Equity Securities and Investment Fundamentals

Fundamentals of Stock Splits and Market Mechanics

• Definition of Stock Split: A stock split is a corporate action that increases the number of a corporation's outstanding shares without changing the proportionate equity ownership of its existing shareholders.
• Split Ratio: The specific ratio of the split (e.g., a 2-for-1 split) determines both the number of new shares to be issued and the corresponding proportional change in the price of the stock.
• Primary Purpose: The main objective of a stock split is to increase the marketability of the stock by reducing its market price, making it more accessible to a broader range of investors.
  • Example: In 2020, Apple announced a 4-for-1 stock split. Before the split, the stock traded at approximately $500$ per share. After the split, the price per share dropped to $125$. This price reduction increases marketability because more investors can afford a $125$ share than a $500$ share.
• Mechanics and Certificates: When a split occurs, investors receive a new certificate representing the additional shares.
• Par Value: The par value of the stock decreases in a manner that is proportionate to the split ratio.
• Approval Process:
  • A stock split must first be approved by the corporation's Board of Directors.
  • Subsequently, it must be submitted for a vote by the outstanding common shareholders for final approval or disapproval.
• Capitalization: The total capitalization (market capitalization) of the corporation remains unchanged by a stock split. The company does not receive any additional capital or money through this process.
  • Market Capitalization Formula: $\text{Market Capitalization} = \text{Outstanding Shares} \times \text{Current Market Price}$
  • Case Study (XYZ Company): XYZ has $2,000,000$ shares outstanding at a market price of $50$.
    • Initial Capitalization: $2,000,000 \times 50 = 100,000,000$
    • After a 2-for-1 split: Outstanding shares double to $4,000,000$ and the price is halved to $25$.
    • Ending Capitalization: $4,000,000 \times 25 = 100,000,000$ (Unchanged).
• Transfer Agent: In a publicly traded company, the transfer agent is the entity responsible for maintaining the accounting of shareholders who are entitled to receive the stock split or dividends.

Reverse Stock Splits

• Definition: A reverse stock split, also known as stock consolidation, is the opposite of a regular split. It decreases the number of outstanding shares while increasing the market price per share.
• Purpose: Companies often employ a reverse split to artificially inflate the market price of the stock, often to give the appearance of better performance when the company may actually be in trouble.
• Implications:
  • It is frequently viewed as a sign of financial distress within the company.
  • The par value of the stock increases proportionately to the reverse split.
• Identifying Split Types:
  • Regular Split: The larger number is the first number in the ratio (e.g., 2-for-1).
  • Reverse Split: The larger number is the second number in the ratio (e.g., 2-for-3).

Advanced Split and Price Calculations

Calculation Steps for New Shares

1. Express the split ratio as a fraction (First Number / Second Number).
2. Multiply this fraction by the current number of shares.
   • Example (2-for-1 split with 200 shares): $\frac{2}{1} \times \frac{200}{1} = \frac{400}{1} = 400 \text{ shares}$
   • Example (3-for-2 split with 200 shares): $\frac{3}{2} \times \frac{200}{1} = \frac{600}{2} = 300 \text{ shares}$
   • Example (2-for-3 reverse split with 200 shares): $\frac{2}{3} \times \frac{200}{1} = \frac{400}{3} = 133.33 \text{ shares}$

Fractional Share Rounding Policy

• For exam purposes, assume fractional shares are handled by rounding.
• If the decimal is below $.5$: Drop the decimal and keep the integer (e.g., $133.33 \rightarrow 133$ shares).
• If the decimal is $.5$ or higher: Round up to the next whole number (e.g., $133.5 \rightarrow 134$ shares).

Calculation Steps for New Market Price

1. Identify the total initial dollar value (Initial Shares $\times$ Initial Price).
2. Divide the total initial dollar value by the new number of shares.
   • 2-for-1 Example: Total value is $200 \times 20 = 4,000$. New price is $\frac{4,000}{400} = 10$
   • 3-for-2 Example: Total value is $200 \times 30 = 6,000$. New price is $\frac{6,000}{300} = 20$
   • 2-for-3 Example: Total value is $200 \times 30 = 6,000$. New price is $\frac{6,000}{133} = 45.11$

Critical Reading: Additional Shares

• Always Read the Full Question (RFQ). If a question asks for "additional shares" after a 3-for-2 split starting with $100$ shares:
  • New Total: $150$ shares.
  • Additional Shares: $150 - 100 = 50$

Equity Security Derivatives

• Definition: Securities that derive their value from an underlying common stock.
• Primary Types: Warrants, Rights, and Options.

