Series 7 Chapter 3 Flashcards
KYC
The know your customer (KYC) rule places an obligation on the firm and associated person to seek information from customers. Customers are not required to provide all information asked; therefore, the KYC rule provides some flexibility when information is unavailable, despite the fact that the firm or the associated person asked for it.
In this case, when some customer information is unavailable despite a firm’s request for it, the firm may narrow the range of recommendations it makes. The rule does not prohibit a firm from making a recommendation in the absence of certain customer-specific information if the firm has enough information about the customer to have a reasonable basis to believe the recommendation is suitable based on what the firm knows. The significance of specific types of customer information will depend on the facts and circumstances of the particular case. Of course, the firm itself may require, in order for customers to receive recommendations, that customers provide certain types of information.
Both financial and nonfinancial information must be gathered before making investment recommendations.
Before making a recommendation for a new customer a representative must
must try to find out as much about that person’s financial and nonfinancial situation as possible. Financial investment considerations can be expressed as a sum of money. Financial questions have answers that show up on a customer’s personal balance sheet or income statement. Asking a customer, “when would you like to retire?” is not a financial question—it is nonfinancial. The answer does not show up on the customer’s personal balance sheet or income statement.
customer balance sheet
An individual, like a business, has a financial balance sheet—a snapshot of the individual’s financial condition at a point in time. A customer’s net worth is determined by subtracting liabilities from assets (assets – liabilities = net worth). Representatives determine the status of a customer’s personal balance sheet by asking questions similar to the following.
■ What are the values of tangible assets? Home? Car? Collectibles?
■ What are your liabilities? How much do you owe on your mortgage? Car? Outstanding
Loans?
■ What are the values of securities you currently own?
■ Have you established long-term investment accounts, and what are the values of those accounts? Do you have an IRA, corporate pension, or profit-sharing plan; and what are the values of those plans? What is the cash value of your life insurance?
■ What is your net worth? How much of it is liquid?
customer income statement
To make appropriate investment recommendations, representatives must know the customer’s income situation. They gather information about the customer’s marital status, financial responsibilities, projected inheritances, and pending job changes by asking the following questions.
■ What is your total gross income? Total family income?
■ How much do you pay in monthly expenses?
■ What is your net spendable income after expenses? How much of this is available for investment?
Before recommending any investment to a customer, a representative must,
at a minimum, make a reasonable effort to obtain information concerning the customers financial status and investment objectivies
customer profile:non financial investment considerations
Once representatives have an idea of the customer’s financial status, they gather information on the nonfinancial status. A nonfinancial investment consideration is one that cannot be expressed as a sum of money or a numerical cash flow (risk tolerance, or tax bracket, for example). Nonfinancial considerations often carry more weight than the financial considerations and include the following:
■ Age
■ Marital status
■ Number and ages of dependents
■ Employment
■ Employment of family members
■ Current and future family educational needs
■ Current and future family health care needs
■ Risk tolerance
■ Attitude toward investing
■ Tax status
No matter how much an analysis of a customer’s financial status tells the representative about the ability to invest, it is the customer’s emotional acceptance of investing and motivation to invest, which molds the portfolio.
To understand a customer’s attitude for investment, the representative should ask questions similar to the following.
■ What kind of risks can you afford to take?
■ How liquid must your investments be?
■ How important are tax considerations?
■ Are you seeking long-term or short-term investments?
■ What is your investment experience?
■ What types of investments do you currently hold?
■ How would you react to a loss of 5% of your principal? 10%? 50%?
■ What level of return do you consider good? Poor? Excellent?
■ What combination of risks and returns do you feel comfortable with?
■ What is your investment temperament?
■ Do you get bored with stable investments?
■ Can you tolerate market fluctuations?
■ How stable is your income?
■ Do you anticipate any financial changes in the future?
risk points
■■ Low risk—conservative
■■ Some risk—moderate
■■ More than average risk—moderately aggressive
■■ High risk—aggressive
If you key on the right word, you’ll get the correct answer.
preservation of capital
For many people, the most important investment objective is to preserve their capital. In general, when clients speak of safety, they usually mean preservation of capital. Recommendations may include the following:
■ Money market securities
■ Money market mutual funds
■ Certificates of deposit (CDs)
■ Government securities
■ Principal-protected funds may also be appropriate if they are looking to invest for a longer time horizon
current income
Many investors, particularly those on fixed incomes, want to generate additional current income.
■ Traditional debt securities such as corporate, government, municipal bonds, and agency securities may provide steady interest income.
■ Equity securities may be purchased for the dividends they produce; these include preferred stocks, utilities, and blue-chip stocks that have a solid dividend paying history. (A blue- chip stock is the stock of a large, well-established and financially sound company that has operated for many years and is usually a company people are familiar with.)
■ Many pooled investments can provide income as well, such as income-oriented mutual
capital growth
refers to an increase in an investment’s value over time. This can come from increases in the security’s value. Growth-oriented investments are equity oriented.
price to earnings ratio
Measures the relationship between a company’s
stock price, with the company’s earnings per share (EPS). The P/E ratio indicates how
much investors are willing to pay for a every dollar of earnings.
A high P/E ratio indicates investors expect higher earnings (growth momentum).
A low P/E ratio may indicate the stock is undervalued and may be more representative of a value investment.
higher the pe ratio
the better
tax advantage products
Investors often seek ways to reduce their taxes. Some products, like IRAs and annuities, allow interest to accumulate tax-deferred (an investor pays no taxes until money is withdrawn from the account). Other products, like municipal bonds, offer tax-free interest income.
are municipal bonds suitable for retirement accounts
no
liquid investments include
securities listed on an exchange or unlisted Nasdaq securities; ■ mutual funds;
■ exchange-traded funds; and
■ real estate investment trusts (REITs).
illiquid investments include
■ annuities, when initially purchased and/or when the annuitant is under age 591⁄2; ■ real estate;
■ direct participation programs;
■ hedge funds; and
■ funds of hedge funds.
annuities and liquidity
Annuities—particularly when issued—are not considered liquid. Most annuities have a surrender penalty that may last at least seven to 10 years. In addition, there are taxes and a 10% tax penalty for withdrawals before 591⁄2 years of age.
speculation
A customer may want to speculate—that is, try to earn much higher-than-average returns in exchange for higher-than-average risks. Investors who are interested in speculation may be interested in:
■ option contracts;
■ high-yield bonds;
■ unlisted or non-Nasdaq stocks or bonds;
■ sector funds;
■ precious metals; and
■ special situation funds.
