Equity Investments II
Reading 39. Overview of Equity Securities
Learning Outcome Statements
b. describe differences in voting rights and other ownership characteristics among different equity classes;
CFA Curriculum, 2020, Volume 5
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Subject 2. Types and Characteristics of Equity Securities
Common shares represent ownership shares in a corporation.
The two most important characteristics of common shares are:
- Residual claim means the shareholders are the last in line of all those who have a claim on the assets or income of the corporation.
- Limited liability means that the greatest amount shareholders can lose in the event of the failure of the corporation is the original investment.
Each share of voting common stock entitles its owner to one vote on any matters of corporate governance that are put to a vote at the corporation's annual meeting. Shareholders who do not attend the annual meeting can vote by proxy, empowering another party to vote in their name.
Statutory voting, also known as straight voting, is a procedure of voting for a company's directors in which each shareholder is entitled to one vote per share. For example, if you owned 100 shares, you would have 100 votes.
Cumulative voting is another procedure of voting for a company's directors. Each shareholder is entitled to one vote per share times the number of directors to be elected. For example, if you owned 100 shares and there were three directors to be elected, you would have 300 votes. This is advantageous for individual investors because they can apply all of their votes toward one person.
Common shares can be callable or putable. Callable common shares give the issuer the right to buy back the shares from shareholders at a pre-determined price. Putable common shares give shareholders the right to sell the shares back to the issuer at a pre-determined price.
A preferred share, also called a preference share, has features similar to both equities and bonds.
- Like a bond, it promises to pay to its holder fixed dividends each year. In this sense it is similar to an infinite-maturity bond, that is, a perpetuity. It also resembles a bond in that it does not convey voting power regarding the management of the firm.
- A preferred share is an equity investment in the sense that failure to pay the dividend does not precipitate corporate bankruptcy. It has priority over a common share in the payment of dividends and upon liquidation.
Preferred dividends can be cumulative; that is, unpaid dividends cumulate and must be paid in full before any dividends may be paid to common shareholders. All passed dividends on a cumulative stock are dividends in arrears. A stock that doesn't have this feature is known as a noncumulative or straight preferred stock and any dividends passed are lost forever if not declared. The implication is that the dividend payments are at the company's discretion and are thus similar to payments made to common shareholders.
Participating preferred shares offer the holders the opportunity to receive extra dividends if the company achieves some predetermined financial goals. The investors who purchased these shares receive their regular dividends regardless of how well or how poorly the company performs, assuming the company does well enough to make the annual dividend payments. If the company achieves predetermined sales, earnings, or profitability goals, the investors receive additional dividends. Most preferred shares are non-participating.
Convertible preferred shares give the assurance of a fixed rate of return plus the opportunity for capital appreciation. The fixed-income component offers a steady income stream and some protection of capital. The option to convert these preferred shares into common shares gives the investor the opportunity to gain from a rise in share price.