Understanding stocks: an ATM for business funds

Overview of stocks:
Stocks are issued by a corporation to spread ownership of that corporation proportionally to those who own the shares. Usually a corporation will issue shares of stock to investors who purchase the stocks at a set price, usually during a public offering. In this way, a corporation with strong revenues/earnings or prospects of strong revenues/earnings can generate working capital by selling shares of stock. Thus the simple analogy of selling stocks acting similar to an ATM machine for businesses to get access to working capital funds.

Two types of stocks – common and preferred.
Corporations can offer two types of stocks to investors – common and preferred. Both have their pros and cons. Generally, common stock owners have voting rights on Corporate matters while preferred stocks do not, however, preferred stocks usually pay a defined high dividend and are first to get paid before common shares. There are variations to these two types of stocks including convertible preferred which can be traded for a certain number of common shares at a set price on a future date

What are additional pros and cons of each stock type?
Here are some general comparisons between common and preferred stocks:

- Common stock holders share a percentage ownership of the corporation and therefore a share of the corporation’s earnings. For this reason, the price of a stock usually increases as earnings grow. As a quick example, if there are 1 million common shares issued by the corporation and it earns $1 million in earnings, then each share of stock represents ownership of $1 in earnings. If the same corporation later earns $5 million in earnings, then each share of stock represents $5 in earnings. For this reason, you would expect to pay more for the stock when it represents $5 in earnings than when it used to represent only $1 in earnings.

- Common stock tend to increase and decrease in value as the underlying corporation’s earnings increase or decrease for the reasons explained above. For this reason, they are more risky that preferred stock. However, they can also experience much more increase in price for corporations that have strong earnings growth over time.

- Preferred stock is not as susceptible to variation in corporate earnings since they are guaranteed a set dividend payment first before common share holders can receive a dividend. For this reason, there is less risk for preferred stock owners and the stock price does not tend to fluctuate as much unless the corporation is losing money and in danger of paying the preferred dividend. Also, if the preferred stock has a future option to transfer into common shares, then those preferred stock prices do tend to more closely follow the price changes in the underlying common stock price while continuing to pay the set preferred dividend until converted to common stock.

- If the corporation sells more shares of common stock to the public, then this is considered a dilution of the existing stock owner’s percentage of ownership in the corporation. As an example, if the consider the same situation described above where the corporation has $1 million in earnings, if there are now another additional 1 million shares of stock issued (sold to the public), then there will be a total of 2 million shares representing a proportional ownership in the same $1 million earnings. In that case, each share of stock represents only 50 cents ($1 million in earnings divided by 2 million shares of common stock). In that case, the price of each common stock usually goes down when new shares are issued to the public in large quantities.

- Continuing the above thought, there are situations where issuing new common shares to the public actually increases the price of existing common stock. If the corporation is going to use the resulting funds from the sale of the new stock to further expand business and do other proactive things that will result in increased business and growth, then the fact that the corporation is able to generate these new funds quickly from the sale of stock and use those funds for growth can cause investors to want to buy more stock. The increased demand then can result in an increase in stock price, even though there could be a significant increase in the number of shares that dilutes ownership. Consider the situation mentioned earlier where the corporation first earned $1 million and later grew to earning $5 million for the same 1 million in common stocks. Assume the corporation sells another 1 million shares of stock at $10 each resulting in a total of $10 million in new funds to use for investment in growth (new plants, new products or services, perhaps purchase of a competitor, etc.). The result could mean the corporation grows from $1 million in earnings to $100 million in earnings over the same time period it would have only earned $5 million in earnings without the $10 million in new funds for investment in growth. If investors see this huge potential for new growth, they may want to pay more for these stocks, even with the large increase in new common stock shares being issued.

- Preferred stock owners usually have no vote in corporate matters since they don’t have any ownership in the corporation, only rights to a set dividend. For this reason, many corporations desire to sell preferred stock instead of common stock. The existing common stock owners do not have their percentage of ownership diluted while the corporation has access to the resulting funds from the sale of preferred stock to use for business needs. However, they are then on the hook to pay a high dividend to these preferred stock owners. Many corporations therefore issue these stocks with the right to buy them back in the future. In that case, they no longer need to pay the dividends.

Issuing stocks can be very expensive to the corporation.
There are many laws and regulations that must be followed very closely by corporations when they issue (sell) stocks to the public. For this reason, most of these corporations use firms that specialize in issuing stocks. These firms will take care of the legal aspects as well as marketing the stock to perspective investors. Also, these investors usually have to be accredited investors since the Securities and Exchange Commission (S.E.C.) assumes only accredited investors can understand the risks involved and have access to enough excess risk capital to use for investing in these types of offerings.

Summary:
Offering stock for sale to the public is a great way for a corporation to quickly get access to working capital funds to pay off debts, buy out competitors, invest for growth perhaps in developing and/or deploying new products or services, or to use for other business needs. As mentioned before, this can seem like a ATM for cash since it looks like the corporation simply prints stock certificates on paper and sells it to the public for cash. For companies with a strong future outlook, that is not too far from the truth. Sharing ownership in strong and growing companies is the root of capitalism and free enterprise at its best.

Next article in the series:
Next week, the next article will cover what happens when corporations are not able to sell stocks to raise funds - their ATM is broken.

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Please provide feedback to our generic email at MarcobeInvestmentsInc@gmail.com on questions you have, ideas for future articles, and any other thoughts that could lend themselves to future articles for the benefit of all readers. Happy investing to you.

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Copyright 2008 Ole Cram. Ole Cram is President of Marcobe Investments, Inc., a corporation that invests in various oil and gas ventures and refers accredited investors, investment managers, financial advisors, investment funds, and others to the associated oil producer of these projects for their consideration to also participate. We are not licensed to sell any interest in a project, nor are we registered advisors. Feel free to email us at MarcobeInvestmentsInc@gmail.com with any questions, thoughts, or requests for other topics to cover in future articles.

This article was posted at Accredited Investor Blog: http://accreditedinvestortalk.blogspot.com/. Key past articles related to investments in oil and gas can be found at http://www.MarcobeInvestmentsInc.com/Oil_and_Gas_Investor_TOC.html. This article is provided for educational purposes only and is not meant to be a substitute for tax, legal, financial, or other registered professional advice for your specific situation. Always seek the advice of a professional before making any related decision. Sphere: Related Content