An entrepreneur with a good idea can do nothing without capital to act on that idea. As a start, the entrepreneur can use personal resources to form a sole proprietorship. In this form the entrepreneur and the business are indistinguishable, and the amount of capital is limited to the personal wealth and borrowing power of the entrepreneur. The entrepreneur is personally liable for all obligations. If the business grows and prospers even more capital will be required, often rapidly outrunning the resources of the entrepreneur. Forming a partnership with other parties solves some of the problems, adding the personal resources of one or more partners. This form of organization dilutes the claim and authority of the entrepreneur. Partnerships do not work well if large amounts of capital are required since potential investors with large amounts of capital are hard to find. Once found, they are reluctant to enter partnerships for three reasons. The first reason is that all partners are equally and totally responsible for the obligations of the partnership. This risk exposure may easily exceed the original investment. The second reason is that the partnership is a temporary alliance. Partners may withdraw at any time. Finally, partnership interests are not liquid. Liquidity is the ability to convert an asset to cash quickly and at a fair price. Potential investors are reluctant to enter partnerships because of the difficulties of disposing of the investment and realizing a return. Many of these problems are avoided by the corporate form of ownership.
In the corporate form, a business is set up as legal entity that has the power to act as an individual, and for legal purposes is considered to be a real person. This entity by itself has no net legal value, as recognized in the basic accounting equation: "Assets equals liabilities plus owners equity." What the firm owns as assets is owed to creditors and others as liabilities, and to the owners as equity. This creation of a legal person, however, separates the liabilities of the corporation from the liabilities of the owners. This results in "limited liability": should the firm fail, the obligations of the firm are not the obligations of the owners. The value of owning the firm may go to zero, but the investors' loss is limited to their original investment. Limited liability greatly reduces investor risk, so that investors are willing to consider more and riskier investments and will not require as great an anticipated return. This increased willingness to undertake new projects encourages innovation. Limited liability of investors has been an important factor encouraging economic growth. Another attraction of the corporate form is that ownership is subdivided into shares of stock. Shares may be sold to many investors, in varying amounts. The ease with which shares are transferred results in higher liquidity, and this higher liquidity reduces investor risk. The stockholder can exit the investment for another investment, or realize a return, more easily than is possible with a partnership interest. Finally, the investor can take a much smaller position through stock, which allows diversification over many ventures. The pool of potential investors becomes much larger, and raising capital becomes easier. Given these advantages, it is not surprising that many business ventures choose the corporate form, either at first or after growth makes the other forms overly cumbersome.
The corporate form does have some disadvantages. One disadvantage is double taxation of earnings. The earnings of sole proprietorships and partnerships are taxed once, as the earnings of the proprietor. The firm is a legal entity, however, and its earnings are taxed. Any distribution of the already once-taxed earnings is considered income of the investor, and the earnings are taxed a second time. Another disadvantage is that as ownership becomes wider, it becomes more diverse. Entrepreneurs remaining as managers may be distracted more often by fellow owners and more formal requirements. A different style of management may be required. On the positive side, the corporate form facilitates separation of ownership and management. This separation is a mixed blessing—it allows professional management and the application of expertise not yet developed by the entrepreneur, but raises the agency, or control, problem. The professional manager is now an agent of the stockholders, not necessarily part of the ownership, and may have different goals and agenda. Finally, ownership may be diluted, and control limited to less direct, impersonal procedures.
Securities issued by a corporation are classified as debt or as equity, equity being an ownership claim. Under the corporate form, ownership may be complicated. The main types of equity claims are common and preferred stock. These equity claims may take many forms. There are related claims, such as rights, warrants, and convertible securities. The securities also may be divided into those that are publicly traded, and those that are not. Although the underlying securities are in the same class, public trading implies a much wider ownership and liquidity, and often a much different set of problems and considerations. Securities of firms that are closely held, or have few shareholders, look quite different from an investment viewpoint.
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.
