Common Stock Characteristics and Features

3.1.1 Characteristics and Features

Understanding the characteristics and features of common stock is crucial for anyone preparing for the Series 7 Exam, as it forms the foundation of equity securities knowledge. This section delves into the intricacies of share structures, market and book values, and the implications of stock splits, providing essential insights for aspiring General Securities Representatives.

Authorized, Issued, and Outstanding Shares

One of the fundamental aspects of common stock is the classification of shares, which includes authorized, issued, and outstanding shares. Understanding these terms is essential for analyzing a company’s capital structure and evaluating its financial health.

Authorized Shares

Authorized shares refer to the maximum number of shares a corporation is legally permitted to issue as specified in its articles of incorporation. This number can be altered through shareholder approval, usually during a corporate meeting. Authorized shares provide a company the flexibility to raise capital, issue stock options, or undertake mergers and acquisitions without needing immediate shareholder approval for each transaction.

Issued Shares

Issued shares are the total number of shares that have been sold to and held by shareholders, including both public investors and insiders. Issued shares include all stock that has been sold and remains in the hands of investors, as well as treasury shares that the company has repurchased but not retired.

Outstanding Shares

Outstanding shares are those currently held by all shareholders, including institutional investors and company insiders, but excluding treasury shares. The number of outstanding shares is critical for calculating key financial metrics, such as earnings per share (EPS) and market capitalization.

Illustrative Figure: Share Structures

    graph TD;
	    A[Authorized Shares] --> B[Issued Shares];
	    B --> C[Outstanding Shares];
	    B --> D[Treasury Shares];

Market Value vs. Book Value

Understanding the distinction between market value and book value is essential for evaluating a company’s stock and making informed investment decisions.

Market Value

Market value, also known as market capitalization, is the total value of a company’s outstanding shares at the current market price. It is calculated by multiplying the current share price by the number of outstanding shares. Market value reflects the collective assessment of a company’s worth by investors and can fluctuate based on market conditions, investor perceptions, and company performance.

Book Value

Book value represents the net asset value of a company as recorded on its balance sheet. It is calculated by subtracting total liabilities from total assets. Book value per share is derived by dividing the book value by the number of outstanding shares. While market value reflects investor sentiment, book value provides a more stable, accounting-based measure of a company’s intrinsic worth.

Impact of Stock Splits and Reverse Splits

Stock splits and reverse splits are corporate actions that alter the number of a company’s outstanding shares and its stock price, without changing the company’s market capitalization.

Stock Splits

A stock split increases the number of shares outstanding by issuing more shares to current shareholders. For example, in a 2-for-1 stock split, each shareholder receives an additional share for every share they own, effectively doubling the number of shares while halving the share price. Stock splits are often executed to make shares more affordable and increase liquidity.

Example:

• A company with 1 million shares outstanding at $100 per share undergoes a 2-for-1 stock split.
• Post-split, the company will have 2 million shares outstanding at $50 per share.

Reverse Stock Splits

A reverse stock split reduces the number of shares outstanding by consolidating shares. For example, in a 1-for-2 reverse split, shareholders receive one share for every two shares they own, effectively halving the number of shares and doubling the share price. Reverse splits are often used to increase the stock price and meet listing requirements or improve the perception of the stock.

Example:

• A company with 1 million shares outstanding at $2 per share undergoes a 1-for-2 reverse split.
• Post-split, the company will have 500,000 shares outstanding at $4 per share.

Illustrative Figure: Stock Split vs. Reverse Split

    graph TD;
	    A[Pre-Split] --> B[2-for-1 Stock Split];
	    B --> C[Post-Split: 2x Shares, 1/2 Price];
	    A --> D[1-for-2 Reverse Split];
	    D --> E[Post-Split: 1/2 Shares, 2x Price];

Conclusion

Understanding the characteristics and features of common stock, including the distinctions between authorized, issued, and outstanding shares, as well as the differences between market and book values, is vital for making informed investment decisions. Additionally, recognizing the impact of stock splits and reverse splits helps in comprehending how these corporate actions affect share price and investor perception. This knowledge is not only essential for the Series 7 Exam but also for a successful career in the securities industry.

Series 7 Exam Practice Questions: Characteristics and Features