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Aside from living frugally and saving money for emergencies, we all know that it’s important to invest your money in order to grow and compound your wealth over time.
How else can we prepare for retirement and live the life we want?
Perhaps you’re a beginner to stock investing and would like to learn more about the different types of shares issued by companies.
In the investing world, there are many types of investments for us to invest in to grow our money.
One of the best ways to build wealth quickly is to invest in stocks.
Stocks are very popular and are often touted as one of the best types of investments for long-term investors. It’s no surprise when the average annual return on the S&P 500 index is approximately 10% since the inception of the index.
In this post, we will go over what are shares and the different types of shares.
What are shares?
Shares represent a fraction of ownership in a corporation.
When you purchase shares issued by Apple, you become an Apple shareholder and own a very small portion of Apple.
Just because you’re an Apple shareholder doesn’t mean you can walk into any Apple store and walk out with an iPhone without paying. What you can get is a piece of Apple’s pie!
Trust me, the pie is much better than getting a free iPhone.
As Apple shareholders, you have the rights to receive a share of the profits (dividends) earned by Apple. The more shares you have, the bigger the slice of pie you’ll get.
There are other benefits of being a shareholder than getting a slice of pie, which we will talk about in a bit.
What is the importance of shares?
Why would a successful corporation issue shares and give people the opportunity to take control of the company? Why not just keep all the profit themselves?
The reason why companies issue shares to investors are because they need to raise money to fund their operations, pay off debt, invest in projects, and to expand into new markets.
You may have heard of the terms initial public offering (IPO) and “going public” and wondered what they meant.
These terms are used to describe companies issuing shares to the public for the first time.
Companies have to go through the IPO process in order to launch itself on the stock market so public investors can invest in them.
In addition to raising money to expand and grow their businesses, going public allow private company founders and early investors to sell their shares and monetize their investments.
Why do people buy shares?
As mentioned earlier, one of the best ways to build wealth is to buy stocks or invest in shares of companies.
Researchers have shown that stocks are more likely to outperform certificate of deposits, government bonds and corporate bonds in the long run.
Investors buy shares for the following reasons:
- Dividend payment: when a company is profitable and have money left over after paying its employees, creditors, and taxes, they are likely to distribute some of its earnings back to shareholders in the form of dividends.
- Capital appreciation: companies that perform well – expanding their businesses or generating record profits – will see their company shares increase in price. When stock prices rise, shareholders can sell their shares for more than what they bought it and walk away with capital gains.
- Voting rights: common stock or equity shares generally carry voting rights. When you have voting rights, you can vote on corporate matters, such as selection of the board of directors or mergers and acquisitions.
Different types of shares
Not all shares are created equally. Some shares enjoy more privileges than others.
Let’s take a look at the different classification of shares.
1. Ordinary shares or common stock
Just like ordinary plain vanilla ice cream, ordinary shares, also known as common shares or common stock in the U.S., are the most common type of shares issued by companies.
These are the type of stocks that most people like you and I invest in.
When you hold common shares, you are entitled to a company’s profit and have the right to vote on company matters.
Majority of profitable companies pay dividends but mind you, dividends are optional payments.
Companies that are doing well and making money are likely to return some of their profits back to shareholders by declaring dividends. However, companies facing financial difficulty may cut or stop dividend payments.
Common stock typically entitles shareholders the right to vote at shareholder meetings.
You can cast your vote to elect the next board of directors or whether the company should proceed with a proposed merger or acquisition.
The benefit of investing in common stock is that when companies perform well, the returns from dividends and capital appreciation are higher than other types of shares.
The drawback of common stock is that common stockholders are last in line if the company goes bankrupt. This means that everyone else, such as employees and creditors, are paid first before shareholders are paid. Common stockholders have a residual claim on company assets.
2. Non-voting shares
Non-voting shares have the same rights as common stock, except they carry no voting rights.
Issuing non-voting shares allow founders and management teams can raise funds without losing control of the company. By having greater control, outside investors are less likely to attempt hostile takeovers.
