Reflective Questions

1. How do common shares compare to preferred shares in terms of

asset claims in the case of bankruptcy?
Position on asset claims in case of bankruptcy Senior creditors (such as banks),
bond and debenture holders, and preferred shareholders all have prior claims over
common shareholders on the company’s assets in case of bankruptcy. Common
shares, therefore, have a relatively weak position on asset claims.
2. How do common shares compare to preferred shares in terms of
dividend payments?
Dividends Unlike the payment of interest on outstanding debt, common share
dividends are payable at the discretion of the board of directors. In other words,
there is no guarantee of dividend income.
3. Can you describe the difference between a standard trading unit and
odd lots?
Stocks trade in uniform lot sizes on stock exchanges. A standard trading unit is a
unit whose size has uniformly been decided upon by the exchanges. The usual unit
of trading for most stocks is 100 shares. A group of shares traded in less than a
standard trading unit is called an odd lot.
4. Can you list nine benefits of common share ownership?
I. Potential for capital appreciation
II. The right to receive any common share dividends paid by the company
III. Voting privileges, including the right to elect directors, approve financial
statements and auditor’s reports, and vote on important issues
IV. Favourable tax treatment in Canada of dividend income and capital gains
V. Marketability—the shareholdings of most public companies can easily be
increased, decreased, or sold
VI. The right to receive copies of the annual and quarterly reports, as well as
other mandatory information pertaining to the company’s affairs
VII. The right to examine certain company documents, including its by-laws and
its register of shareholders, at specified times
VIII. The right to question management at shareholders’ meetings
IX. Limited liability
5. Can you list three risks of common share ownership?
I. The issuer has no obligation to pay dividends.
II. Common shareholders generally have very little influence over the day-to-
day operations of the company.
III. Common share prices can be volatile, and price changes can lead to investors
losing money.
IV. In terms of claims to assets, common shareholders fall behind creditors,
bondholders, and preferred shareholders in the case of bankruptcy or
dissolution.
 6. Can you define capital appreciation and explain the role it plays in
the value of common share ownership?
Capital appreciation is any increase in the value of a company’s assets, including
the value of its common shares. The prospect of capital appreciation is the main
attraction of common shares for many investors. A company’s net earnings may be
kept as retained earnings and reinvested in the business or distributed to
shareholders, in whole or in part, as dividends. When earnings are retained, the
value of the company’s common shares may increase. The size of shareholder’s
equity increases accordingly, which makes the stock more attractive to investors.
Higher demand for a company’s stock, and a corresponding increase in the
company’s value, can also result from increasing profits and dividend payments.
7. Can you describe the difference between a regular dividend and an
extra dividend?
Companies paying common share dividends might designate a specified amount to
be paid each year as a regular dividend. The term regular indicates to investors
that, barring a major collapse in earnings, those payments will be maintained. Some
companies may pay an extra dividend on the common shares, usually at the end of
the company’s fiscal year. The extra payment is a bonus paid in addition to the
regular dividend. The term extra indicates that investors should not assume that the
payment will be repeated the following year.
8. Can you compare the cum dividend period and the ex-dividend
period?
To determine whether the seller or the buyer is entitled to a dividend when a sale
takes place around the time of the dividend payment, the stock exchange names an
ex-dividend date. Before this date, shares are sold cum dividend (with dividend);
that is, the buyer receives the dividend. On and after this date, they sell ex-
dividend; that is, the seller retains the dividend. The first ex-dividend date is the
same day as the dividend record date. Because common and preferred share trades
settle on the first business day after a trade, an investor who buys shares on the
record date would not have the trade settle until the business day after the record
date. The buyer would therefore not be a shareholder of record and thus would not
receive the dividend. The last day a stock trades cum dividend is the business day
before the dividend record date.
9. If you purchased shares on a Monday, would you be able to describe
the ramifications of a dividend record date on Wednesday of that
same week?
When a stock is actively traded, the record of shareholders is continually changing.
For convenience, the issuing company names a date known as the dividend record
date, and all shareholders recorded as of this date are entitled to the declared
dividend. The dividend record date is usually two to four weeks in advance of the
payment date.