As a registered representative, one must always determine the suitability of such recommendations.
recommendation for preservation of capital/safety
CDs, money market mutual funds, fixed annuities, government securities and funds, agency issues, investment-grade corporate bonds and corporate bond funds
Growth (balanced/moderate growth)
(aggressive growth)
recommendation
Common stock, common stock mutual funds Blue-chip stocks, defensive stocks Technology stocks, sector funds
income
(tax free income)
(high yield income)
(from stock portfolio)
recommendation
Bonds (but not zero coupons), REITs, CMOs
Municipal bonds, municipal bond funds, Roth IRAs
Below investment-grade corporate bonds, corporate bond funds Preferred stocks, utility stocks, blue-chip stocks
liquidity recommendation
Securities listed on an exchange, Nasdaq stocks or bonds, mutual funds, publicly traded REITS
portfolio diversification
recommendation
Mutual funds, in general; more specifically, asset allocation funds and balanced funds
For equity portfolios, add some debt and vice versa For domestic portfolios, add some foreign securities For bond portfolios, diversify by region/rating
speculation recommendation
Option contracts, DPPs, high-yield bonds, unlisted/non-Nasdaq stocks or bonds, sector funds, precious metals, commodities, futures
business risk
Business risk is a form of unsystematic risk; it affects companies and industries individually. Business risk can be reduced by diversifying investments.
inflation risk
Also known as purchasing power risk or constant dollar risk, inflation risk is the effect of continually rising prices on investments, resulting in less purchasing power as time goes on. A client who buys a fixed return security such as a bond, fixed annuity, or preferred stock
may not see the investment keep pace with inflation.
capital risk
Capital risk or principal risk is the potential for an investor to lose all his money (invested capital) under circumstances either related or unrelated to an issuer’s financial strength.
timing risk
Even an investment in the soundest company with the most profit potential might do poorly simply because the investment was timed wrongly. The risk to an investor of buying or selling at the wrong time and incurring losses or lower gains is known as timing risk.
interest rate risk
Interest rate risk refers to the sensitivity of an investment’s price or value to fluctuations in interest rates. The term is generally associated with debt (i.e., bonds, bond funds) and preferred stocks because their prices are interest-rate sensitive. An inverse relationship exists with these securities; as yields go up, prices go down, and vice versa.
Know that the longer a bond’s maturity (or duration), the more volatile it is in response to interest rate changes compared with similar short-term bonds. For bonds with short maturities, the opposite is true. Their prices remain fairly stable because investors generally will not sell them at deep discounts or buy them at high premiums.
short term interest rates are more or less volatile than long term
more
duration
is another useful tool in bond calculations; it is a measure of the amount of time a bond will take to pay for itself. Each interest payment is taken to be part of a discounted cash flow, so there is more to the calculation than simply adding up the interest payments. For the Series 7, remember that duration is often used to assess the sensitivity of a bond in response to interest rate changes—the longer the duration, the greater the sensitivity, and thus greater interest rate risk in an environment of changing interest rates. Remember also that the duration of an interest-paying bond is always shorter than the time to its maturity because the interest payments can be reinvested and earn additional interest. By way of comparison, the duration of a zero-coupon bond is always equal to the time to its maturity because there is only one payment—the one made when the bond matures.
Remember that there are two components to the computation: the interest rate and the maturity date. If the maturity dates are about the same (the difference between a 20-year maturity and a 22-year one is almost insignificant), then the bond paying the highest coupon rate will always have the shortest duration and that with the lowest coupon, the longest. However, if the coupon rates are approximately the same, then the bond that will mature first will have the shortest duration, and the one that will mature last will have the longest duration.
reinvestment risk
When interest rates decline, it is difficult for bond investors to reinvest the proceeds from investment distributions and maintain the same level of return at the same level of (default) risk. Reinvestment risk is mostly associated with bonds that mature or when a bond or preferred stock is called by the issuer.
market risk
Both stocks and bonds involve some degree of market risk—the risk that investors may lose some of their principal due to price volatility in the overall market (also known as systematic risk).
An investor cannot diversify away market risk. If the entire market is in a tailspin, all of the investor’s securities will likely decline.
This is systematic
credit risk
Credit risk, also called financial risk or default risk, involves the danger of losing all or part of one’s invested principal through an issuer’s failure. Credit risk is associated with debt securities, not equity securities, and varies with the investment product.
Bonds backed by the federal government or municipalities tend to be very secure and have low credit risk. Long-term bonds involve more credit risk than short-term bonds because of the increased uncertainty that results from holding bonds for many years.
Bond investors concerned about credit risks should pay attention to the ratings. Two of the best-known rating services that analyze the financial strength of thousands of corporate and municipal issuers are Moody’s Investors Service and Standard & Poor’s (S&P) Corporation.
To a great extent, a bond’s value depends on how much credit risk investors take. The higher the rating, the less likely the bond is to default and, therefore, the lower the coupon rate. Clients seeking the highest-possible yields from bonds might want to buy bonds with lower ratings; higher yields reward investors for taking more credit risk.
There is also a variable price difference between speculative and investment-grade debt, other things such as maturity date being equal. During times of confidence in the economy, the price of a AAA bond and that of a BB bond, for example, will be closer together than during periods of economic uncertainty. This reflects investors’ reduced willingness to take risks during periods of uncertainty: speculative debt is discounted more than during periods of confidence.
liquidity risk
The risk that a client might not be able to sell an investment and receive its current market value quickly is known as liquidity risk.
The marketability of the securities you recommend must be consistent with the client’s liquidity needs.
legislative risk
Legislative risk exists because federal and state legislatures have the power to change laws, and this can impact securities (companies) negatively and result in capital loss for investors.
social risk or political risk
Risk associated with the possibility of unfavorable government action or social changes resulting in a loss of value is also called social risk or political risk. Political risk is an important risk to discuss when recommending foreign or international investments because governments outside the United States may not be as stable as ours.
call risk
Related to reinvestment risk, call risk is the risk that a bond might be called by the issuer before maturity, and investors cannot reinvest their principal at the same or a higher rate of return. When interest rates are falling, bonds with higher coupon rates are most likely to be called.
call protection
Investors concerned about call risk should look for call protection, a period of time during which a bond may not be called. Corporate and municipal issuers generally provide some years of call protection.
bonds can’t be ____ but
bonds can’t be called but the bonds within a bond portfolio can be called
how can callable bonds benefit the issuer
If general interest rates decline, the issuer can redeem bonds with a high interest rate and replace them with bonds with a lower rate.
■ The issuer can call bonds to reduce its debt any time after the initial call date.
■ The issuer can replace short-term debt issues with long-term issues and vice versa.
