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Understand Stock Terminology

There are a number of important terms that you should understand before you begin working with stocks.

Common stock: Common stock is an ownership share of a company. The company initially sells common stock through an initial public offering, or IPO. The stock is then traded among investors in secondary markets. Owners of common stock take more risk than owners of other types of stock, but they also receive a greater reward if the company performs well.

Preferred stock: Preferred stock is also an ownership share of a company. However, this type of stock differs from common stock in that the dividend is guaranteed, and the dividend is paid before dividends on common stock are paid. However, if the company’s profits increase, the dividend is not increased accordingly, so return is limited.

Classes of stock: Some companies have multiple classes of stock; these multiple classes allow for ownership in a specific subsidiary of a company. Each class is designated for specific investment purposes. Companies may also have different dividend policies for different classes of stock.

Shareholders (stockholders): Shareholders, or stockholders, are investors who own shares, or equity, in a company. When you purchase shares of stock from a company, either individually or through a mutual fund, you become a partial owner in that company.

Voting rights: Shareholders have the right to vote on major policy issues. Usually, a shareholder is given one vote for each share of common stock that he or she owns. However, some companies issue different classes of shares, and some classes have extra voting rights. Generally, shareholders vote by proxy, a practice similar to voting with an absentee ballot.

Book value per share: The book value is the value of each share of the company’s stock after the company’s liabilities have been subtracted from the company’s assets. To find the book value per share, subtract the company’s liabilities from the company’s assets to find the company owner’s equity (as seen on a balance sheet); then divide this amount by the weighted average number of shares that are outstanding. The book value per share is based on the value the company’s assets at their purchase cost, less depreciation, or the amount the asset has decreased in value since it was purchased.  In other words, it is the value of the company’s assets at cost less their depreciated amount. A more meaningful ratio is the price-to-book ratio, which is found by dividing the market price per share by the book value per share. This ratio gives an indication of how much money you are paying for every dollar of assets.

Earnings per share: Earnings per share refers to the level of earnings of each share of stock—not necessarily the amount that will be paid out as dividends. Earnings per share are calculated by dividing the amount of company earnings (after payment of preferred stock dividends) after taxes by the weighted average number of shares that are outstanding. Earnings per share equals the net income minus preferred stock dividends divided by the weighted average number of common shares outstanding. The price earnings ratio, the current stock price divided by the earnings per share, may be more helpful. This ratio gives an indication of how much money you are paying for every dollar of earnings.

Dividend yield: The dividend yield refers to the annual yield of dividends per share divided by the current market price. The dividend yield indicates the amount of return on the current share price.

Stock splits: If the price of a stock is too high, most investors are reluctant to buy new shares. To keep the price of a company’s stock in the preferred buying range (roughly $6 to $100 per share) a company will often split a stock. A stock split of (x) for one stock would cause the current share price to decline by the stock price divided by (x). Through splitting a stock, a company is able to keep its share price within buying range. For example, assume you have ten shares of stock priced at $100 per share ($1,000 total). If the stock splits two-for-one, you would then have twenty shares (ten shares multiplied by two). The price of the stock would most likely decline from $100 per share to $50 per share ($100 divided by two). You would still have the same total value of $1,000, but the price for each share would now be $50 per share instead of $100 per share, and you would now have twenty shares instead of ten shares. While a stock split has no impact on a company’s value, it may be a positive indicator of the company’s prospects.

Reverse split: If the price of the company’s stock is too low, the company may do a reverse split: a reverse split reduces the number of shares outstanding and raises the stock’s price to bring the price closer to the preferred buying range. A reverse split is the opposite of a stock split.

Stock repurchases: Stock repurchases happen when companies buy back their own shares. This is generally positive for the investor because each time a company repurchases stock, the investor owns a larger proportion of the company.


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