10. How does a dividend reinvestment plan work?
In such a plan, the company diverts the shareholders’ dividends to the purchase of
additional shares of the company. Reinvested dividends are taxable to the
shareholder as ordinary cash dividends, even though the dividends are not received
as cash. Share purchases, in most dividend reinvestment plans, are made on the
open market under the direction of a trustee. Participating shareholders are
periodically sent a statement showing the number of shares bought under the plan
(including fractional shares in some cases) and the price at which they were bought.
The provision in some plans for crediting participating shareholders with applicable
fractions of shares is unique. Normally, fractions of shares cannot be purchased in
the market by a shareholder. Under a reinvestment plan, the company uses
authorized dividends to purchase additional shares in bulk. For this reason, it pays a
lower commission than would an individual shareholder buying the same small
number of shares. The commission is particularly high for individuals when odd lots
are involved.
11. Can you define dollar cost averaging?
In effect, a dividend reinvestment plan is an automatic savings plan that allows
investors to reinvest small amounts of cash. Participating shareholders acquire a
regular, gradually increasing share position in the company at a reduced average
cost per unit. This process is known as dollar cost averaging.
12. How do cash dividends compare to stock dividends?
Some dividends are in the form of additional stock rather than cash. These so-called
stock dividends are typically paid by rapidly growing companies that must retain a
high proportion of earnings to finance future growth. Shareholders receiving stock
dividends can sell them if they require the cash. Stock dividends are recorded on a
company’s statement of retained earnings in the same fashion as cash dividends.
Because stock dividends are treated as regular cash dividends for tax purposes,
many investors, given the option, elect to receive dividends in cash.
13. Can you name the three categories of restricted shares and
describe each category?
Restricted shares (or special shares) give the shareholder the right to participate to
an unlimited degree in the earnings of a company and in its assets on liquidation,
but they do not carry full voting rights. There are three categories of restricted
shares:
 Non-voting shares carry no right to vote, except in certain limited
circumstances.
 Subordinate voting shares carry a right to vote if another class of shares is
outstanding and those shares carry a greater voting right on a per-share
basis.
 Restricted voting shares carry a right to vote, subject to a limit or restriction
on the number or percentage of shares that may be voted by a person,
company, or group.
 14. Can you list the stock exchange and securities commissions
regulations regarding restricted shares?
I. Restricted shares must be identified by the appropriate restricted share term.
II. Disclosure documents—including information circulars, annual reports, and
financial statements sent to voting shareholders—must also be sent to
holders of restricted shares, and the documents must describe the
restrictions on their voting rights.
III. Restricted shares must be identified in the financial press with a code.
IV. Dealer and advisor literature must properly describe restricted shares.
V. Trade confirmations must identify restricted shares.
VI. Holders of restricted shares must be given notice of shareholders’ meetings.
They must also be invited to attend and be permitted to speak at the
meetings.
VII. Minority approval is required for any corporate action that would result in the
creation of new restricted shares.
15. How do stock splits and reverse stock splits affect the number
of shares an investor owns, the price of the shares, and the
shareholder’s investment value?
With a stock split, the number of shares outstanding increases as the company will
issue more shares to the current shareholders. After the split, the stock’s price will
be reduced because the number of shares outstanding has increased. When the
market price of a company’s shares is too low, a reverse stock split can be used
to raise the price. The new price reflects the basis of the consolidation, and each
shareholder’s total shareholdings in the company are reduced accordingly.
The split itself does not affect the dollar value of the company’s equity, nor does it
change the proportion and value of a shareholder’s stake. Equity per share is
reduced as the total number of shares outstanding increases, but the equity section
of the statement of financial position remains unchanged.
16. Why do companies issue preferred shares compared to debt?
From a company’s viewpoint, preferred shares do not generally create the demands
that a debt issue creates. They do not usually have a maturity date, and if a
preferred dividend payment is omitted, no assets can be seized by preferred
shareholders. A corporation will choose to issue preferred shares rather than debt in
the following circumstances:
 It is not feasible for the company to market a new debt issue because
existing assets are already heavily mortgaged.
 Market conditions are temporarily unreceptive to new debt issues.
 The company has enough short- and long-term debt outstanding (i.e., its
debt-to-equity ratio is high).
 The directors are reluctant to assume the legal obligations to pay interest and
principal.
  The directors decide that paying preferred share dividends will not be
onerously expensive.
