What is a Common Stock?
Before we discuss what exactly a common stock is, we should first understand exactly how in history the joint stock company has been used, and what advantages this form of organization had over other forms at the time.
Before the invention of the joint stock company, if you wanted to start a business, and you needed capital of some form or another, you usually had to negotiate some sort of charter or agreement that usually set up a partnership. In essence, all parties to the partnership were owners in it in some way, usually delineated by the agreement. Unfortunately, this organization has many disadvantages: 1) ownership was harder to track, transfer, and acquire, 2) as a corollary to this, it was much harder to raise capital, and 3) the owners of the company usually did not enjoy shielding of liability. The first joint stock company was created around 1250 in France, but the idea didn’t really catch on until the discovery of the New World – the discovery, exploration, and colonization of which needed a better, more flexible business organization. If you have seen Pirates of the Caribbean, you know about the East India Trading Company; a joint stock company created in 1600 which exploited a Monarchy-granted monopoly of trade, which grew into one of the largest, most powerful organizations in the world.
Basically, the simple, but revolutionary idea behind a Joint Stock Company is that it is owned by shareholders. As a shareholder, you hold shares, or ownership interest in a company. This ownership interest entitles you to some pro-rata (proportionate to your ownership) share of the profits and losses of the company. The ownership of the equity of a company, is also determined by the proportion of ownership shares one has.
One of the primary benefits of the joint stock company was that capital could easily be raised by issuing more shares. Additionally, ownership stakes become more easily transferable, and the Joint Stock Companies Act 1844 created limited liability for this business organization. Thus, all the major problems of the original systems were solved. Another major benefit of this form was that the business always remained under the control of and for the shareholders traditionally through an elected Board of Directors who represent the shareholder’s interest and make important decisions about the company’s management team, dividend, direction, and lots of other big-picture issues.
Example – International Business Machines (IBM)
The way to think about shares is that they each represent a small “piece” of a company; that is, IBM is split into 1,117,000,000 different parts. Each one of those billion shares is owned by somebody, somewhere in the world.
Profit and EPS
In the last quarter of 2012, IBM generated $5,833,000,000 of profit from all of its operations. That means that each share of IBM was entitled to $5.30 of earnings for that quarter. This number is called the Earnings Per Share (EPS) and it can be calculated roughly like this:
EPS = (Net Income) / (Shares Outstanding)
If you owned 1,000 shares of IBM – just .9% of 1% of 1% the company – your portion of the company’s profits last quarter was $5,300. This number is called your look-thru earnings, it is the byproduct of a simple formula:
Look-Thru Earnings = (EPS) x (# Shares Owned)
= (Net Income) x (# Shares Owned / Shares Outstanding)
You can see in the math that your look thru earnings are basically just your percentage cut of the profits, in proportion to your ownership share.
Normally when you calculate these numbers you would use the year totals or the last 12 month totals. IBM, in the last 12 months, generated $16,604,000,000 in net profit, out of which each share was entitled to approximately $14.48. So your thousand shares of IBM would have earned you a cut of $14,480 of the profit.
I can’t stress enough the fact that the earnings per share tells you how much your shares of the company literally earned. Too much noise is made about capital gains in the media and we are not nearly as conditioned to think of stocks as what they are – portions of ownership in a company. One of the first distinctions Benjamin Graham makes in The Intelligent Investor is the distinction between Investing and Speculation; speculators are betting on a change of the quoted stock price to make profits, and investors focus on the earnings power each of their shares have, and will continue to have. It is important to realize that a significant portion of the total return of the stock market comes literally from the profit that these companies generate, and not just appreciation of the stock price.
When the Board of Directors wants to return the profits from the underlying business to the shareholders, they declare a dividend, the a portion of each shares EPS gets returned to the investors. This dividend comes as a check or direct deposit from the company directly into the owners mailboxes and bank accounts. Of course, the company doesn’t usually distribute all of the earnings they make, often times a significant portion is withheld for further reinvestment, growth, and other activities. The payout ratio is the percentage of the net earnings that are actually paid out:
Payout Ratio = (Dividend Per Share) / (EPS)
Of your 1,000 shares of IBM stock, you would have received 4x $850 dividend checks throughout the year totalling $3,400. That is cash that can be reinvested in IBM or other companies, or spent on vacations, clothes, furniture, and other items without touching the principal.
An important nuance about dividends is that dividends are really a reclassification on the balance sheet, when they are paid the stock price drops by the amount of the dividend (although it usually recovers from this drop quite quickly). What is happening is that the dividends are accounted for as a debit from Cash and a credit to Retained Earnings account. The “income” from the stock occurs every day the business is in operation, even though you just don’t see it yourself until you receive your dividend (which comes from, but is different from “income”).