Stockholders share directly in the income of the firm in the form of cash dividends. The firm is not obligated to pay dividends, which will be paid only if declared by the board of directors. As a result, the size and timing of the dividends is uncertain. Although higher earnings are desired, the dividend policy of the firm—which is the long-run or average fraction of earnings that will be paid as dividends—is sometimes argued to be irrelevant. One argument is that in a perfect economic environment, dividends would be considered as a "residual." This is because the stockholders may share indirectly in the income of the firm through capital gains —an increase in the stock price. In this view, management must choose between paying dividends now, or investing in projects that will increase stock price. Dividends would be paid only if the firm had no better use for the funds. Note that in this case, it could be argued that declaring or increasing dividend payout would be a negative signal, since the firm would be admitting that it lacked attractive investments and indicating lessened possibilities for growth. Another argument is that investors can change the dividend policy to suit themselves, selling stock to create dividends if higher payout is desired, or reinvesting dividends in the firm if lower payout is desired. It is also argued that investors form clienteles, investing in firms with the dividend policy they prefer. Tax considerations, on the other hand, suggest that stockholders are better off with low dividend policy. This is because capital gains are taxed at a lower rate than dividends, and capital gains are not taxed until realized, so that it is better to retain and reinvest earnings to produce capital gains.
For widely held, publicly traded firms there are a number of indications that stockholders and investors have a positive view of dividends and dividend increases. The explanation is that dividends are taken as a signal that the firm is healthy, and can afford to pay dividends. An increase would signal an improvement and the ability to pay higher dividends. A decrease in dividends would indicate inability to maintain the level of dividends, signaling a decline in prospects. The signal from a dividend increase is strong because management would be hesitant to increase dividends unless they could be maintained. The signal from a dividend decrease is strong because management would wish to give only positive signals by at least maintaining the dividend, and would cut the dividend only when absolutely necessary. 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 onetime-only dividends arising from a temporary excess of cash. This label is applied by management in an attempt to avoid signaling a higher earnings level. Note, however, that this argument does not deal with dividend policy, but instead with increasing or decreasing the size of the dividend under a constant dividend policy or payout ratio.
The signaling approach is not applicable to closely held corporations, which have few stockholders. 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 perks. 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 several business days for completion, the stock goes "ex-dividend" 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 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 ceteris paribus share price 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. Decreasing price through stock dividends attracts more investors and results in wider ownership. Wider ownership is sometimes issued to thwart takeovers. 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 restriction from the Internal Revenue Service.
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 stockholder's 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 the number of shares held, and may cast those votes for candidates for that position only. 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. If there are four directors to be elected and I 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 do not vote or routinely vote for management. Further, dissidents must spend their own money, while management has the resources of the firm at its disposal. Another reason for a lack of independence on the part of directors is the practice of interlocking boards of directors, who are likely to reach a tacit agreement. Conventional wisdom on Wall Street has long been to sell the stock rather than oppose an entrenched management.
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, some classes having no voting power at all. A number of firms have changed from cumulative to majority voting. Staggered boards, with only a portion of the board terms expiring in a given year, and supermajority voting for some questions 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. While Sidney Cottle, Roger F. Murray, and Frank E. Block may have gone too far in saying that "The shareholder has become an ineffectual nuisance to be pacified by self-congratulatory reports and increasing dividends," it would appear that stockholder power has become more tenuous.
There has been some recent movement toward 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. At least part of this movement may be the result of takeover activities. The takeover and breakup or consolidation of firms, with accompanying job loss, has been much criticized. This activity showed that challenging management was possible, however, and encouraged dissident groups. It also sent a message to management that mediocre performance might not be tolerated. It has been suggested that the threat of takeover may have done much to reinforce the rights of stockholders. The use of defense mechanisms detrimental to the stockholder has called attention to managerial abuses. The appropriate level of salary and of management perks, such as use of the corporate jet and limousines, has come under scrutiny in the financial and popular press.
The common stockholder has a claim on the assets of the firm. This is an undifferentiated or general claim that 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.
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 the success of the offering. The rights are then valuable because possession of the rights allows subscription to the underpriced issue. The rights can be transferred, and are traded. Rights will be given to the owner of the stock on the date of record. During the time that a purchase will be completed before the date of record, the stock is said to be trading with rights or rights on. During this period the price of the stock reflects both the value of the stock and the value of the (to-be-issued) right. When purchase of the stock will not be completed until after the date of record, but before the offering, the stock is said to be trading ex-rights or rights off. Similar to the exdividend date, the ex-rights date will be four days before the date of record. At the ex-rights day the price of the stock will drop by the value of the right, since the stock purchase will not include the right.
