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Understanding Capital Stock

Updated on September 7, 2009

Capital stock represents ownership of an incorporated business. Total ownership is divided into a number of shares of stock, each share representing an equal fractional equity in the venture. Thus 100 shares of stock in a corporation with 50,000,000 shares outstanding represents ownership of 1/500,000 of that business.

Stock of publicly owned corporations is usually sold initially to investors by investment banking firms (also called "underwriters") that specialize in arranging and marketing new issues. In the United States, interstate offerings of $300,000 or more are registered with the Securities and Exchange Commission (SEC) and are described in a legal "prospectus" that must accompany any sale. Resale of stock, after the initial offering, is carried out on stock exchanges or in the over-the-counter market.

If two or more classes of stock are issued by a single company, the residual ownership is called "common stock," rather than "capital stock." Other classifications carry such names as "preferred stock" or "class A stock".

Characteristics of Capital (Common) Stock

Capital stock conveys certain specific rights. (1) The owner receives an engraved certificate evidencing his equity. Sale of the stock requires endorsement on this certificate or on a separate power-of-attorney form. (2) Stockholder funds are committed for the life of the company. However, any stockholder may sell his shares to someone else at any mutually agreeable price. The issuing company itself has no obligation to redeem its own stock. (3) The stockholder receives his pro-rata share of any dividends declared by the board of directors and, in the event of liquidation, his pro-rata share of any assets remaining after all debts have been paid. (4) Stockholders may inspect general corporate books and records. (5) In some companies, stockholders possess a "preemptive right" allowing them to subscribe to new issues of stock in proportion to their present ownership before the new stock can be offered to the general public. (6) Stockholders may vote on matters affecting the company, including the election of directors.

Terms Used with Capital Stock

Authorized Stock is the maximum number of shares allowed by the corporate charter. To issue more shares than presently authorized, a company must amend its charter to increase the authorization. Issued stock is the number of shares actually issued, which may be equal to or less than the number of shares authorized. Shares reacquired by the company after they have been issued are held as treasury stock or are canceled. Outstanding stock refers to issued stock less any treasury stock.

A stock split is the division of each outstanding share into two or more shares of correspondingly less value. A stock split does not affect the total size of the company nor any stockholder's proportional ownership. Companies often effect a stock split to make the market price more attractive to the average investor and in an effort to broaden ownership.

Corporate directors sometimes declare stock dividends, payable in new shares of stock, instead of the more normal cash dividend. Since each stockholder receives his proportional share of any stock dividend, his fractional interest does not change and he has nothing (except a new certificate) that he did not own previously. A stock dividend of 200% or 300% is equivalent to a 2-for-1 or 3-for-1 stock split, respectively.

For financial statement purposes, each share of stock is given a par, or stated, value. In the 19th century, par value was presumed to represent the amount of original investment. However, shares sometimes were issued for property, patents, or trademarks that often were of dubious value, and so the intent of par value was easily circumvented. When transaction taxes were levied on the basis of par value, many corporations changed to stock with a low or nominal par value, such as $1 per share. Other corporations issued no-par shares with a stated value for financial statement purposes.

Book value is the per-share amount of net assets shown on the corporate financial records. Because corporate assets are recorded at cost, which does not necessarily reflect current values, book value is seldom equal to either market value or liquidating value. Market value is the price of a share of stock in the stock market, as determined by the supply and demand of investors. In most instances, market value is based upon investor expectation for future earnings. Liquidating value is the amount per share that might be realized if all corporate assets were sold, all corporate debts paid, and any remaining funds distributed on a pro-rata basis to all capital stockholders.

Preferred Stock

Preferred stock is a class of ownership possessing certain specific preferences over common stock. Preferred stock is most often characterized by a prior claim to a limited dividend. A 7.5% preferred stock with a $50 par value promises that an annual cash dividend of $3.75 per share will be paid before dividends are paid to holders of common stock. Most preferred stock is also cumulative, which means that dividends "passed" (not paid) in any year must be made up in future years before dividend payments can be resumed on the common stock.

Some preferred stock is "convertible" into shares of common stock, permitting the stockholder to exchange his preferred stock for a specified number of shares of common. Such an exchange becomes beneficial when the market price of the common stock rises significantly.

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