Equity Services: Common and Preferred Shares

Question 1

What are common shares and why are they considered venture capital or risk capital?

Answer 1

• Common shareholders can be an individual investor, a business, or an institutional investor. The shareholders have an ownership stake in the company and are considered the owners of the public company. If the venture prospers, the shareholders benefit from the growth in value of their original investment and from the flow of dividend income that may arise. However, if the business fails, the common shareholders may lose their entire investment. This possibility of total loss explains why common share capital is sometimes referred to as venture capital or risk capital.

Question 2

What are some benefits and risks associated with common shares?

Answer 2

• Potential for capital appreciation: A company’s net earnings may be kept as retained earnings and reinvested in the business or distributed to shareholders, in whole or in part, as dividends. When earnings are retained, the value of the company’s common shares may increase.
• The right to receive any common share dividends paid by the company: Dividend policy is determined by a company’s board of directors, who are guided primarily by the company’s size, goals, and financial position, and by the industry in which it participates. For example, a large, established company such as a bank may pay out a substantial percentage of its earnings as dividends to shareholders, whereas a growing tech company may need to keep a higher proportion of earnings within the business to fund research and development. Dividends are sometimes reduced or halted, particularly in poor economic times. Companies paying common share dividends might designate a specified amount to be paid each year as a regular dividend. The term regular indicates to investors that, barring a major collapse in earnings, those payments will be maintained. Some companies may pay an extra dividend on the common shares, usually at the end of the company’s fiscal year. The extra payment is a bonus paid in addition to the regular dividend. The term extra indicates that investors should not assume that the payment will be repeated the following year.
• The issuer has no obligation to pay dividends
• Common share prices can be volatile, and price changes can lead to investors losing money

Question 3

A deeper dive into dividends – explain what dividend reinvestment plans

Answer 3

• Some major companies give their preferred and common shareholders the option of participating in an automatic dividend reinvestment plan. In such a plan, the company diverts the shareholders’ dividends to the purchase of additional shares of the company. Reinvested dividends are taxable to the shareholder as ordinary cash dividends, even though the dividends are not received as cash. In effect, a dividend reinvestment plan is an automatic savings plan that allows investors to reinvest small amounts of cash. Participating shareholders acquire a regular, gradually increasing share position in the company at a reduced average cost per unit. This process is known as dollar cost averaging.
• Here’s how it works:
  o Instead of getting cash dividends, the company uses that money to buy more shares for you.
  o Over time, you keep getting more shares, and your investment grows.
  o Even though you don’t get cash in hand, you still have to pay taxes on those dividends as if you did.
  o Since you’re buying shares regularly, sometimes they are cheaper, sometimes more expensive—but overall, you get a good average price. This strategy is called dollar cost averaging and helps reduce the risk of buying at a high price.

Question 4

Explain what stock splits and reverse stock splits are, when they are used, and for what purpose

Answer 4

• At any one time, a publicly traded company will have a set number of outstanding shares trading in the marketplace. The company’s board of directors may decide, as part of their corporate strategy, to alter the number of shares outstanding using a stock split or reverse stock split (or consolidation). Most companies believe it is good corporate strategy to keep the market price of their shares within a specific price range, say between $10 and $20, or comparable to the price levels of similar companies in their sector. The primary motive in using a stock split or reverse split is to make the company’s share price more affordable for investors.
• With a stock split, the number of shares outstanding increases as the company will issue more shares to the current shareholders. After the split, the stock’s price will be reduced because the number of shares outstanding has increased.
  o EXAMPLE: In a four-for-one split, three additional shares are given for each share held by a shareholder. So, if you owned 1,000 shares of the company before the split, you would now own 4,000 shares after the split. If the market price of the shares was $100 before the split, the share price will be somewhere in the $25 range after the split. What is important to understand is that the investment value of your holdings would remain unchanged: Pre-split value: $100 × 1,000 shares = $100,000 After the split: $25 × 4,000 shares = $100,000
  o When the market price of a company’s shares is too high, a stock split is an effective means to reduce the price. The market price of the new shares reflects the basis of the split, and each shareholder’s total shareholdings in the company increase accordingly.
• When the market price of a company’s shares is too low, a reverse stock split can be used to raise the price. The new price reflects the basis of the consolidation, and each shareholder’s total shareholdings in the company are reduced accordingly. Reverse splits occur most frequently when a company’s shares have fallen in value to a level that is unattractive to investors with large amounts of capital. Companies use them when they are in danger of being delisted by a stock exchange because their share price has fallen below the exchange’s minimum share price rule. A reverse split raises the market price of the new shares and can put the company in a better position to raise new capital.