Warrants

• Nature: A voluntary issuance ("want to") used as a "sweetener" to make a new securities offering more appealing.
• Definition: A long-term option to buy stock at a specified price (exercise price) from the issuing company.
• Value: Initially, warrants have no value because the exercise price is set higher than the current market price.
  • Example: Buying an IPO at $20$ with a warrant to buy more at $30$. If the stock rises to $45$ years later, the warrant has a Market Premium or Intrinsic Value of $15$ ($45 - 30 = 15$).
• Duration: Can last for years ($30$, $50$, $100$ years) or be perpetual.
• Underwriter Compensation: Warrants are sometimes paid to underwriters at a price lower than the public offering price.

Rights (Preemptive Rights)

• Nature: An obligatory issuance ("have to") if a company has a preemptive rights clause in its indenture.
• Definition: Allows existing shareholders to maintain their proportionate ownership by buying new shares before they are offered to the public.
• Mechanics: Each share of common stock held generally receives one right. Rights are issued for free to existing holders.
• Duration: Very short-term (maximum maturity of roughly $90$ days).
• Options for Rights Holders:
  1. Exercise/Subscribe to new shares through the transfer agent.
  2. Sell the rights in the market.
  3. Let the rights expire.
  4. Gift the rights.
  • Note: Shareholders may not redeem rights for cash from the issuer.
• Dilution: Shareholders who do not exercise their rights will have their proportionate ownership share reduced/diluted when the new shares are issued.
• Rights Calculation Example:
  • Outstanding shares: $1,000,000$.
  • New shares to be issued: $250,000$.
  • Calculation: $\frac{1,000,000}{250,000} = 4$
  • Result: It takes 4 rights to purchase 1 new share.
  • If an investor owns $1,000$ shares, they get $1,000$ rights. They can buy $\frac{1,000}{4} = 250 \text{ new shares}$.

Preferred Stock Fundamentals

• Equity Classification: Preferred stock represents ownership (equity) in a corporation.
• Priority: It has priority over common stock regarding dividend payments and asset distribution during liquidation.
• Fixed Income: Preferred stock is a fixed-income security. The dividend is stated as a percentage of par or a fixed dollar amount.
• Interest Rate Sensitivity: Like bonds, preferred stock has an inverse relationship with interest rates. When interest rates rise ($\uparrow$), the market price of outstanding preferred stock falls ($\downarrow$), causing yields to rise ($\uparrow$).
• Par Value: The default par value is $100$ unless a question specifies otherwise (e.g., $25$).
• Attributes: Generally lacks voting privileges and preemptive rights. It is less volatile than common stock and offers less capital appreciation potential.

Characteristics of Preferred Stock

• Cumulative: All dividends must be current—including any unpaid dividends from previous years (dividends in arrears)—before any dividend can be paid to common stockholders. Most preferred stock is cumulative.
• Convertible: Can be exchanged for a fixed number of common shares at the holder's discretion.
  • Parity/Tag: Convertible prices fluctuate more because they "play tag" with the common stock price to maintain Parity (equal value).
  • Dilution: Conversion increases common shares outstanding, which dilutes Earnings Per Share (EPS).
• Participating: Provides a minimum fixed dividend but allows the holder to share in additional corporate earnings if the company has an excellent year (fixed minimum, no maximum).
• Callable: Allows the issuer to demand the stock be returned (called away) for a price, usually at a slight premium over par.
  • Motivation: Companies call stock when interest rates drop so they can refinance at a lower dividend rate. This characteristic is beneficial to the issuer, not the investor.

