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What is a Stock?

Mr. Rahul Singh | Posted On Monday, February 02,2009, 02:44 PM

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What is a Stock?



Stock is a security issued in the form of shares that represent interests of owners in a company. It is a type of security that signifies ownership in a corporation and represents a claim on part of the corporation's possessions and earnings.

A holder of share/stock of a company (a shareholder) has a claim to a part of the corporation's/company’s assets and earnings. In other words, a shareholder is an owner of a company/firm. Ownership right of an investor/share holder is determined by the number of shares a person owns relative to the number of outstanding shares. For example, if a company has 1,000 shares of stock outstanding and one person owns 100 shares, that person would own and have claim to 10% of the firm's assets.

Importance of Stocks:

Stocks are very important to any company as it is a source of financing. It is an important tool for the firms to collect funds from the public or private investors. Both public and private limited companies can issue stocks to their investors. However, the difference is that stocks of publicly listed companies are traded on stock exchanges while stocks of private companies are held by promoters and investors.

Public Ltd companies issue stocks (fully paid shares) to general public but private companies issue stocks to individuals or investors; however, these information are not made available and are private stocks are not available for everyone to trade. Companies need capital to start the business and to run it. By issuing stocks they collect money from the public and invest them to run their business. Public companies also get good media attention and increase their visibility in the industry by going public.

Distinction between a Public Company and a Private Company

1. Minimum Paid-up Capital:

A company to be incorporated/built-in as a Private Company must have a minimum paid-up capital of Rs. 1, 00,000, whereas a Public Company must have a minimum paid-up capital of Rs. 5, 00,000.

2. Minimum number of members:

Minimum number of members required to form a private company is 2, whereas a Public Company/firm requires at least 7 members.

3. Maximum number of members:

Maximum number of members in a Private Company is limited to 50; there is no restriction of maximum number of members in a Public Company.

4. Transferability of Shares:

There is complete restraint on the transferability of the shares of a Private Company through its Articles of Association, whereas there is no restriction on the transferability of the shares of a Public company

5. Issue of Prospectus:

A Private Company is forbidden from inviting the public for subscription of its shares, i.e. a Private Company cannot issue Prospectus, whereas a Public Company is free to invite public for subscription i.e., a Public Company can issue a Prospectus.

6. Number of Directors:

A Private Company may have 2 directors to handle the affairs of the company, whereas a Public Company must have at least 3 directors.

7. Consent of the Directors:

There is no need to give the approval by the directors of a Private Company, whereas the Directors of a Public Company must have file with the Registrar consent to act as Director of the company.

8. Qualification Shares:

The Directors of a Private Company need not sign an undertaking to obtain the qualification shares, whereas the Directors of a Public Company are required to sign an undertaking to acquire the qualification shares of the public Company.

9. Commencement of Business:

A Private Company can begin its business immediately after its incorporation, whereas a Private Company cannot start its business until a Certificate to commencement of business is issued to it.

10. Shares Warrants:

A Private Company/corporate cannot issue Share Warrants against its fully paid shares, whereas a Private Company can issue Share Warrants against its fully paid up shares.

11. Further issue of shares:

A Private Company need not present the further issue of shares to its existing shareholders, whereas a Public Company has to offer the further issue of shares to its existing share holders as right shares. Further issue of shares can only be offer to the general public with the consent of the existing shareholders in the general meeting of the shareholders only.

Types of Shares:

Common Stock:

Common stock is a form of company equity ownership represented in the securities. It is risky in comparison to preferred shares and some other investment options, in that in the event of bankruptcy, common stock investors receive their funds after preferred stockholders, bondholders, creditors, etc. On the other hand, common shares on average do better than preferred shares or bonds over time.

Holders of common stock are able to control the corporation through votes on establishing corporate objectives and policy, stock splits, and electing the company's board of directors. Some holders of common stock also receive preemptive rights, which enable them to maintain their proportional ownership in a company should it issue another stock offering. Additional benefits from common stock/shares include earning dividends and capital appreciation.

