1. Introduction
In the stock market, the hardest part is to evaluate a company’s valuation, so we don’t over pay for its common share shares, which are traded in public on stock exchanges. We will discuss briefly how a company go to the public market to get finance or money to fund its operations by issuing bonds, preferred shares, or common shares to other investors.
Figure 1. Overview of financing options by a corporation. Details are described in latter sections.
2. Capital gain or capital loss
Capital gain or capital loss was incurred after you had invested and sold some things such as bond coupons, preferred shares, or common shares.
Let’s the Present Value (PV) be the initial capital investment and the Future Value (PV) be the value or money collected after selling the investment.
FV – (PV + commissions) > 0
If FV is higher than (PV + commissions), we incurred capital gain, which will be subjected to taxes by government.
FV – (PV + commissions) < 0
If FV is lower than (PV + commissions), we incurred capital loss, which could be used to offset other capital gains to lower taxes by government.
3. Bonds
“Bonds are issued by governments and corporations when they want to raise money. By buying a bond, you're giving the issuer a loan, and they agree to pay you back the face value of the loan on a specific date, and to pay you periodic interest payments along the way, usually twice a year.”
“Unlike stocks, bonds issued by companies give you no ownership rights. So you don't necessarily benefit from the company's growth, but you won't see as much impact when the company isn't doing as well, either—as long as it still has the resources to stay current on its loans.”
“Bonds, then, give you 2 potential benefits when you hold them as part of your portfolio: They give you a stream of income, and they offset some of the volatility you might see from owning stocks.”
Source: What is a bond? | Vanguard - https://investor.vanguard.com/investing/investment/what-is-a-bond
Usually bond carries fixed interest rate for each bond unit/coupon, which is purchased by a bond holder. We could buy bond coupons from a stock exchange or bond broker, e.g. BMO Investorline. The bond holder couldn’t vote or participate in the company’s business operations or plans. This is kind of passive investors, who are lending money to a corporation to collect fixed interest and its initial capital back at maturity date.
Bond could be unsecured or unsecured, i.e. securely or insecurely tied to the asset of issued company. Usually unsecured bonds are offered at higher fixed interest rates for its higher risks.
Investors are buying bond units or bond coupons at fixed rate by the corporation. The price of bond coupons or units does fluctuate with the interest rate, which are set by central banks. The bond coupon rate is higher than interest rate, but its coupon price would go down if the interest rate goes up. Let’s consider an example, corporation ABC issues 5-year $10,000 coupon (face value) with bond rate of 5% while the interest rate out there is 2%. The interest of the coupon should be $10,000 * 0.05 = $500/year or $500 * 5 years = $2500. ABC would sell bond coupon as ($10,000 - $2500) = $7,500 each to bond buyers. Each $7,500 coupon would be paid as $10,000 by the end of 5 years from ABC. The bond rate is higher to make bond investors interested in buying, because they would deposit their money in saving account or Guarantee Investment Certificate (GIC) for 2% interest rates otherwise.
Assuming the interest rate is constant, each year bond traders would adjust the bond price on the bond market to maintain its coupon rate. For example, the above $7500 bond coupon with 5% would be priced as follows after second year: ($10,000 * 0.05) = $500/year or $500 * 3 years = $1,500. The coupon price could be traded as $10,000 - $1,500 = $8,500 on the bond market in the third year.
Let’s assume in end of second year, the interest rate goes up to 4%, which makes the bond coupon unattractive, because it’s risky to hold bond coupons than deposit money in GIC. Bond traders would adjust the bond coupon rate by trading the $8,500 coupon at lower price, e.g. $8,200 each. The $8,200 would still be $10,000 (face value) by the end of 5-year of its original issue date. However the coupon interest rate would be calculate as follows
$10,000 - $8,200 = $1,800 interests -> Bond interest is $1,800 / $8,200 = 21.95% for remaining 3 years. Each year bond would yield 21.95% / 3 = 7.32%. As we can see the coupon rate went up to make it attractive to new bond holders.
Corporations issue bonds to markets. They would use the money raised to fund business operations. After initial issuing, the bond coupons are traded or changed hands between bond investors, i.e. capital gain or capital loss is irrelevant to corporations.
4. Dividends
“In the U.S., most dividends are cash dividends, which are cash payments made on a per-share basis to investors. For instance, if a company pays a dividend of 20 cents per share, an investor with 100 shares would receive $20 in cash. Stock dividends are a percentage increase in the number of shares owned.”
Source: What Are Dividends and How Do They Work? | Investing 101 | US News - https://money.usnews.com/investing/investing-101/articles/what-are-dividends-and-how-do-they-work
Dividends are paid per share, which could be a preferred share or common share discussed below. The dividend could be increased or decreased, but its amount should be fixed annually. For example, the dividend payment could be $0.25 this year, but it could be $0.50, $0.20, or stay the same $0.25 per share next year.