Preferred shareholders rank ahead of common shareholders but behind creditors
and debtholders in their claim to assets. Preferred shareholders are therefore better
protected than common shareholders but less protected than creditors and
debtholders. Because preferred shareholders usually have no claim on earnings
beyond the fixed dividend, it is fair for their position to be buttressed by a prior
claim on assets, ahead of the common shares. The common shareholder must be
content with anything that is left after all creditor, debtholder, and preferred
shareholder claims have been met.
17. Why do companies issue preferred shares compared to
common shares?
When a company has decided that it will not, or cannot, issue bonds or debentures,
it may find that conditions are not favourable for selling common shares either. The
stock market may be falling or inactive, or business prospects may be uncertain. In
such circumstances, preferred shares might be marketed as a compromise
acceptable to both the issuing company and investors. Preferred shares also offer
the advantage of avoiding the dilution of equity that results from a new issue of
common shares.
Preferred shares are usually entitled to a fixed or floating dividend expressed either
as a percentage of the par or stated value or as a stated amount of dollars and
cents per share. Dividends are paid from earnings, either current or past. However,
unlike interest on a debt security, dividends are not obligatory; they are payable
only if declared by the board of directors. If the board omits the payment of a
preferred dividend, there is very little the preferred shareholders can do about it.
However, in almost all cases, company charters provide that no dividends are to be
paid to common shareholders until preferred shareholders have received full
payment of the dividends to which they are entitled.
Directors have the right to defer the declaration of preferred dividends indefinitely.
In practice, however, dividends are paid if they are justified by earnings. Failure to
declare an anticipated preferred dividend has unfavourable repercussions. Besides
weakening investor confidence, the general credit and future borrowing power of
the company will suffer. Because most preferred shares can be considered fixed-
income securities, they do not offer the same potential for capital appreciation that
common shares provide for investors. Should interest rates decline, preferred share
prices will tend to increase in price, much like a bond. However, good corporate
earnings will have no effect on a preferred share’s dividend or claim to assets.
Therefore, the preferred share dividend rate is of prime importance to the preferred
shareholder.
18. Can you describe how cumulative and non-cumulative features
work?
Preferred share dividends can be cumulative or non-cumulative. If a company’s
board of directors votes not to pay one or more preferred share dividends when due,
and the preferred share has a cumulative dividend feature, the unpaid dividends
accumulate in what is known as arrears. All arrears of cumulative preferred
dividends must be paid before common share dividends are paid or before the
preferred shares are redeemed. With a non-cumulative dividend feature, arrears do
not accrue, and the preferred shareholder is not entitled to catch-up payments if
dividends resume. Most preferred shares in Canada have a non-cumulative dividend
feature.
19. Can you describe how a callable and non-callable feature
works?
Almost all preferred shares are callable, meaning they can be called or redeemed by
the issuer at a stated time and stated price. Depending on when a preferred share is
called, it may provide for the payment of a small premium above the issue price.
The premium is compensation to the investor whose shares may be called for
redemption.
20. What is a retractable preferred share? Can you describe what a
soft retractable preferred share is?
A preferred share with a retraction feature gives shareholders the right to force the
company to buy back the shares on a specified date at a specified price. Some are
issued with two or more retraction dates. The principle of retraction, or pulling back,
is identical to the principle for retractable bonds and debentures, which we
discussed in Chapter 6. The holder of a preferred share with a retractable feature
can create a maturity date for the preferred by exercising the retraction privilege
and tendering the shares to the issuer for redemption. With a hard retraction
feature, the company must pay the redemption value in cash. A soft retraction
feature allows the company to pay the redemption value in cash or common shares
of the issuer.
21. What is the advantage to an investor who owns a floating-rate
preferred share?
Floating-rate preferred shares pay a dividend that adjusts, or floats, based on either
a percentage of the Canadian Bank Prime Rate or the yield on 3-month Government
of Canada Treasury bills plus a spread. Some floating-rate preferred shares pay
dividends quarterly while others pay monthly. Dividend payments can be based on
the value of the floating-rate benchmark on the previous dividend payment date or
on the average value of the floating-rate benchmark during the current period.
Floating-rate preferred shares do not have a stated maturity date but can be called
by the issuer, usually after a set period after the issue date and regularly thereafter,
at prices determined at the time of issue.