Dividend Payments and Processes

• Definition: A distribution of a portion of a company's net profit to its stockholders.
• Forms of Payment: Cash, stock (unissued, treasury, or from another company), or products (rare, e.g., restaurant coupons).
• Eligibility: Cash dividends are paid on Common Stock, Preferred Stock, Mutual Funds, and ADRs.
  • Exclusion: Dividends are not paid on warrants or bonds (bonds pay interest).
• Taxation: Most are "qualified cash dividends," generally taxed at a federal rate of $15\%$.
• Short Positions: Investors who are short stock must owe dividends and splits to the lender of the stock.
  • Example: If short $200$ shares and a $10\%$ stock dividend is paid, the investor must now buy back $220$ shares to cover ($200 \times 1.10 = 220$).
• Accounting: Dividends are recorded as a current liability on the balance sheet on the declaration date. They are typically paid quarterly.

Important Dividend Dates (The DERP Chart)

1. Declaration Date: The date the Board of Directors announces the dividend.
2. Ex-Dividend (Ex-Date): The date the stock begins to trade without the dividend. This is set by the stock exchange or FINRA, not the company.
   • To receive a dividend, an investor must buy the stock at least one business day before the ex-date.
   • Buyers on/after the ex-date do not get the dividend; sellers on/after the ex-date do get it.
3. Record Date: The date the company closes its books to determine the list of shareholders eligible for the dividend.
   • Rule: For regular-way settlement ($T+1$), the Ex-Date and Record Date are the same day.
   • Cash Exception: For cash transactions (same-day settlement), the Ex-Date is the business day after the Record Date.
4. Payable Date: The date the dividend check is sent. This creates the taxable event for the year.

Dividend Yield Formula

• Formula: $\text{Current Yield} = \frac{\text{Annual Dividend}}{\text{Current Market Price}}$
• Note: Always use the annual dividend and the market price (not the purchase price).
• Example: Stock bought at $9$, market value $10$, quarterly dividend of $0.50$.
  • Annual Dividend: $0.50 \times 4 = 2.00$.
  • Current Yield: $\frac{2.00}{10.00} = 20\%$
• Due Bill: A statement of money owed used between broker-dealers to adjust for incorrect dividend payments.

Real Estate Investment Trusts (REITs)

• Structure: Companies that manage portfolios of real estate to earn profits for shareholders. They issue shares of common stock. Investors are shareholders, not partners.
• Taxation (90/75 Rule): To avoid double taxation at the corporate level, REITs must:
  • Pay out at least $90\%$ of their income to shareholders.
  • Invest at least $75\%$ of assets in real estate-related activities.
• Tax Treatment for Investors: Dividends are taxed at the individual's ordinary income tax rate, not the qualified dividend rate of $15\%$.
• Types of REITs:
  • Equity REITs: Own/manage property; income from rent; potential for capital gains from sales.
  • Mortgage REITs: Lend money for construction/mortgages; income from interest; highly leveraged.
  • Hybrid REITs: Combination of equity and mortgage.
• Characteristics:
  • Seeking income and capital appreciation.
  • Low correlation to stocks and bonds; provide stability and diversification.
  • No pass-through of losses or depreciation write-offs (unlike limited partnerships).
  • Public REITs must register with the SEC.
  • Private REITs are illiquid and not registered with the SEC.
• Exclusions: REITs are not investment companies, they are not redeemable, and they are not DPPs/Limited Partnerships.

Direct Participation Programs (DPPs)

• Structure: Typically organized as Limited Partnerships composed of a General Partner (GP) (manager with unlimited liability) and Limited Partners (LP) (investors with liability limited to their investment).
• Taxation (Conduit/Flow-Through Theory): Income and expenses flow through to the investors. The partnership files a tax return but pays no tax itself. Partners receive a Form K-1.
• Adjusted Basis: Represents the partner's economic interest.
  • Increases: Additional cash contributions.
  • Decreases: Cash distributions, partnership losses, non-deductible expenses, and depletion (for oil/gas).
• At-Risk Investment: Initial cash investment plus Recourse Loans (loans for which the investor is personally responsible). Non-recourse loans (where only collateral is at risk) generally do not increase at-risk basis.
• Advantages: Single tax status (no double taxation), capital risk limited to investment, write-offs from depreciation/depletion, professional management.
• Disadvantages:
  • Lack of Liquidity: The single biggest disadvantage; no active secondary market; GP must approve transfers.
  • Lack of control over management.
  • Tax code changes and IRS scrutiny.
• Other Alternative Investments: Include commodities futures, private equity, and derivatives.