Preferred Stock:

Preferred stock, also called preferred shares or preference shares, is typically a higher ranking stock than voting shares, and its terms are negotiated between the company and the investor.

Preferred stock carries no voting rights, but carries superior priority over common stock in the payment of dividends and upon liquidation. Preferred stock may carry a dividend that is paid out prior to any dividends to common share holders. Preferred shares may have a convertibility feature into common stock. Preferred stockholders will be paid out in assets before common stockholders and after debt holders in liquidation Terms of the preferred stock are stated in a "Certificate of Designation".

Rights of Preferred Stocks:

Unlike common stock, preferred share has several rights attached to it :

  • The core right is that of preference in the payment of dividends and upon bankruptcy of the company. Before a dividend can be declared on the common shares, any dividend compulsion to the preferred shares must be satisfied.
  • The dividend rights are often cumulative, which means if the dividend is not paid it accumulates from year to year. Preferred share may or may not have a fixed liquidation value, or par value, associated with it. This represents the amount of capital that was contributed to the company when the shares were first issued.
  • Preferred stock has a claim on liquidation proceeds of a stock company, equivalent to its par or liquidation value unless otherwise negotiated. This claim is superior to that of common stock, which has only a residual claim.
  • Almost all preferred stocks have a negotiated fixed dividend amount. The dividend is specified as a percentage of the par value or as a fixed amount. Sometimes, dividends on preferred stocks may be negotiated as floating i.e. may change according to a benchmark interest rate index such as LIBOR.
  • Some preferred shares have special voting rights to support certain extraordinary events (such as the issuance of new shares or the approval of the acquisition of the company) or to elect directors, but most preferred shares provide no voting rights associated with them. Some preferred shares only get voting rights when the preferred dividends are in arrears for a substantial time.
  • Usually preferred shares contain defensive provisions which prevent the issuance of new preferred shares with a senior claim. Individual series of preferred shares may have a senior, junior relationship with other series issued by the same corporation. Occasionally companies use preferred stocks as means of preventing hostile takeovers, creating preferred shares with a poison pill or forced exchange/conversion features that exercise upon a change in control.

Types of Preferred Stocks:

There are various types of preferred stocks that are common to many corporations :

Cumulative Preferred Stock:

If the dividend is not paid, it will gather for future payment.

Non-cumulative Preferred Stock:

Dividend for this type of preferred shares will not accumulate if it is unpaid. Very common in bank preferred share, since under BIS rules, preferred stock must be non-cumulative if it is to be included in Tier 1 capital.

Convertible Preferred Stock:

This type of preferred share carries the option to convert into a common stock at a prescribed price.

Exchangeable Preferred Stock:

This type of preferred shares carries the option to be exchanged for some other security upon certain conditions.

Monthly Income Preferred Stock:

It is a combination of preferred shares and subordinated debt.

Participating Preferred Stock:

This type of preferred shares allows the possibility of additional dividend above the stated amount under certain conditions.

Perpetual Preferred Stock:

This type of preferred stock has no fixed date on which invested capital will be returned to the stock holder, although there will always be redemption privileges held by the corporation. Most preferred shares are issued without a set redemption date.

Putable Preferred Stock:

These issues have a "put" opportunity whereby the holder may, upon certain conditions, force the issuer to redeem shares.

Initial Public Offering (IPO):

IPO, also referred to simply as a "public offering", is when a company issues common shares to the public for the first time. They are often issued by smaller, younger firms seeking capital to expand, but can also be done by large privately-owned companies looking to become publicly traded. In an IPO, the issuer may get the assistance of an underwriting firm (an investment bank), which helps it determine what type of security to issue (common or preferred), best offering price and time to bring it to market.

Initial Public Offerings can be a risky investment. For the individual investor, it is tough to forecast what the stock or shares will do on its initial day of trading and in the near future since there is often little historical data with which to analyze the company. Also, most IPOs are of firms going through a transitory growth period, and they are therefore subject to additional uncertainty regarding their future value.