22. Can you name a U.S. stock index and a U.S. stock average?
THE DOW JONES INDUSTRIAL AVERAGE: Although normally around 2,000 issues
trade daily on the New York Stock Exchange, the most publicity is given to the
trading performance of the 30 issues that make up the Dow Jones Industrial
Average. The DJIA has been criticized because so few companies are included in this
average, which means that it is not a truly representative indicator of broad market
activity. Also, because it is price-weighted, when a higher-priced stock rises, it may
distort the average. Even with the DJIA’s shortcomings, many people still use it as if
it were an overall indicator of market performance. The DJIA is calculated by adding
the prices of each of the 30 issues in the average and dividing by a specially
calculated divisor. The divisor was initially the number of stocks in the average –
originally 14 (12 railways and 2 industrials). Because of obvious distortion through
stock splits (a 2-for-1 split would mean a $100 share would become $50 in the
average after the split), the divisor was adjusted downward for each split.
THE S&P 500: Because the Dow Jones average is not completely satisfactory as an
indicator of broad market performance, other market indexes have been developed,
such as the Standard & Poor’s 500 Stock Composite Index. This index is based on a
large number of industrial stocks, some financial stocks, some utility stocks, and a
smaller number of transportation stocks, which are weighted in the index by their
market capitalization. Since the S&P 500 is weighted by market capitalization, more
heavily weighted stocks have a greater effect on the value of the index. The S&P
has become the main gauge for measuring the investment performance of
institutional investments in the United States because of its broad industry
coverage and the method of weighting the index. Many institutional investors have
created investment funds that track the S&P 500.
23. What is the mathematical difference between a stock average
and a stock index?
A stock index is a time series of numbers used to calculate a percentage change
of this series over any period of time. Most stock indexes are value-weighted and
are derived by using the total market value (i.e., market capitalization) of all stocks
used in the index relative to a base period. The total market value of a stock is
found by multiplying its current price by the number of shares outstanding.
A stock average is the arithmetic average of the current prices of a group of
stocks designed to represent the overall market or some part of it. Within a stock
index, each stock has a relative weight based on the stock’s market capitalization.
In contrast to a market-weighted stock index, stocks included in an average are
composed of equally weighted items (i.e., no specific weights are applied when
constructing the average). A stock’s relative weight within an index can change
every day, whereas a stock’s weight within an average is always the same.
However, stock averages are price weighted, which means that movements in the
average are tied directly to changes in the prices of the various stocks included in
the average. This occurs because some prices are higher than others and will
naturally have a greater influence on the average as a whole.
24. What does the S&P/TSX 60 Index measure?
The S&P/TSX 60 Index includes the 60 largest companies that trade on the TSX as
measured by market capitalization and is broken down into 11 sectors that cover all
S&P/TSX Index subgroups. All stocks listed on this index must also be included in
the S&P/TSX Composite Index.
COMMON SHARES
1. Why would a dividend payment reduce the price of the stock on the first ex
dividend day?
You can think of it in the following manner. The company, by paying a dividend, is
paying out a portion of its equity per share. Anyone buying stock on or after the first
ex-dividend date will not have access to that equity. So the value of the stock drops
in price equivalent to the dividend per share the company is paying out to eligible
investors.
2. How long does the ex-dividend period last for?
The ex-dividend period starts on the date of record and lasts until the dividend is
actually paid.
3. What is a dividend reinvestment plan?
A dividend reinvestment plan is a plan offered by a corporation allowing investors to
reinvest their cash dividends by purchasing additional shares or fractional shares on
the dividend payment date.
4. What is dollar cost averaging?
From the interactive glossary, dollar cost averaging refers to investing a fixed
amount of dollars in a specific security at regular set intervals over a period of time,
thereby [hopefully] reducing the average cost paid per unit.
For example if you buy 100 shares at $10 and another 100 shares at $8, your
average cost would be $9 rather than the original $10 you paid when you first
started buying shares.
This technique would increase the unit cost if prices were rising. Dollar cost
averaging really refers to averaging the cost per unit as a result of multiple
purchases. Since it’s a popular way to reduce the average cost by purchasing more
units at lower prices, that’s why the term is often associated with lowering costs.
5. Can you please give me a mathematical example of dollar cost averaging?
Here’s an example:
You buy $1,000 worth of shares of stock A when the price is $10 (total shares
purchased would be 100).