■ The issuer can call bonds as a means of forcing the conversion of convertible corporate bonds.
currency risk
This is the risk that changes in the exchange rate between the investor’s home currency and that of the issuer’s one will have an adverse affect on an investment’s return. As a rule of thumb, an investor who purchases an international fund (e.g., a foreign bond fund) will lose if the U.S. dollar appreciates against the foreign currency. The investor will profit if the U.S. dollar weakens (depreciates) against the foreign currency.
in measuring investment performance
be sure to avoid comparing apples to oranges. Finding and applying the right evaluation standards for investments is important. Otherwise, the wrong conclusions may result.
asset allocation
Asset allocation (more accurately, but rarely stated, asset class allocation) refers to the spreading of portfolio funds among different asset classes. Proponents of asset allocation feel that the mix of assets within a portfolio, rather than individual stock selection or marketing timing, is the primary factor underlying the variability of returns in portfolio performance. There are three major types (each with subclasses) of asset classes: ■ Stock, with subclasses based on market capitalization, value versus growth, and foreign equity ■ Bonds, with subclasses based on maturity (intermediate versus long-term), and issuer (Treasury versus corporate versus non-U.S. issuers) ■ Cash, focusing mainly on the standard risk-free investment, the 90-day Treasury bill, but also including other short-term money market instruments
strategic asset allocation
Strategic asset allocation refers to the proportion of various types of investments composing a long-term investment portfolio
portfolio rebalancing
Over time, the portfolio is rebalanced to bring the asset mix back to the target allocations. If the stock market should perform better than expected, the client’s proportion of stocks to bonds would be out of balance. So, on some timely basis (perhaps quarterly), stocks would be sold and bonds would be purchased (or funds would be placed in cash) to bring the proportions back to the desired levels.
tactical asset allocation
refers to short-term portfolio adjustments that adjust the portfolio mix between asset classes in consideration of current market conditions.
Modern portfolio theory
MPT employs a scientific approach to measuring risk and, by extension, to choosing investments. It involves calculating projected returns of various portfolio combinations to identify those that are likely to provide the best returns at different levels of risk. It is the concept of minimizing risk by combining volatile and price-stable investments in a single portfolio.
Harry Markowitz, the founder of MPT, explained how to best assemble a diversified portfolio and proved that the portfolio with a lower amount of volatility would do better than a portfolio with a greater amount of volatility.
MPT focuses on the relationships among all the investments in a portfolio. This theory holds that specific risks can be diversified by building portfolios of securities whose returns are not correlated. MPT seeks to reduce the risk in a portfolio while simultaneously increasing expected returns.
Holding securities that tend to move in the same direction as one another does not lower an investor’s risk. Diversification reduces risk only when assets whose prices move inversely, or at different times, in relation to one another are combined.
Modern portfolio theory wants
wants securities in a portfolio to have negative correlation, not positive correlation. Perfect negative correlation is –1.0 and would indicate that if one security goes up, the other security would go down the same amount. Obviously, this is not an exact science, but it is an indication of the movement of the portfolio.
Some analysis tools that are used in MPT include the following terms.
Capital Asset pricing model
The CAPM is used to calculate the return that an investment should achieve based on the risk that is taken. The more risk taken, the higher the potential returns. Investors should be rewarded for the risk they take. CAPM calculates a required return based on a risk multiplier called the beta coefficient.
A portfolio’s total risk is made up of unsystematic risk and systematic risk. If an investor has a diversified portfolio, unsystematic risk is reduced to almost zero. Therefore, the only real risk is systematic risk and this is the risk that needs a required return.
Investors with a well-diversified portfolio will find that the risk affecting the portfolio is wholly systematic (markets moving together). Individual investments have both systematic and unsystematic risk; however, in a portfolio that is diversified, only the systematic risk of a new security would be relevant.
In other words, if an individual investment becomes part of a well-diversified portfolio, the unsystematic risk can be ignored.
Beta (beta coefficient)
Beta and beta coefficient mean the same thing. In the securities industry, coefficient is ordinarily dropped for purposes of convenience. A stock or portfolio’s beta is a measure of its volatility in relation to the overall market (systematic risk). The overall market is typically based on the S&P 500. A security that has a beta of one moves in line with the market. A security or portfolio with a beta of greater than one is generally going to be more volatile than the overall market. The reverse is true when the beta is less than one.
A security that does not move in relation to market movement would have a beta of zero. For example, a money market security or money market mutual fund would have a beta of close to zero.
alpha
Analysts advise when to buy, sell, or hold securities. The CAPM is a method that analysts may use to make these decisions. Based on its beta, an analyst would calculate the expected return for the security.
Alpha is the extent to which an asset’s or portfolio’s actual return exceeds or falls short of its expected return. A positive alpha would indicate a buy recommendation.
a positive or negative alpha is desirable
positive alpha
Fundamental analysis
Fundamental analysis is the study of the business prospects of an individual company within the context of its industry and the overall economy.
They do this by examining the company in detail, including the financial statements and company management.
business cycle
Expansion
Peak
Contraction
Trough
Defensive industries
are least affected by normal business cycles. Companies in defensive industries generally produce nondurable consumer goods, such as: ■ food; ■ pharmaceuticals; ■ tobacco; and ■ utilities.
sector rotation
will “rotate” into defensive issues when it appears the business cycle is headed into the contraction phase. They then rotate into cyclical issues when the economy is in the expansion phase. This is also called segment rotation.
cyclical industries
are highly sensitive to business cycles and inflation trends. Most cyclical industries produce:
■ steel;
■ heavy equipment (such as tractors, airplanes, cranes);
■ automobiles; and
■ capital goods (such as washers and dryers).
During recessions, the demand for durable goods declines as manufacturers postpone investments in new capital goods and consumers postpone purchases of automobiles.
Cyclical industries perform better in expanding economies.
countercyclical industries
Countercyclical industries, on the other hand, tend to turn down as the economy heats up and to rise when the economy turns down. Gold and gold mining stocks have historically been a countercyclical industry.
growth industries
Every industry passes through four phases during its existence: introduction, growth, maturity, and decline. An industry is considered in its growth phase if the industry is growing faster than the economy as a whole because of technological changes, new products, or changing consumer tastes.
Technology associated with computers and bioengineering are considered growth industries. Because many growth companies retain nearly all of their earnings to finance their business expansion, growth stocks usually pay little or no dividends.
special situation stocks
Special situation stocks are stocks of a company with unusual profit potential resulting from nonrecurring circumstances, such as new management, the discovery of a valuable natural resource on corporate property, or the introduction of a new product.
financial statements
A corporation’s financial statements provide a fundamental analyst with the information needed to assess that corporation’s profitability, liquidity, financial strength (ability of cash flow to meet debt payments), and operating efficiency. By examining how certain numbers from one statement relate to prior statements, and how the resulting ratios relate to the com- pany’s competitors, the analyst can determine how financially viable the company is.
