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 StocksStocks
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 CapitalA
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 membersMinimum 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 membersMaximum
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 SharesThere
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 ProspectusA
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 DirectorsA
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 DirectorsThere
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 sharesA
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 SharesCommon StockCommon
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 StockPreferred
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 StocksUnlike 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 StocksThere are various types of preferred stocks that are common to many corporations:
Cumulative Preferred StockIf the dividend is not paid, it will gather for future payment.
Non-cumulative Preferred StockDividend
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 StockThis type of preferred share carries the option to convert into a common stock at a prescribed price.
Exchangeable Preferred StockThis type of preferred shares carries the option to be exchanged for some other security upon certain conditions.
Monthly Income Preferred StockIt is a combination of preferred shares and subordinated debt.
Participating Preferred StockThis type of preferred shares allows the possibility of additional dividend above the stated amount under certain conditions.
Perpetual Preferred StockThis
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 StockThese 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 ListingWhen
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 IPOIPOs
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 BuybackA
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 SplitRELIANCE 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 StockCompanies
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
