In a previous article, we introduced the
CFA Institute Investment Foundation Program (Read
more here). It is a free program
designed for anyone who wants to enter or advance within the investment
management industry, including IT, operations, accounting, administration, and
marketing. Candidates who successfully
pass the online exam earn the CFA Institute Investment Foundations Certificate.
There are total of 20 Chapters in 7
modules, covering all the essential topics in finance, economics, ethics and
regulations. This series of articles
will highlight the core knowledge of each chapter.
Chapter 10 provides an overview of equity
securities. The learning outcome of chapter 10 is as follows:
·
Describe
features of equity securities;
·
Describe
types of equity securities;
·
Compare
risk and return of equity and debt securities;
·
Describe
approaches to valuing common shares;
·
Describe
company actions that affect the company’s shares outstanding.
In addition to borrowing funds,
companies may raise external capital to finance their operations by issuing
(selling) equity securities. Issuing shares (also called stock and shares of
stock) is a company’s main way of raising equity capital and shares are the
primary equity securities discussed in this chapter.
There are four features that
characterise and vary among equity securities:
·
Life
·
Par
value
·
Voting
rights
·
Cash
flow rights
Life. Many equity securities are issued with
an infinite life. In other words, they are issued without maturity dates. Some equity
securities are issued with a maturity date.
Par Value. Equity securities may or may not be
issued with a par value. The par value of a share is the stated value, or face
value, of the equity security. In some jurisdictions, issuing companies are required
to assign a par value when issuing shares.
Voting Rights. Some shares give their holders the
right to vote on certain matters. Shareholders do not typically participate in
the day-to-day business decisions of large companies. Instead, shareholders with
voting rights collectively elect a group of people, called the board of
directors, whose job it is to monitor the company’s business activities on
behalf of its shareholders. The board of directors is responsible for
appointing the company’s senior management (e.g., chief executive officer and
chief operating officer), who manage the company’s day-to-day business
operations. But decisions of high importance, such as the decision to acquire
another company, usually require the approval of shareholders with voting
rights.
Cash Flow Rights. Cash flow rights are the rights of
shareholders to distributions, such as dividends, made by the company. In the
event of the company being liquidated, assets are distributed following a
priority of claims, or seniority ranking. This priority of claims can affect
the amount that an investor will receive upon liquidation.
Companies may issue different types and
classes of equity securities. The two main types of equity securities are
common shares (also called common stock or ordinary shares) and preferred
shares (also known as preferred stock or preference shares). In addition,
companies may issue convertible bonds and warrants. Depositary receipts are not
issued by a company, but they give the holder an equity interest in the
company.
Common stock (also known as common shares, ordinary
shares, or voting shares) is the main type of equity security issued by
companies. A common share represents an ownership interest in a company. Common stock typically provides its owners with
voting rights and cash flow rights in proportion to the size of their ownership
stake. Common shareholders usually have the right to vote on certain matters.
Companies often pay out a portion of their profits each year to their
shareholders as dividends; the rights to such distributions are the
shareholders’ cash flow rights.
Many companies have a single class of
common stock and follow the rule of “one share, one vote”. But some companies
may issue different classes of common stock that provide different cash flow
and voting rights. In general, an arrangement in which a company offers two
classes of common stock (e.g., Class A and Class B) typically provides one
class of shareholders with superior voting and/or cash flow rights.
Example 1 describes the two classes of
common stock of Berkshire Hathaway and their cash flow and voting rights.
The reason for having multiple share
classes is usually that the company’s original owner wants to maintain control,
as measured by voting power, while still offering cash flow rights to attract
shareholders. In general, for large public companies in which nearly all
shareholders hold small ownership positions, the difference in voting rights
may not be important to shareholders.
Companies may also issue preferred
stock (also known as preferred shares or preference shares). These
shares are called preferred because owners of preferred stock will receive
dividends before common shareholders. They also have a higher claim on the
company’s assets compared with common shareholders if the company ceases
operations. In other words, preferred shareholders receive preferential
treatment in some respects. Generally, preferred shareholders are not entitled
to voting rights and have no ownership or residual claim on the company.
Sample question:
Sample question:
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