it does tell us much about the real world. Stocks are different from bonds because of the differences in information needed to profit from these two types of investments. All bondholders need to know is that corporate officers are doing their jobs well enough so that the corporation can avoid bankruptcy and pay interest on its bonds. With stockholders things are different. Every penny that the corporate officers waste or take for themselves is money lost to the stockholders. Consequently, stockholders need to be much better informed about the activities of corporate officers than do bondholders. Bonds are a good investment for people who want a decent rate of return without much bother. Stocks can deliver a higher rate of return but require more attention from investors. Consequently, owners of stocks act as corporate watchdogs to make sure that corporations run efficiently. Of course, some stockholders fail to pay proper attention to their corporate officers. But many stockholders do pressure corporate executives to run their businesses more efficiently, and this pressure contributes to the overall efficiency of the economy.

SEE ALSO Bubbles; Capitalism; Corporate Social Responsibility; Corporations; Efficient Market Hypothesis; Financial Instability Hypothesis; Financial Markets; Information, Asymmetric; Lender of Last Resort; Modigliani-Miller Theorem; Panics; Risk; Socialism; Speculation; Stock Exchanges; Stock Exchanges in Developing Countries; Tobin’s Q; Veblen, Thorstein

BIBLIOGRAPHY

Jensen, Michael, and William Meckling. 1976. Theory of the Firm: Managerial Behavior, Agency Costs and Ownership Structure. Journal of Financial Economics 11: 5–50.

Miller, Merton. 1977. Debt and Taxes. Journal of Finance 32: 261–275.

Modigliani, Franco, and Merton Miller. 1958. The Cost of Capital, Corporation Finance and the Theory of Investment American Economic Review 48 (3): 261–297.

D. W. MacKenzie

STOCK

A security issued by a corporation that represents an ownership right in the assets of the corporation and a right to a proportionate share of profits after payment of corporate liabilities and obligations.

Shares of stock are reflected in written instruments known as stock certificates. Each share represents a standard unit of ownership in a corporation. Stock differs from consumer goods in that it is not used or consumed; it does not have any intrinsic value but merely represents a right in something else. Nevertheless, a stockholder is a real owner of a corporation's property, which is held in the name of the corporation for the benefit of all its stockholders. An owner of stock generally has the right to participate in the management of the corporation, usually through regularly scheduled stockholders' (or shareholders') meetings. Stocks differ from other securities such as notes and bonds, which are corporate obligations that do not represent an ownership interest in the corporation.

The value of a share of stock depends upon the issuing corporation's value, profitability, and future prospects. The market price reflects what purchasers are willing to pay based on their evaluation of the company's prospects.

Two main categories of stock exist: common and preferred. An owner of common stock is typically entitled to participate and vote at stockholders' meetings. In addition to common stock, some corporate bylaws or charters allow for the issuance of preferred stock. If a corporation does not issue preferred stock, all of its stock is common stock, entitling all holders to an equal pro rata division of profits or net earnings, should the corporation choose to distribute the earnings as dividends. Preferred stockholders are usually entitled to priority over holders of common stock should a corporation liquidate.

Preferred stocks receive priority over common stock with respect to the payment of dividends. Holders of preferred stock are entitled to receive dividends at a fixed annual rate before any dividend is paid to the holders of common stock. If the earnings to pay a dividend are more than sufficient to meet the fixed annual dividend for preferred stock, then the remainder of the earnings will be distributed to holders of common stock. If the corporate earnings are insufficient, common stockholders will not receive a dividend. In the alternative, a remainder may be distributed pro rata to both preferred and common classes of the stock. In such a case, the preferred stock is said to "participate" with the common stock.

A preferred stock dividend may be cumulative or noncumulative. In the case of cumulative preferred stock, an unpaid dividend becomes a charge upon the profits of the next and succeeding years. These accumulated and unpaid dividends must be paid to preferred stockholders before common stockholders receive any dividends. Noncumulative preferred stock means that a corporation's failure to earn or pay a dividend in any given year extinguishes the obligation, and no debit is made against the succeeding years' surpluses.

Par value is the face or stated value of a share of stock. In the case of common stocks, par value usually does not correspond to the market value of a stock, and a stated par value is of little significance. Par is important with respect to preferred stock, however, because it often signifies the dollar value upon which dividends are figured. Stocks without an assigned stated value are called no par. Some states have eliminated the concept of par value.

Blue chip stocks are stocks traded on a securities exchange (listed stock) that have minimum risk due to the corporation's financial record. Listed stock means a company has filed an application and registration statement with both the securities and exchange commission and a securities exchange. The registration statement contains detailed information about the company to aid the public in evaluating the stock's potential. Floating stock is stock on the open market not yet purchased by the public. Growth stock is stock purchased for its perceived potential to appreciate in value, rather than for its dividend income. Penny stocks are highly speculative stocks that usually cost under a dollar per share.

cross-references

Securities; Stock Market.