For retail investors like us, the fact that we don’t have the ability to vote doesn’t really concern us. As long as the people in charge are maximizing profits, non-voting shareholders will enjoy a steady stream of dividends.
3. Preferred shares
Preferred shares are also called preferred stock or preference shares. These types of shares have qualities of equity and debt securities.
Similar to common stock, preferred stock shareholders are entitled to dividends when companies declare them. Again, dividend payments are optional – companies are not required to pay dividends to shareholders.
Dividends for preferred stock are often expressed as a percentage of the par value or as a fixed amount. Here’s an example: Bank of America Corporation 5.875% Non-Cumulative Preferred Stock.
As the name suggests, preferred stock has preference over common stock when dividends are paid.
In the event of bankruptcy, preferred stock also gets paid before common shareholders are paid. However, preferred shareholders are paid after creditors, such as banks, suppliers, and bondholders, are paid.
In addition to having priority over common stock, preferred stock shareholders receive higher dividend payments compared to common stock.
Why does preferred stock receive higher dividends compared to common stock?
The trade-off for higher dividend payments is not having voting rights. Without voting rights, preferred shareholders don’t have a voice in selecting the board of directors or other company affairs.
Another reason is that preferred stock has limited price appreciation.
For instance, if a gold company struck gold and the gold mine happen to have way more gold than expected, the gold company’s common stock will likely soar due to the anticipation of higher profits.
Preferred stock prices, on the other hand, will likely move by a little bit because preferred shareholders receive fixed dividends even if the gold company is expected to earn more profits.
Types of preference shares
There are various types of preferred stocks in the market to serve the needs of different investors.
The common types of preferred stocks issued by companies are:
Cumulative preferred stock
Cumulative preferred stock offers investors dividend protection when company profits decline and are unable to pay dividends.
Dividends that were missed or not paid in full will be added to the next dividend payment. Cumulative preferred stockholders are paid in full before common stockholders receive any dividends.
For example, if a company pays $25 per cumulative preferred stock each year but missed two years of dividend payments. In the third year, the company will need to pay $75 in dividends per cumulative preferred stockholder before common stockholders can get their dividends.
Convertible preferred stock
Convertible preferred stock allows investors the option to convert their preferred shares to a predetermined number of common shares. Once the shares are converted to common stock, investors cannot convert the shares back to preferred stock.
Let’s assume that you are holding 10 shares of convertible preferred stock, which is valued at $20 per share, and you have the option to convert each share of preferred stock to five shares of common stock. If you want to profit by converting the shares from preferred stock to common stock, the price of the common stock needs to be at least $4 per share.
This type of stock allows holders to benefit from rising stock prices.
Participatory preferred stock
Participatory preferred stock also allows investors to participate in the success of company performance.
In addition to regular fixed dividend payments, this type of preferred stock offers investors the opportunity to receive extra dividends when the company achieves predetermined financial goals, such as sales or profits.
Let’s assume a company pays regular dividends of $8 per share of participatory preferred stock every year. Last year, the company did so well that profits soared 75% and decided to issue a special dividend of $1 per share of participatory preferred stock. Instead of receiving only $8 in dividends, participatory preferred stockholders will an extra dividend of $1. The total dividends will be $9 per share.
Callable preferred stock
As the name implies, a callable preferred stock allows the option to buyback their preferred stock at a fixed price in the future.
For instance, if a preferred stock is callable by the issuer at $50 and the price of the preferred stock in the market is $55, the company can exercise the right to repurchase the preferred stock at $50 from preferred stockholders.
Final words on the type of shares
As you can see, there are many types of shares in the market.
It’s important to understand what they are and how they are different before you invest in them.
Just because an investment is suitable for you doesn’t mean it’s right for me and vice versa.
Don’t forget that there’s always a price tag to investment options. Investments that offer favorable clauses to investors will be more expensive to buy (higher prices or lower yields).
Readers, I hope you learned a thing or two about the type of shares in today’s article. Feel free to leave your thoughts and comments about the types of shares you invest in below. What do you like or not like about each?