Companies issue quarterly and annual financial reports to the SEC. A company’s balance sheet and income statement are included in these reports.
balance sheet
The balance sheet provides a snapshot of a company’s financial position at a specific point in time. It identifies the value of the company’s assets (what it owns) and its liabilities (what it owes). The difference between these two figures is the corporation’s owners’ equity, or net worth.
equation =assets=liabilities +owners equity
assets
Assets appear on the balance sheet in order of liquidity, which is the ease with which they can be turned into cash. Assets that are most readily convertible into cash are listed first, followed by less liquid assets. Balance sheets commonly identify three types of assets: current assets (cash and assets easily convertible into cash), fixed assets (physical assets that could eventually be sold), and other assets (usually intangible and only of value to the corporation that owns them).
current assets
Current assets include all cash and other items expected to be converted into cash within the next 12 months, including the following.
■ Cash and equivalents include cash and short-term safe investments, such as money market instruments that can be readily sold, as well as other marketable securities.Accounts receivable include amounts due from customers for goods delivered or services
rendered, reduced by the allowance for bad debts.
■ Inventory is the cost of raw materials, work in process, and finished goods ready for sale.
■ Prepaid expenses are items a company has already paid for but has not yet benefited from, such as prepaid advertising, rents, insurance, and operating supplies.
fixed assets
Fixed assets are property, plant, and equipment. Unlike current assets, they are not easily converted into cash. Fixed assets, such as factories, have limited useful lives because wear and tear eventually reduce their value. For this reason, their cost can be depreciated over time or deducted from taxable income in annual installments to compensate for loss in value.
other assets
Intangible assets are nonphysical properties, such as formulas, brand names, contract rights, and trademarks. Goodwill, also an intangible asset, reflects the corporation’s reputation and relationship with its clients.
liabilities
Total liabilities on a balance sheet represent all financial claims by creditors against the corporation’s assets. Balance sheets usually include two main types of liabilities: current liabili- ties and long-term liabilities.
current liabilities
Current liabilities are corporate debt obligations due for payment within the next 12 months. These include the following:
■ Accounts payable—amounts owed to suppliers of materials and other business costs
■ Accrued wages payable—unpaid wages, salaries, commissions, and interest
■ Current long-term debt—any portion of long-term debt due within 12 months
■ Notes payable—the balance due on equipment purchased on credit or cash borrowed
■ Accrued taxes—unpaid federal, state, and local taxes
long term liabilities
are financial obligations due for payment after 12 months. Examples would include bonds and mortgages.
under current accounting practice, deferred tax credits are treated as
liability
shareholder equity
shareholder equity, also called net worth or owners’ equity, is the stockholder claims on a company’s assets after all its creditors have been paid. Shareholder equity equals total assets less total liabilities. On a balance sheet, three types of shareholder equity are identified: capital stock at par, capital in excess of par, and retained earnings.
capital stock at part
Capital stock includes preferred and common stock, listed at par value. Par value is the total dollar value assigned to stock certificates when a corporation’s owners (the stockholders) first contributed capital. Par value of common stock is an arbitrary value with no relationship to market price.
capital in excess of par
Capital in excess of par, often called additional paid-in capital or paid-in surplus, is the amount of money over par value that a company received for selling stock.
retained earnings
sometimes called earned surplus or accumulated earnings, are profits that have not been paid out in dividends. Retained earnings represent the total of all earnings held since the corporation was formed, less dividends paid to stockholders. Operating losses in any year reduce the retained earnings from prior years.
capitalization
is the combined sum of its long-term debt and equity securi- ties.
capital structure
The capital structure is the relative amounts of debt and equity that compose a compa- ny’s capitalization. Some companies finance their business with a large proportion of borrowed funds; others finance growth with retained earnings from normal operations and little or no debt.
Looking at the balance sheet, a corporation builds its capital structure with equity and debt, including the following four elements:
■ Long-term debt
■ Capital stock (common and preferred)
■ Capital in excess of par
■ Retained earnings (earned surplus)
financial leverage
Financial leverage is a company’s ability to use long-term debt to increase its return on equity. A company with a high ratio of long-term debt-to-equity is said to be highly leveraged. Stockholders benefit from leverage if the return on borrowed money exceeds the debt service costs. But leverage is risky because excessive increases in debt raise the possibility of
default in a business downturn.
In general, industrial companies with debt-to-equity ratios of 50% or higher are considered
highly leveraged. However, utilities, with their relatively stable earnings and cash flows, can be more highly leveraged without subjecting stockholders to undue risk. If a company is highly leveraged, it is also affected more by changes in interest rates.
working capital
Working capital is the amount of capital or cash a company has available. Working capital is a measure of a firm’s liquidity, which is its ability to quickly turn assets into cash to meet its short-term obligations.
working capital =current assets - current liabilities
current ratio
Knowing the amount of working capital is useful, but it becomes an even better indicator when paired with the current ratio. This computation uses the same two items—current assets and current liabilities—but expresses them as a ratio of one to the other. Simply divide the current assets by the current liabilities, and the higher the ratio, the more liquid the company is.
quick asset ratio
Sometimes it is important for the analyst to use an even stricter test of a company’s ability to meet its short-term obligations (as such, “pass the acid test”)The quick asset ratio uses the company’s quick assets instead of all of the current assets. Quick assets are current assets minus the inventory. Then divide these quick assets by the current liabilities to arrive at the quick ratio.
debt-equity ratio
The best way to measure the amount of financial leverage being employed by the company is by calculating the debt-to-equity ratio. It is really a misnomer—it should be called the debt- to-total capitalization ratio because that is what it is. For example, using the numbers in the capitalization example, we see that the total capital employed in the business is $90 million. Of that, $50 million is long-term debt. So, we want to know how much of the $90 million total is represented by debt capital. The answer is simple: $50 million of the $90 million, or 55.55%. That is the debt-to-equity ratio, and it indicates that this is a highly leveraged company (over 50%).
book value per share
A fundamental analyst is described as one who focuses on the company’s books. Therefore, one of the key numbers computed is the book value per share. The calculation is almost identical to one we have already studied—net asset value (NAV) per share of an investment company.
In the case of a corporation, it is basically the liquidation value of the enterprise. That is, let’s assume we sold all of our assets, paid back everyone we owe, and then split what is left among the stockholders. But, remember, before we can hand over anything to the common shareholders, we must take care of any outstanding preferred stock. So, from the funds that are left after we pay off all the liabilities, we give the preferred shareholders back their par (or stated) value and the rest belongs to the common stockholders.