Question 5

What are Canadian Depositary Receipts (CDRs), what benefits do they serve, how does it adjust if the Canadian dollar increases or decreases versus the US dollar?

Answer 5

• Canadian Depositary Receipts (CDRs) are securities designed to give Canadians access to popular U.S. and global companies that trade on the NYSE and NASDAQ, but they are listed on the Cboe Canada Exchange in Canadian dollars. Trading CDRs in Canadian dollars removes the impact of fluctuating exchange rates. Although CDRs are a relatively new product for the Canadian markets, they were first introduced in the U.S. as American Depositary Receipts in 1927.
• The CDR Ratio is the method used to increase or reduce the number of underlying shares of the CDR based on how the Canada/U.S. exchange rate changes. The process virtually eliminates the effect of exchange rate changes on the investment.
• The CDR ratio is adjusted as follows:
  o If the value of the Canadian dollar increases versus the U.S. dollar, the CDR is adjusted so that it represents a larger number of underlying shares.
  o If the value of the Canadian dollar decreases versus the U.S. dollar, the CDR is adjusted so that it represents a smaller number of underlying shares.

Question 6

Read the stock quotation and interpret it

Answer 6

• BEC common has traded as high as $12.55 per share and as low as $9.25 during the last 52 weeks.
• BEC common has paid dividends totalling $0.50 per share during the last 52 weeks. (Sometimes, an indicated dividend rate may appear if the company pays regular dividends and has recently increased a dividend payment.)
• During the day under review, BEC common shares traded as high as $10.65 and as low as $10.25.
• The last trade of the day in this stock was made at $10.35.
• The closing trade price was $0.50 higher than the previous trading day’s closing trade price. (Therefore, BEC shares closed at $9.85 on the previous trading day.)
• A total of 6,000 BEC common shares traded that day.

Question 7

Explain simply what preferred shares are and how are they similar to fixed-income securities?

Answer 7

• When a company needs to raise capital, there are generally three types of securities they can issue: bonds or debentures, common shares, and, less frequently, preferred shares (which are sometimes referred to as preferred stock or simply preferreds).
• Preferred shareholders are usually entitled to a regular dividend payment, subject to the discretion of the board of directors. Because of this income stream, most preferred shares are treated by investors like a type of fixed-income security. However, preferred shareholders are not in the same category as creditors holding typical fixed-income securities, such as bonds and debentures. As part owners of a company, along with common shareholders, preferred shareholders rank behind creditors in their claim to assets. Preferred shareholders do, however, have priority status over common shares in the event of bankruptcy or dissolution of the company.

Question 8

Explain what stock indexes or averages are and list some purposes they are used for:

Answer 8

• Stock indexes or averages are indicators used to measure changes in a representative grouping of stocks, such as the S&P/TSX Composite Index or the Dow Jones Industrial Average (DJIA). These indicators are important tools, and are used for the following purposes:
  o Gauge the overall performance and directional moves in the stock market.
  o Enable portfolio managers and other investors to measure their portfolio’s performance against a commonly used yardstick within the stock market.
  o Create index mutual funds.
  o Serve as underlying interests for options, futures, and exchange-traded funds.

Question 9

What does it mean when we say most stock indexes are value-weighted by using the total market value (i.e., market capitalization) & in contrast to this, what are average indexes and how are they composed?

Answer 9

• Most stock indexes are value-weighted and are derived by using the total market value (i.e., market capitalization) of all stocks used in the index relative to a base period. The total market value of a stock is found by multiplying its current price by the number of shares outstanding.
• Each day, the total market value of all stocks included in the series is calculated, and this value is compared to the initial base value to determine the percentage change in the index.
• The S&P/TSX Composite Index closed at a value of 15,562. A year later, the same index closed at a value of 16,385. The change in the index translates into a gain of 5.29% for the year—calculated as follows:
• Within a stock index, each stock has a relative weight based on the stock’s market capitalization. In contrast to a market-weighted stock index, stocks included in an average are composed of equally weighted items (i.e., no specific weights are applied when constructing the average). A stock’s relative weight within an index can change every day, whereas a stock’s weight within an average is always the same

Question 10

How do you interpret indexes differently based on point changes and percentage changes?

Answer 10

• To interpret the indexes, it is important to understand the distinction between point changes and percentage changes. Based on the starting level of 250 for an index, for example, a 1% change in the index is equivalent to 2.5 index points (calculated as 0.01 × 250).
• Therefore, as indexes move up and down, the percentage change is a more accurate reflection of market performance than net point changes. Also, when a percentage change in the S&P 500 is compared to a percentage change in the S&P/TSX, currency values should be taken into account. An investment in the S&P 500 is in U.S. dollars, whereas an investment in the S&P/TSX would be made in Canadian dollars.