Reasons for Public Listing:

When a company lists its shares on a public exchange, it will almost invariably look to issue additional new stocks in order to raise extra capital at the same time. The money paid by investors for the newly-issued shares goes directly to the corporate (in contrast to a later trade of shares on the exchange, where the money passes between investors). An IPO, therefore, allows a firm to tap a wide pool of stock market investors to provide it with large volumes of capital for future growth. The corporate is never required to repay the capital, but instead the new stock holders have a right to future profits distributed by the company and the right to a capital distribution in case of dissolution.

The existing stock holders will see their shareholdings diluted as a proportion of the company's shares. However, they hope that the capital investment will make their stockholdings more valuable in absolute terms.

In addition, once a firm is listed, it will be able to issue further stocks via a rights issue, thereby again providing itself with capital for expansion without incurring any debt. This regular ability to raise large amounts of capital from the general market, rather than having to seek and negotiate with individual investors, is a key incentive for many firms seeking to list. Moreover, a public company has more visibility and exposure in the industry because media and research firms cover it extensively.

Procedure of IPO:

IPOs involve one or more investment banks as "underwriters." The company offering its shares, called the "issuer," enters a contract with a lead underwriter to sell its stocks to the public. The underwriter then approaches investors with offers to sell these stocks. An underwriter, generally an investment bank, is called so because they sign the IPO prospectus which is then circulated to different investors. Hence, they are called “under” + “writer”.

The sale (that is, the allocation and pricing) of stocks in an IPO may take several forms. Common methods include :

  • Best efforts contract
  • Firm commitment contract
  • All-or-none contract
  • Bought deal
  • Dutch auction
  • Self Distribution of Shares

A large Initial Public Offer is underwritten by a "syndicate" of investment banks led by one or more major investment banks (lead underwriter). Upon selling the shares, the underwriters keep a commission based on a percentage of the value of the stocks sold. The lead underwriters, i.e. the underwriters selling the largest proportions of the IPO, take the highest commissions—up to 8% in some cases.

Multinational IPOs may have as many as three syndicates to deal with differing legal necessities in both the issuer's domestic market and other regions. For instance, an issuer based in the E.U. may be represented by the main selling syndicate in its domestic market, Europe, in addition to separate syndicates or selling groups for US/Canada and for Asia. The lead underwriter in the main selling group is also the lead bank in the other selling groups.

Because of the extensive array of legal requirements, IPOs typically involve one or more law firms with major practices in securities law.

Usually, the offering will include the issuance of new stocks, intended to raise new capital, as well the secondary sale of existing shares. However, certain regulatory limitations and restrictions imposed by the lead underwriter are often placed on the sale of existing shares. Public offerings are primarily sold to institutional investors, but some stocks are also allocated to the underwriters' retail investors. A broker selling stocks of a public offering to his clients is paid through a sales credit instead of a commission. The client pays no commission to purchase the stocks of a public offering; the purchase price simply includes the built-in sales credit.

The issuer usually allows the underwriters an option to boost the size of the offering by up to 15% under certain circumstance known as the green shoe or overallotment option. This is an extremely lucrative business for investment banks. They make a flat earning of up to 7% of the spread (price at which they sell the stocks – price at which they buy stocks from companies). Let us say company ABC hires Goldman Sachs India and ICICI Securities to write its IPO. These banks value ABC stock at Rs. 100 using different stock valuation methods. What these banks will do is that they will buy these stocks from ABC at Rs. 97 per stock and then sell it to investors (mutual funds, hedge funds or retail) at Rs. 104. The spread is thus Rs. 104-97 i.e. Rs. 7 per stock. It is an extremely profitable business for investment banks.

Share Buyback:

A company’s buyback shares when it feels its stock is undervalued and has lot of cash to do so. This gives a message to the market that its stock is underpriced and hence stock price goes up. Management of companies also buyback shares in order to increase their ownership of the company.