But, there is one more thing. In the case of liquidation, some of the assets on our books might not really be worth what we’re carrying them at—in particular, those that are known as intangible assets (goodwill, patents, trademarks, copyrights, etc.). That is why the analyst uses only the tangible assets, computed by subtracting those intangibles from the total assets.
balance sheets
Balance sheets, by definition, must balance. Every financial change in a business requires two offsetting changes on the company books, known as double-entry bookkeeping. For example, when a company pays a previously declared cash dividend, cash (a current asset) is reduced while dividends payable (a current liability of the same amount) is eradicated. This results in no change to working capital or net worth because each side of the balance sheet has been lowered by the same amount.
book value per share formula
tangible assets- liabilities-par value perfered
_________
shares of common outstanding stock
depreciating assets
Because fixed assets (e.g., buildings, equipment, and machinery) wear out as they are used, they decline in value over time. This decline in value is called depreciation. A company’s tax bills are reduced each year the company depreciates fixed assets used in the businesses.
Depreciation affects the company in two ways: accumulated depreciation reduces the value of fixed assets on the balance sheet, and the annual depreciation deduction reduces tax- able income on the income statement.
Companies may elect either straight-line or accelerated depreciation. By use of the straight-line method, a company depreciates fixed assets by an equal amount each year over the asset’s useful life. A piece of equipment costing $1 million with a 10-year useful life will generate a depreciation deduction of $100,000 per year.
Accelerated depreciation is a method that depreciates fixed assets more during the earlier years of their useful life and less during the later years.
footnotes
Footnotes to the financial statements identify significant financial and management issues that may affect the company’s overall performance, such as accounting methods used, extraor- dinary items, pending litigation, and management philosophy.
Typically, a company separately discloses details about its long-term debt in the footnotes. These disclosures are useful for determining the timing and amount of future cash outflows. The disclosures usually include a discussion of the nature of the liabilities, maturity dates, stated and effective interest rates, call provisions and conversion privileges, restrictions imposed by creditors, assets pledged as security, and the amount of debt maturing in each of the next five years.
Also disclosed in the footnotes would be off-the-books financing arrangements, such as debt guarantees.
footnotes are generally found
found on the bottom of the financial statements and can be several pages long
income statement
The income statement, sometimes called the profit and loss or P&L statement, summarizes a company’s revenues (sales) and expenses for a fiscal period, usually quarterly, year to date, or the full year. It compares revenue against costs and expenses during the period. Fundamental analysts use the income statement to judge the efficiency and profitability of a company’s oper- ation. Just as with the balance sheet, technical analysts generally ignore this information—it is not relevant to their charting schemes.
revenues
indicate the firm’s total sales during the period (the money that came in).
cost of goods sold
is the costs of labor, material, and production (includ- ing depreciation on assets employed in production) used to create finished goods. Subtracting COGS from revenues shows the gross operating profit.
The two major methods of accounting for material costs are the first in, first out method (FIFO) and last in, first out method (LIFO). Under LIFO accounting, COGS normally will reflect higher costs of more recently purchased inventory (last items in). As a result of higher reported production costs under LIFO, reported income is reduced. The opposite is true if the FIFO method is used.
Pretax margin is determined by subtracting COGS and other operating costs (rent and utilities) from sales to arrive at net operating profit. The resulting figure is earnings before interest and taxes (EBIT).
Interest payments on a corporation’s debt is not considered an operating expense. However, interest payments reduce the corporation’s taxable income. Pretax income, the amount of tax- able income, is operating income less interest payment expenses.
If dividends are paid to stockholders, they are paid out of net income after taxes have been paid. After dividends have been paid, the remaining income is added to retained earnings and is available to invest in the business.
pretax income
the amount of tax- able income, is operating income less interest payment expenses.
If dividends are paid to stockholders, they are paid out of net income after taxes have been paid. After dividends have been paid, the remaining income is added to retained earnings and is available to invest in the business.
income statement shows
whats comes in, what goes out and how much is left before taxes
balance sheet reports
The balance sheet reports what resources (assets) a company owns and how
it has funded them. How the firm has financed the assets is revealed by the capital structure—for example, long-term debt and owners’ equity (preferred stock, common stock, and retained earnings)
interest payments _____a corporations taxable income
dividend payments to stock holders are paid from ___
because dividends are taxable as income to stockholders, they are taxed
interest payments are taxed
reduce
after tax dollars
twice
once
Accounting for depreciation
As mentioned earlier, when reviewing the balance sheet, fixed assets are shown at their cost minus accumulated depreciation. For these assets, which wear out over a period of time, tax law requires that the loss of value be deducted over the asset’s useful life, longer for some assets, shorter for others (you won’t have to know depreciation schedules). On the income statement, the allowable portion for the year is shown as an expense and, for our purposes, will generally be part of COGS. Remember, if the company uses accelerated depreciation, the expenses will be higher in the early years, resulting in lower pretax income (and lower-income taxes) but higher income later on.
earnings per share
EPS= Earns available to common
__________
number of shares outstanding
SPS after dilution
assumes that all convertible securities, such as warrants and convertible bonds and preferred stock, have been converted into the common. Because of tax adjustments, the calculations for figuring EPS after dilution can be complicated and will not be tested.
current yield (dividend yield)
A common stock’s current yield (CY), like the current yield on bonds, expresses the annual income payout (dividends rather than interest) as a percentage of the current stock price:
CY= annual dividends per common share
_________
Market value per common share
dividend payout ratio
The dividend payout ratio measures the proportion of earnings paid to stockholders as dividends:
=Annual dividends per common share
___________
Earnings per share
In general, older companies pay out larger percentages of earnings as dividends. Utilities as a group have an especially high payout ratio. Growth companies normally have the lowest ratios because they reinvest their earnings in the businesses. Companies on the way up hope to reward stockholders with gains in the stock value rather than with high dividend income.
statement of cash flow
The statement of cash flow reports a business’s sources and uses of cash and the beginning and ending values for cash and cash equivalents each year. The three components generating cash flow are:
■ operating activities;
■ investing activities; and
■ financing activities.
Most financial professionals add revenues and expenses that do not involve cash inflows or outflows (e.g., cost allocations, such as depreciation and amortization) back to the company’s net income to determine the cash flow.