A rights offering may be attractive to management because the stockholders, who thought enough of the firm to buy its stock, are a presold 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 underpricing of the issue rather than from an inherent value of rights. The real question is whether the issue should be undertaken at all—i.e., what is to be done with the funds from the offering? If the funds are to be used in a way that the market perceives as having little value, the price of the stock will decline. If the funds are to be used in a way that the market perceives as having great value, the price of the stock will increase. The value of the rights ultimately depends on the use of the funds.
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 that, if invested at the required rate of return on the stock, could exactly re-create 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 ratio , 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 traded stock is 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 that 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 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.
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 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 the capital markets , and lenders would be wary.
There is also a form of preferred stock, called participating preferred, in which there may be a share in earnings above the specified dividends. Such participation would typically occur only if earnings or common dividends rose over some threshold, and might limited in other ways. A more recent innovation is adjustable-rate preferred stock, with a variable dividend based on prevailing interest rates .
Under normal circumstances preferred stockholders do not have any voting power, resulting in 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 conditions such as required liquidity ratios are not met. Preferred stockholders also may have a preemptive right.
Another source of the preferred designation is that preferred stock has a prior claim on assets over that of common stock. The claim of bonds 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.
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 is much simpler than for common stock. The valuation techniques are actually more 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.
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. ADR's are appealing to individual investors. It has also been suggested that the benefits of international investing can be obtained by investing in international firms.
As a class, common stock has provided the highest rate of return to investors. A study by R. G. Ibbotson & Associates found that, over the period 1926-96, large company common stock provided an arithmetic average annual return of 12.7 percent. This compares with an average annual return of 6 percent for long-term corporate bonds, and 3.8 percent for U.S. Treasury bills (T-bills). Annual inflation over the period averaged 3.2 percent. Common stock also provided the highest risk, with returns having a standard deviation of 20.3 percent, as compared to 8.7 percent for long-term corporate bonds and 3.3 percent for T-bills. Although the data point out the desirability of common stock investment, these long-run averages must be interpreted carefully. Hidden within these averages were some extended loss periods, and some short periods of sharp losses. Also, the returns reflect the effects of diversification. The historical returns of individual stocks or small portfolios could have quite different average returns, and would almost certainly exhibit greater risk. Finally, the disclaimer so frequently found in investment advertisements that future performance may differ from past performance is applicable.
While the above observations give a general idea of the comparative returns to stocks overall, stocks are diverse in nature and can be classified many ways for investment purposes. One such classification has been the discussion of small cap stocks. These are stocks of smaller firms. Ibbotson & Associates found that, over the 1926-96 period, small cap stocks had an average annual return of 17.7 percent, but with a standard deviation of 34.1 percent. It must be noted that the sample used was the stocks in the lowest quintile of the New York Stock Exchange, when ranked on capitalization (shares outstanding times price per share). While small by comparison to the other quintiles, these firms are still sizable. Findings such as these have led to an investment strategy of purchasing such stocks to earn the historical higher return. Indicative of the problems of long-run averages, many such investors have been disappointed.
Stocks are also classified according to the level of risk. Thus risky stocks are sometimes referred to as aggressive or speculative. 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 the economic cycle, 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. As pointed out by Lawrence J. Gitman and Michael D. Joehnk, however, in real terms the Dow Jones Industrial Average (DJIA) fell almost without interruption from 1965 to 1982. The second line of thought is that the total returns to common stock are high enough to overcome inflation (the DJIA measures only the capital gains or price change component of returns). While this is apparently true over longer periods, as shown in the Ibbotson & Associates study, it has not held true over shorter periods.
Preferred stock is generally not considered a desirable investment for individuals. While as noted the junior position of preferred stockholders as compared to bonds 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 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 preferreds is higher for corporations, and buying of preferreds 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.
[ David E. Upton ]
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