When a corporate performs a share buyback, there are a few things that the company can do with the securities they buy back. The company can reissue the shares on the market at a later time. In the case of a stock reissue, the share is not canceled, but is sold again under the same stock number as it was previously sold. The company may give or sell the stock to its workforce as some type of employee compensation or stock sale. Lastly, the company can also retire or remove the securities that it bought back.

In order to retire stock, the company must first buy back the stocks and then cancel them. Shares cannot be reissued on the market, and are considered to have no financial value. They are null and void of ownership in the corporate.

Stock Split:

All publicly-traded corporate have a set number of shares that is outstanding on the stock market. A stock split is a decision by the company's board of directors to increase the number of shares that are outstanding by issuing more shares to current stockholders. For example, in a 2-for-1 stock split, every stockholder with one share is given an additional share. So, if a corporate had 10 million shares outstanding before the split, it will have 20 million shares outstanding after a 2-for-1 split.

A share's price is also affected by a stock split. After a split, the share price will be reduced since the number of shares outstanding has increased. In the example of a 2-for-1 split, the stock price will be halved. Thus, although the number of outstanding shares and the stock price change, the market capitalization remains stable. It is a corporate action in which a company's existing stocks are divided into multiple shares. Although the number of shares outstanding increases by a specific multiple, the total dollar value of the stocks remains the same compared to pre-split amounts, because no actual value has been added as a result of the split.

A stock split is generally done by companies that have seen their share price increase to levels that are either too high or are beyond the price levels of similar companies in their sector. The primary motive is to make stock seem more reasonable to small investors even though the underlying value of the company has not changed.

For instance, in a 2-for-1 split, each shareholder receives an additional share for each share he or she holds. One reason as to why stock splits are performed is that a company's stock price has increased so high that for too many investors, the shares are too expensive to buy in round lots.

For example, if Infosys shares were worth Rs. 40,000 each, investors would need to purchase Rs. 40,00,000 in order to own 100 shares. If each share was worth Rs. 4,000, investors would only need to pay Rs. 4,00,000 to own 100 shares. Lower share prices allow retail investors to invest in the stocks. There is also a mental barrier that higher priced stocks will not increase as much as lower priced stocks.

A stock split can also result in a share price increase following the decrease immediately after the split. Since many small investors think the share is now more affordable and buy the stock, they end up boosting demand and drive up prices. Another reason for the price increase is that a stock split provides a signal to the market that the company's stock price has been increasing and people assume this growth will continue in the future, and again, lift demand and prices.

Another version of a stock split is the reverse split. This procedure is typically used by corp.’s with low share prices that would like to increase these prices to either gain more respectability in the market or to prevent the company from being delisted (many stock exchanges will delist stocks if they fall below a certain price per share). For example, in a reverse 5-for-1 split, 10 million outstanding stocks at 50 cents each would now become two million stocks outstanding at $2.50 per share. In both cases, the company is worth $50 million.

The bottom line is a stock split is used mostly by companies that have seen their stock prices increase substantially and although the number of outstanding shares increases and price per share decreases, the market capitalization (and the value of the company) does not change. As a result, stock splits help make shares more reasonable to small investors and provide greater marketability and liquidity in the market.

An instance of Stock Split:

RELIANCE STEEL & ALUMINUM CO. DECLARES 2-FOR-1 STOCK SPLIT AND 20% INCREASE IN CASH DIVIDEND On May 17, 2006, Reliance's Board of Directors declared a two-for-one stock split. The common stock split will be affected by issuing one additional share of common stock for each share held by shareholders of record on July 5, 2006. The additional shares will be distributed on July 19, 2006.

Reissue of Stock:

Companies reissue shares to raise additional capital. They do when the management believes that their stock price is overvalued. This is generally followed by a drop of stock price in the market because even investors think so. Another reason for reissuing shares is to collect funds for investing in projects where risks are high. Thus, the management wants to share its risks among investors. After reissuance the number of outstanding stock increases in the market.


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