Each company decided how frequent they would pay dividends to shareholders, e.g. monthly, quarterly, or annually. For example, $0.12 annual dividend could be paid once per year, or $0.03 per quarter, or $0.01 per month.
Dividend yield = (Annual dividend / Share price) * 100
If we took the dividend and divided it by its current share price, this would give the dividend yield. Therefore, the annual dividend yield would be decreased if share price went up, or increased if share price went down.
Usually we compared dividend yield of a preferred share or common share with interest rates offered by GIC or banks to evaluate its attractiveness against its risks.
5. Preferred shares
“Preferred shares (“preferreds”) are hybrid securities with both equity and fixed income characteristics. Similar to an equity security, a preferred share represents an ownership interest, generally does not have a maturity date and is recognized on the equity side of a company's balance sheet.” Written by BMO
“The main difference between preferred and common stock is that preferred stock gives no voting rights to shareholders while common stock does. Preferred shareholders have priority over a company's income, meaning they are paid dividends before common shareholders.”
Source: Understanding Preferred vs. Common Stock (investopedia.com) - https://www.investopedia.com/ask/answers/difference-between-preferred-stock-and-common-stock/
“Disadvantages of preferred shares include limited upside potential, interest rate sensitivity, lack of dividend growth, dividend income risk, principal risk and lack of voting rights for shareholders.”
Source: The Disadvantages of Preferred Shares (pocketsense.com) - https://pocketsense.com/disadvantages-preferred-shares-4527.html
As we can see from the above notes, preferred shares are for investors, who are interested in higher (more secured) dividends paid by corporations.
If the company didn’t have a lot of cash or slow business, they would only have enough cash to pay preferred shareholders, i.e. no dividends to common shareholders.
“Let’s take a simple example and see how it works.”
“Urusula has invested in preferred stocks of a firm. As the prospectus says, she will get a preferred dividend of 8% of the par value of shares. The par value of each share is $100. Urusual has bought 1000 preferred stocks. How much dividend will she get every year?”
“The basic two things to calculate the dividend are given. We know the rate of dividend and also the par value of each share.”
“Preferred Dividend formula = Par value * Rate of Dividend * Number of Preferred Stocks
= $100 * 0.08 * 1000 = $8000.”
“It means that every year, Urusula will get $8000 as dividends.”
Source: Preferred Dividend (Definition, Formula) | How to Calculate? (wallstreetmojo.com) - https://www.wallstreetmojo.com/preferred-dividend/
The preferred share price would fluctuate a little, but it is sensitive to interest rates in similar way as bond coupons described previously, i.e. its share price could go up or down in according with the interest rate.
The dividend paid to a preferred share is fixed based on its face value, but the actual dividend yield is varied based on traded price of a preferred share.
Corporations issue preferred shares, e.g. 1,000,000 preferred shares at $25 each with $0.25 annual dividend (5% dividend yield initially), to markets. They would use the money raised to fund business operations. After initial issuing, the preferred shares are traded or changed hands between preferred shares investors, i.e. capital gain or capital loss is irrelevant to corporations. Corporations only pay fixed dividend, e.g. $0.25 per share annually in this case, to each preferred share as initially stated. If share price goes up or goes down, the dividend yield would be changed accordingly.
6. Common share
Common shares are issued to business owners and other investors as proof of the money they have paid into a company. Of all shareholders, common shareholders have the least claim on a company’s assets.
Common shares make up one part of a company’s shareholder equity, which also includes any preferred shares that have been issued as well as any retained earnings.
Owners of common and preferred shares are typically compensated with dividends (money paid to them out of the company’s earnings after tax in return for using their capital). Common shareholders are paid dividends after preferred shareholders. In the event that a company needs to sell off its assets, common shareholders are not paid until all creditors have been satisfied and the preferred shareholders have been reimbursed.
Because shares are unsecured investments, a company is not required to repay shareholders for their original investment unless it legally declares that it will.
Source: What are common shares | BDC.ca - https://www.bdc.ca/en/articles-tools/entrepreneur-toolkit/templates-business-guides/glossary/common-shares
By looking at the above descriptions, we would likely to say that common shares should be the least favorable investment to investors. Actually common shares are mostly traded and preferred by investors, who are betting on business growth of a corporation. If a business is getting more profitable over years, its common share price would appreciate or be increased in value quickly. The bond price and preferred share price, which are paid with fixed dividends, are fluctuated very little or unchanged with exceptional business performance.
Corporations issue common shares to markets. They would use the money raised to fund business operations. After initial issuing, the common shares are traded or changed hands between common shares investors, i.e. capital gain or capital loss is irrelevant to corporations. Corporations only pay variable dividend to each shareholder depending on business performance or profits.
It is not easy to evaluate the real value of a corporation, so we could purchase its common shares on the market. We don’t want to over pay for our investment. However some good business with exceptional revenues and incomes would attract many investors, who would be willing to pay a premium to own its common shares.