As described previously, the cash flow statement will also reflect money from operations, financing, and investing, but not accounting changes.
operating activities
Operating activities (all transactions and events that normally enter into the determina- tion of operating income) include cash receipts (money coming in) from selling goods or pro- viding services, as well as income from items such as interest and dividends. Operating activi- ties also include cash payments (money going out) such as cost of inventory, payroll, taxes, interest, utilities, and rent. The net amount of cash provided (or used) by operating activities is the key figure on a statement of cash flows. Even though it would seem that interest and dividends would belong in investing activities, the accounting gurus put them here.
investing activities
Investing activities include transactions and events involving the purchase and sale of securities, land, buildings, equipment, and other assets not generally held for resale as a prod- uct of the business. It also covers the making and collecting of loans. Investing activities are not classified as operating activities because they have an indirect relationship to the central, ongoing operation of the business (usually the sale of goods or services).
financing activities
All financing activities deal with the flow of cash to or from the business owners (equity financing) and creditors (debt financing). For example, cash proceeds from issuing stock or bonds would be classified under financing activities. Likewise, payments to repurchase stock (treasury stock) or to retire bonds and the payment of dividends are also financing activitie
cash flow from operations will only use
items from the income statement, while cash flow from financing activities will use balance sheet items.Make sure you know which one the question is asking about.
Earnings before interest and taxes
EBIT helps a fundamental analyst to evaluate a company’s performance without incorporating interest expenses or income tax rates. Without accounting for interest or taxes that are variables for every company, the fundamental analyst can focus on operating profitability as a single measure of success.
This is very important when comparing companies within an industry that have different debt obligations or tax obligations.
It is calculated from information found on the income statement.
earnings before taxes
With EBIT, the analyst has taken out the tax structure when evaluating a company in an industry—once again, making it easier to compare companies within an industry. Note that a highly-leveraged company will have a relatively higher interest expense, and a lower EBT to a company with less debt obligations.
price-to-earnings ratio
The widely used price-to-earnings (P/E) ratio provides investors with a rough idea of the relationship between the prices of different common stocks compared with the earnings that accrue to one share of stock.
Current market price of a common share
_______
earnings per share
if the stocks market price and P/E are known, the EPS can be calculated
Current market price of common stock
_________
P/E ratio
technical analysis
Technical analysis attempts to predict the direction of prices on the basis of historic price and trading volume patterns when laid out graphically on charts.
Both technical and fundamental analyses attempt
to predict the supply and demand of markets and individual stocks.
fundamental analysis
concentrate on broad-based economic trends; current business conditions within an industry; and the quality of a particular corporation’s business, finances, and management.
market averages and indexes
Stock prices tend to move, or trend, together, although some move in the opposite direction. The average stock, by definition, tends to rise in a bull market and decline in a bear market. Technical analysts chart the daily prices and volume movements of individual stocks and market indexes to discern patterns that allow them to predict the direction of market price movements.
trading volume
Market trading volume substantially above normal signifies or confirms a pattern in the direction of prices. If overall volume has been listless for months and suddenly jumps significantly, a technical analyst views that as the beginning of a trend.
support and resistance levels
Stock prices may move within a narrow range for months or even years.
The bottom of this trading range is known as the support level;
the top of the trading range is called the resistance level.
bearish breakout
A decline through the support level
bullish breakout
a rise through the resistance level
breakouts usually signal the
beginning of a new upward or downward trend.
market breadth
The number of issues closing up or down on a specific day reflects market breadth. The number of advances and declines can be a significant indication of the market’s relative strength. When declines outnumber advances by a large amount, the market is bearish even if it closed higher. In bull markets, advances substantially outnumber declines.
advance/decline line
Technical analysts plot daily advances and declines on a graph to produce an advance/decline line that gives them an indication of market breadth trends.
charting stocks
In addition to studying the overall market, technical analysts attempt to identify patterns in the prices of individual stocks.
trendlines
Although a stock’s price may spike up or down daily, over time its price tends to move in one direction. Technical analysts identify patterns in the trendlines of individual stocks from graphs as they do patterns in the overall market. They base their buy or sell recommendations on a stock’s price trendline. An upward trendline is bullish; a downward one is bearish.
consolidations
If a stock’s price stays within a narrow range, it is said to be consolidating. When viewed on a graph, the trendline is horizontal and moves sideways, neither up nor down.
reversal
A reversal indicates that an upward or a downward trendline has halted, and the stock’s price is moving in the opposite direction. Between the two trendlines, a period of consolida- tion occurs, and the stock price levels off. A genuine reversal pattern can be difficult to rec- ognize because trends are composed of many rises and declines, which may occur at different rates and for different lengths of time.
saucer
Because of its gently curving shape, an easily identifiable reversal pattern
(reversal of a downtrend)
inverted saucer
reversal of an uptrend
head and shoulders
named for its resemblance to the human body.
head and shoulders top indicates
the beginning of a bearish trend in the stock. First, the stock price rises, then it reaches a plateau at the neckline (left shoulder). A second advance pushes the price higher, but then the price falls back to the neckline (head). Finally, the stock price rises again, but falls back to the neckline (right shoulder) and contin- ues downward, indicating a reversal of the upward trend.
head and shoulders bottom
and indicates a bullish reversal.
If market indexes such as the S&P 500 and the Dow are declining, but the number of declining stocks relative to the number of advancing stocks is failing (fewer stocks declining),
the market is said to be oversold and is likely to reverse itself.
Conversely, if market indexes are rising, but the number of declining stocks relative to the number of advancing stocks is rising (fewer stocks rising),
the market is said to be overbought and is ready for a correction.
technical analysis
Technical analysts follow various theories regarding market trends. Some of them are outlined next.
Dow Theory
Analysts use the Dow theory to confirm the end of a major market trend.
According to the theory, the three types of changes in stock prices
Primary trend(1 year or more) Secondary trend(3-12 weeks) short term fluctuations(hours or days)
odd-lot theory
Typically, small investors engage in odd-lot trading. Followers of the odd-lot theory believe that these small investors invariably buy and sell at the wrong times. When odd-lot traders buy, odd-lot analysts are bearish. When odd-lot traders sell, odd-lot analysts are bullish.
This theory goes way back in time. Think of the 1930s when a house might have cost $4,000. People took out mortgages for that kind of money. If a stock is priced at $40, and a round lot of that stock cost $4,000, most people didn’t have that kind of money. So they bought one or two shares because that is what they could afford. They were not necessarily well-informed investors and often traded on emotion—buying when they should have sold, selling when they should have bought.
The standard trading unit for equity securities
odd lot is
a round lot (100 shares)
less than 100 shares
short interest
refers to the number of shares that have been sold short. Because short posi- tions must be repurchased eventually, most analysts believe that short interest reflects man- datory demand, which creates a support level for stock prices. High short interest is a bullish indicator, and low short interest is a bearish indicator.
equity securities
Corporations issue equity (and debt) securities as a means of raising capital in order to implement ideas such as expanding operations or funding a merger or acquisition.
