How Corporations Work: Part 4

Today we are going to briefly talk about shares within a corporation, the difference between preferred vs common stock, and the dilution and buybacks of shares.

 

Shares, as mentioned earlier, represent an ownership within the company. Having ownership in a company can give you voting power, allowing you to have a say in the direction of the company, as well as dividends, a payment to you that comes from the profits of the company.  We can see then, from past information, how exactly a majority shareholder could take advantage of a company. The majority shareholder, someone who owns more than 50% of the shares for a company, can unanimously control who is on the Board of Directors. This means he could also vote themself as the Chairman of the Board. Since the Board of Directors is in control of dividend payment, the majority shareholder could pay themselves the appropriate dividends to themselves.

 

When referring to shares and voting rights, most people are referring to common stock. Common stock is the type of stock that allow shareholders to vote. Sometimes, common stock is divided into different groups, such as A-shares or B-shares. The difference between these two shares is the amount of voting rights given to them. For example, A-shares could have 5 votes per share, and B-shares could have only one. Intuitively, this means that A-shares are more expensive than B-shares. The disadvantage to common stock, however, comes into play when companies go bankrupt. During bankruptcy, companies must attempt to negotiate and pay all debts it owes to the debtors. This means that, after all the debtors are finished getting their share of the company’s profits, common stock owners are the last to obtain earnings.

 

The other type of stock is preferred stock. For preferred stock, while there is technical ownership of the company, individuals do not have voting rights. The trade-off for this disadvantage is that individuals obtain a predetermined dividend that is continuously paid out to the shareholder. The Board of Directors, instead of deciding how much in dividends to pay to the preferred stock owner, is obligated to pay out a set amount. When dividends are distributed to shareholders, preferred stock owners have priority in obtaining these dividends over common stock owners.

 

The value of a company is called its market capitalization. The price of shares is a function of a company’s market capitalization divided by the amount of shares the company has. In some cases, it could be useful for a company to control the amount of shares it has.

 

When a company wants to control the amount of shares it has, there are two main courses of action: dilution and buybacks. Dilution increases the amount of shares available to shareholders, and buybacks decrease the amount of shares available to shareholders.

 

During dilution, companies issue additional shares to buyers at a given price. A reason why a company may perform this action is that it needs a cash injection, and  it obtains this cash by selling ownership of a company instead of taking on a loan. When companies perform a stock dilution, and if shareholders do not buy these new shares, current shareholders have lower voting power, because they now own a smaller percentage of the company.

 

During buybacks, companies uses its cash reserves to buy back shares from shareholders. As we can see, this is the opposite of a dilution. One advantage of this is that lowering the amount of stock can increase its earnings per share in the future (the ratio of earnings of the company divided by the amount of shares in the company). The higher the earnings per share in a company, the more attractive buying that company’s stock is. During a buyback, shareholders who do not share their shares obtain more voting power, as they now own a larger percentage of the company.

 

It is important to note that dilutions and buybacks do not immediately change the financial situation of shareholders. Shareholders who have experienced a stock dilution may own less of a company, but the extra cash reserves of a company increases its market capitalization, balancing out the decrease in ownership. On the flip side, buybacks cause shareholders to have more ownership of the company, but because cash is used to purchase back stocks, shareholders now own a greater percentage of a less valuable asset. In both of these cases, the increases and decreases in ownership and market capitalization cause shareholders to be in the same situation as before.

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