Company valuation = Value of bonds issued + Price of all common shares + Price of all preferred shares
By looking at the above estimate formula, we would say the bond face value and preferred shares are fixed to a corporation, i.e. they could offer “face value” of those bond coupons and preferred shares as originally issued to cancel those.
The value of common shares would be varied in accordance with the performance of a corporation’s business.
The income of a business would be calculated as follows
Earnings = Revenue – Expense
· Revenues could come from sales of products, services provided to customers, etc.
· Expense could be interest paid to loans such as bonds, salaries, rents, raw materials to make products, etc.
The most common factor used in evaluating share price is “Earning per share (EPS)” and “(share) Price over earning ratio (PE)”.
· Earnings per share (EPS) is the portion of a company's profit allocated to each outstanding share of common stock.
· EPS (for a company with preferred and common stock) = (net income - preferred dividends) ÷ average outstanding common shares
· EPS is sometimes known as the bottom line—the final statement, both literally and figuratively, of a firm's worth.
Source: What Is the Formula for Calculating Earnings per Share (EPS)? (investopedia.com) - https://www.investopedia.com/ask/answers/070114/what-formula-calculating-earnings-share-eps.asp
PE = Share price / EPS
Stock analysts have compiled or calculated average PE for each industry. Therefore we could roughly estimate if a stock is traded below or above average PE of its industry.
Usually the lower the PE, the better for investors to purchase shares as it’s cheaper.
Therefore, a good business would grow their revenue at lowest expense in order to generate greater earnings or EPS. This would lower the PE of the corporation, and attract share buyers as a return. Because there would be many investors are interested to purchase shares of this corporation, the share price would be increased by existing investors, who want to sell their shares to new investors. In contrast, if EPS was decreased over time, its share price would be decreased as PE increased.
Most companies have forecast their earnings growth to investors. Based on the future Price over Earnings Growths (PEG) ratio, investors would decide if a stock was expensive or was attractive.
PEG = Price / (Future EPS growth)
If a stock with PEG ratio is around 1 or less, this stock should be considered reasonably priced or undervalued.
Most of good growth corporations are traded with PEG > 1, e.g. premium price, because investors are willing to pay a premium in order to hold shares. They are expecting EPS to keep growing year after year making stock cheaper in coming years, if share price was unchanged, i.e. future PEG will be decreased in this case.
The common share’s dividend payment is also changed based on business performance. If the company was doing well, they may raise common share dividend to share holders. In contrast, they may reduce or cut common share dividends to share holders to reserve cash to fund business operations in case of weak business performance.
Some common stocks or share prices have appreciated +1,000% within a year, some lost more than -50%, or even declared bankruptcy. It is a risk to invest in financial markets, but we must invest to maintain purchasing power or beat the inflation.
7. Who gets paid first if the company declares bankruptcy
· “If a company goes into liquidation, all of its assets are distributed to its creditors.”
· “Secured creditors are first in line” such as secured bond holders.
· “Next are unsecured creditors, including employees who are owed money,” and unsecured bond holders.
· “Stockholders are paid last.”
Source: Which Creditors Are Paid First in a Liquidation? (investopedia.com) - https://www.investopedia.com/ask/answers/09/corporate-liquidation-unpaid-taxes-wages.asp
Both preferred shareholders and common shareholders are considered as stock holders. Preferred shareholders are higher priority than common shareholders to claim remaining assets of a bankrupted company.
It is common that common shareholders got nothing left to claim when a company was liquidated or bankrupted.
8. Effects of inflation
You can say that financial investment is very risky, so why we should not keep cash safely in saving account at banks. The trouble was inflation rate keeps going up at higher rate than interest payment from a bank’s saving account.
Let’s assume that we have $9.00 cash reserved for 2 bags of milk at $4.50 each every week. The price of each bag of milk increased every year due to higher cost of worker’s salaries, food for cow, transportation cost due to gasoline price, etc. The
rising cost of a basket of consumer goods and services was measured in Consumer
Price Index (CPI).
· Mortgage Rate History - Super Brokers - https://www.superbrokers.ca/tools/mortgage-rate-history
The mortgage rate could go up significantly from this super low level in 2021.
Compare the above data with data about inflation as they’re co-related. Inflation goes high, and then interest rate does.
• Canada - Inflation rate 1986-2026 | Statista - https://www.statista.com/statistics/271247/inflation-rate-in-canada/
CPI rate is how they measure inflation rates
Historic inflation Canada – historic CPI inflation Canada - https://www.inflation.eu/en/inflation-rates/canada/historic-inflation/cpi-inflation-canada.aspx
By looking at the above data, the mortgage rate along with interest rate will go up as inflation rate increased. We need to maintain our savings to pay for daily essential expense as well as mortgage payment by investing our savings in financial markets.
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Author: Vinh Nguyen, B.Eng., LLQP
Email: canvinh@gmail.com
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