Investing in equity securities is perhaps the most visible and accessible means of creating wealth. Individual investors become owners of a publicly traded company by buying stock in that company. In doing so, they can participate in the company’s success over time. They also share in the risk of operating a business; they can lose their investment.
Equity securities are more risky for investors compared with bonds, because once you pay for a security, the issuer is under no obligation to ever give you any of your money back.
two types of equity securities
The two primary types of equity securities most investors are familiar with are common and preferred stocks. These are considered ownership positions in a corporation. All corporations issue common stock. Each share of common stock entitles its owner to a portion of the company’s profits and dividends and an equal vote on directors and other important matters. Most corporations are organized in such a way that their stockholders regularly vote for and elect candidates to a board of directors (BOD) to oversee the company’s business. By electing a BOD, stockholders have some say in the company’s management but are not involved with the day-to-day details of its operations.
common stock
Corporations may issue two types of stock: common and preferred. When speaking of stocks, people generally refer to common stock. Preferred stock represents equity ownership in a corporation, but it usually does not have the same voting rights or appreciation potential as common stock. Preferred stock normally pays a fixed, semiannual dividend and has priority claims over common stock; that is, the preferred is paid first if a company declares bankruptcy. Common stock can be classified as: ■ authorized; ■ issued; ■ outstanding; and ■ treasury.
authorized stock
refers to a specific number of shares the company has authorization to issue or sell. This is laid out in the company’s original charter. Often, a company sells only a portion of the authorized shares to raise enough capital for its foreseeable needs. The company may sell the remaining authorized shares in the future or use them for other purposes. Should the company decide to sell more shares than are authorized, the charter must be amended through a stockholder vote.
issued stock
has been authorized and distributed to investors. When a corporation issues, or sells, fewer shares than the total number authorized, it normally reserves the unissued shares for future needs, including:
■ raising new capital for expansion;
■ paying stock dividends;
■ providing stock purchase plans for employees or stock options for corporate officers;
■ exchanging common stock for outstanding convertible bonds or preferred stock; or
■ satisfying the exercise of outstanding stock purchase warrants.
Authorized but unissued stock does not carry the rights and privileges of issued shares and is not considered in determining a company’s total capitalization.
outstanding stock
includes any shares that a company has issued but has not repurchased— that is, stock that is investor owned.
treasury stock
Treasury stock is stock a corporation has issued and subsequently repurchased from the public. The corporation can hold this stock indefinitely or can reissue or retire it. A corporation could reissue its treasury stock to fund employee bonus plans, distribute it to stockholders as a stock dividend, or under certain circumstances, redistribute it to the public in an additional offering. Treasury stock does not carry the rights of outstanding common shares, such as voting rights and the right to receive dividends.
By buying its own shares in the open market, the corporation reduces the number of shares outstanding. If fewer shares are outstanding and operating income remains the same, EPS increase. A corporation buys back its stock for a number of reasons, such as to:
■ increase EPS;
■ have an inventory of stock available to distribute as stock options, fund an employee
pension plan, and so on; or
■ use for future acquisitions.
common shareholders rights
Common stockholders use their voting rights to exercise control of a corporation by electing a BOD and by voting on important corporate policy matters at annual meetings, such as:
■ issuance of convertible securities (dilutive to current stockholders) or additional common stock;
■ substantial changes in the corporation’s business, such as mergers or acquisitions; and
■ declarations of stock splits (forward and reverse).
Stockholders have the right to vote on the issuance of convertible securities because they will dilute current stockholders’ proportionate ownership when converted (changed into shares of common).
calculating the number of votes
A stockholder can cast one vote for each share of stock owned. Depending on the com- pany’s bylaws and applicable state laws, a stockholder may have either a statutory or cumula- tive vote.
statutory voting
Statutory voting allows a stockholder to cast one vote per share owned for each item on a ballot, such as candidates for the BOD. A board candidate needs a simple majority to be elected.
cumulative voting
Cumulative voting allows stockholders to allocate their total votes in any manner they choose.
Shareholders do not vote on dividend-related matters,such as when they are declared and how much they will be.
they do
They do vote on stock splits, board members, and issuance of additional equity-related securities such as common stock, preferred stock, and convertible securities.
cumulative voting benefits the
statutory voting benefits
smaller investor
larger shareholders
t is not uncommon for one company to attempt to takeover another by acquir- ing a significant percentage of its voting shares.
known as
tender offer
A tender offer may also be made by an issuer of noncallable bonds when interest rates have fallen.
The SEC defines tender offer as “an active and widespread solicitation by a company or third party (often called the bidder or offeror) to purchase a substantial percentage of the company’s securities. Bidders may conduct tender offers to acquire equity (common stock) in a particular company or debt issued by the company. A tender offer where the company seeks to acquire its own securities is often referred to as an issuer tender offer. A tender offer where a third party seeks to acquire another company’s securities is referred to as a third party tender offer.”
In general, tender offers for equity securities need shareholder approval.
proxies
Stockholders often find it difficult to attend the annual stockholders’ meeting, so most vote on company matters by means of a proxy, a form of an absentee ballot. After it has been returned to the company, a proxy can be automatically canceled if the stockholder attends the meeting, authorizes a subsequent proxy, or dies. When a company sends proxies to shareholders, usually for a specific meeting, it is known as a proxy solicitation.
Companies that solicit proxies must supply detailed and accurate information to the shareholders about the proposals to be voted on. Before making a proxy solicitation, companies must submit the information to the SEC for review.
If a proxy vote could change control of a company (a proxy contest), all persons involved in the contest must register with the SEC as participants or face criminal penalties. This registration requirement includes anyone providing unsolicited advice to stockholders about how to vote. However, registered representatives who advise customers who request advice are not considered to be participants. A stockholder may revoke a proxy at any time before the company tabulates the final vote at its annual meeting.
The cost of forwarding proxy material, annual reports, information statements, and other material to shareholders is reimbursed by the issuer to the member firms that send the materials. Reimbursed expenses include postage (including return postage) at the lowest available rate, the cost of envelopes (if not provided by the issuer), and communication expenses (excluding overhead) incurred when receiving voting returns either electronically or over the phone.
nonvoting common stock
Companies may issue both voting and nonvoting (or limited voting) common stock, normally differentiating the issues as Class A and Class B, respectively. Issuing nonvoting stock allows a company to raise additional capital while maintaining management control and continuity without diluting voting power.
preemptive rights
When a corporation raises capital through the sale of additional common stock, it may be required by law or its corporate charter to offer the securities to its common stockholders
before the general public. This is known as an antidilution provision. Stockholders then have a preemptive right to purchase enough newly issued shares to maintain their proportionate ownership in the corporation.
limited liability
Stockholders cannot lose more than the amount they have paid for a corporation’s stock. Limited liability protects stockholders from having to pay a corporation’s debts in bankruptcy.
inspection of corporate
Stockholders have the right to receive annual financial statements and obtain lists of stockholders. Inspection rights do not include the right to examine detailed financial records or the minutes of BOD meetings.
residual claims to assets
If a corporation is liquidated, the common stockholder (as owner) has a residual right to claim corporate assets after all debts and other security holders have been satisfied. The com- mon stockholder is at the bottom of the liquidation priority list.
stock split
Although investors and executives are generally delighted to see a company’s stock price rise, a high market price may inhibit trading of the stock. To make the stock price attractive to a wider base of investors—that is, retail versus institutional investors—the company can declare a stock split.
foward split
A forward stock split increases the number of shares and reduces the price without affect- ing the total market value of shares outstanding; an investor will receive more shares, but the value of each share is reduced. The total market value of the ownership interest is the same before and after the split.
reverse split
A reverse split has the opposite effect on the number and price of shares. After a reverse split, investors own fewer shares worth more per share.
capital appreciation
An increase in the market price of shares is known as capital appreciation. Historically, owning common stock has provided investors with high real returns.
income
Many corporations pay regular quarterly cash dividends to stockholders, but dividends are not considered to be fixed like the dividend stated on preferred stock. A company’s dividends may increase over time as profitability increases. Dividends, which can be a significant source
of income for investors, are a major reason many people invest in stocks. Issuers may also pay stock dividends (additional shares in the issuing company) or property dividends (shares in a subsidiary company or a product sample).
Stock dividends, rather than cash dividends, are more likely to be paid by companies that wish to reinvest earnings for research and development. Technology companies, aggressive growth companies, and new companies are examples of companies likely to pay stock a stock dividend. When a stock dividend is paid, the shareholder receives more common stock of the issuer. There is no economic benefit, because the price of the security is reduced by the amount of the distribution on the morning of the ex-date.
just read it
preferred stock
Preferred stock is an equity security because it represents ownership in the corporation. However, it does not normally offer the appreciation potential associated with common stock. Not all corporations issue preferred stock.
Like a bond, a preferred stock is issued with a fixed (stated) rate of return. In the case of the preferred stock, it is a dividend rather than interest that is being paid. As such, these securities
are generally purchased for income. Although the dividend of most preferred stocks is fixed, some are issued with a variable dividend payout known as adjustable-rate preferred stock. Like other fixed-income assets such as bonds, preferred stock prices tend to move inversely with interest rates. Most preferred stock is nonvoting.
Preferred stock does not typically have the same growth potential as common stock and therefore is subject to inflation risk. However, preferred stockholders generally have two advantages over common stockholders.
■ When the BOD declares dividends, owners of preferred stock must receive their stated dividend in full before common stockholders may be paid a dividend.
■ If a corporation goes bankrupt, preferred stockholders have a priority claim over common stockholders on the assets remaining after creditors have been paid.
Because of these features, preferred stock appeals to investors seeking income and safety.
fixed dividend
Preferred stock’s fixed dividend is a key attraction for income-oriented investors. Normally, a preferred stock is identified by its annual dividend payment stated as a percentage of its par value, which is usually $100 on the Series 7 exam. (A preferred stock’s par value is meaningful to the investor, unlike that of common stock.) A preferred stock with a par value of $100 that pays $6 in annual dividends is known as a 6% preferred. The dividend of preferred stock with par value other than $100 is stated in a dollar amount, such as a $6 preferred.
The stated rate of dividend payment causes the price of preferred stock to act like the price of a bond: prices and interest rates have an inverse relationship.
preferred stock represents
ownership in a company like common stock but is sensitive to interest rates- just like the price of a bond
preferred stock unlike bonds has no preset date at which it matures and no scheduled redemption date or maturity levels
straight preferred
has no special features beyond the stated dividend payment. Missed dividends are not paid to the holder. The year’s stated dividend must be paid on straight pre- ferred if any dividend is to be paid to common shareholders.
cumulative preferred
Buyers of preferred stock expect fixed dividend payments. The directors of a company in financial difficulty can reduce or suspend dividend payments to both common and preferred stockholders. With cumulative preferred, any dividends in arrears must be paid before paying a common dividend.
convertible preferred
A preferred stock is convertible if the owner can exchange each preferred share for shares of common stock. The price at which the investor can convert is a preset amount and is noted on the stock certificate. Because the value of a convertible preferred stock is linked to the value of the issuer’s common stock, the convertible preferred’s price fluctuates in line with the common.
Convertible preferred is often issued with a lower stated dividend rate than nonconvertible preferred because the investor may have the opportunity to convert to common shares and enjoy capital gains. In addition, the conversion of preferred stock into shares of common increases the total number of common shares outstanding, which decreases earnings per common share and may decrease the common stock’s market value. When the underlying common stock has the same value as the convertible preferred, it is said to be at its parity price.
participating perferred
In addition to fixed dividends, participating preferred stock offers owners a share of cor- porate profits that remain after all dividends and interest due other securities are paid. The percentage to which participating preferred stock participates is noted on the stock certificate. Before the participating dividend can be paid, a common dividend must be declared.
callable preferred
Corporations often issue callable preferred or redeemable preferred, which a company can buy back from investors at a stated price on the call date or any date thereafter. The right to call the stock allows the company to replace a relatively high fixed dividend obligation with a lower one should interest rates decline.
adjustable rate preferred
Some preferred stocks are issued with adjustable/variable dividend rates. Such dividends are usually tied to the rates of other interest rate benchmarks, such as Treasury bill and money market rates, and can be adjusted as often as semiannually.
preemptive rights
Existing stockholders have preemptive rights or stock rights that entitle them to main- tain their proportionate ownership in a company by buying newly issued shares before the company offers them to the general public.
rights offering
A rights offering allows stockholders to purchase common stock below the current market price. The rights are valued separately from the stock and trade in the secondary market during the subscription period.
A stockholder who receives rights may:
■ exercise the rights to buy stock by sending the rights certificates and a check for the required amount to the rights agent;
■ sell the rights and profit from their market value (rights certificates are negotiable securities); or
■ let the rights expire and lose their value.
subscription right certificate
A subscription right is a certificate representing a short-term (typically 30 to 45 days) privilege to buy additional shares of a corporation. One right is issued for each common stock share outstanding.
terms of the offering
The terms of a rights offering are stipulated on the subscription right certificates mailed to stockholders. The terms describe how many new shares a stockholder may buy, the price, the date the new stock will be issued, and the final date for exercising the rights.