You buy $1,000 worth of shares of stock A when the price is $8 (total shares
purchased would be 125).
You buy $1,000 worth of shares of stock A when the price is $5 (total shares
purchased would be 200).
Total cost = $3,000
Total number of shares owned = 100 + 125 + 200 = 425
Average cost per share = $3,000 / 425 = $7.06
6. Why are some common shares noted as class A while others are noted as class
B?
Sometimes companies issue different types of shares to investors, and each type
carries special features. Most often, the distinction between classes has to do with
voting rights.
Most often the distinction between preferred share series has to do with the amount
of dividend offered on the share.
7. What constitutes minority approval?
Minority approval usually means a majority of the votes cast by minority
shareholders. Minority shareholders would include anyone who is not a stock
promoter, a director or officer or any other insider of the issuer.
8. Can you please explain share splitting and consolidation?
Splitting a share means you are splitting one share (like an axe through a tree
stump) into several shares. So if you split a $75 share with a ratio of 3:1, you end up
with three shares worth $25 a piece.
A consolidation means you are combining multiple shares into one (like gathering
the stumps and making them into a tree). If the shares are currently worth $75 a
piece and it’s a 3:1 consolidation or reverse split, you would end up with less shares
in the market and each new share would be worth $225 ($75 x 3).
Don’t look at the ratio number to try and figure out what to do on these types of
questions. You need to focus first on whether it is a split or reverse split (i.e.,
consolidation). Once you know that, it doesn’t matter how the ratio is stated (i.e., it
could state 3:1 or 1:3 and the result will still be the same).
If it’s a split, the 1 in the ratio is split into 3 (in this case). If it is a consolidation, the
3 in the ratio are consolidated into 1 (in this case).
9. What is a standard trading unit and an odd lot?
A standard trading unit is 100 shares. Less than a standard trading unit (also known
as an odd-lot) would be something less than 100 shares.
10. Why would trading standard trading unit be any better than trading odd lots?
Standardization often makes the market run more efficiently. Can you imagine if
everyone was trading whatever units they felt like? It would be hard to match up
someone trying to buy 64 shares with another selling 87. It’s much easier to match
up someone buying in units of 100 with those selling in units of 100.
11. If a company does not earn any income for the year, are they restricted from
declaring and paying dividends?
Having an income is not a requirement for declaring and paying dividends. There
are plenty of companies who, in poor economic conditions, lose money but still
declare and pay dividends to their shareholders. Dividends are declared and paid
out of retained earnings. So as long as a company has enough cash on hand to
cover a dividend, a dividend can be declared and paid.
12. Where do the company’s dividend payments come from?
When dividends are paid each year, the retained earnings of the company are
reduced. You may recall from somewhere in the text that retained earnings doesn’t
necessarily represent cash that the company has on hand. A lot of the profits
retained over the years are invested back into the company in the form of plants,
machinery, investments of other sorts, etc. The most important point about paying
dividends is the following: is there enough cash on hand? So even in a year when
the company has very low earnings, dividends can still be paid, provided the
company has enough cash in the cash account.
That means the extremely high payout ratios that you see are a result, as you
suggested, of a company with extremely low earnings but decided to make a
dividend payment with the cash they had on hand.
PREFERRED SHARES
13. What is the relationship between common share prices and preferred share
prices?
There isn’t a strict relationship between common share prices and preferred share
prices. You have to remember that common shareholders have basically purchased
a piece of the company and have claims on all equity items including retained
earnings. As profits rise and the company’s prospects look good, common share
prices tend to rise as well. Preferred shareholders do not have the same kind of
claim on the company. Preferred shareholders generally receive a fixed dividend and
don’t share in any other equity ownership claims on the company other than the par
value of their own shares. So while a common stock can soar in price, it’s not
unusual for a preferred share to move very little or remain, for the most part,
unchanged.
14. Are preferred shares considered fixed income securities like bonds?
Even though they provide fixed income, and you can refer to them as a type of
fixed-income security, preferred shares are still considered to be equity.
15. How do preferred shares differ from common shares?
Preferred shares do not appreciate in price the same way that common shares do.
Preferred shareholders do not participate in the profits of the company in the same
way as common shareholders are entitled to. When you buy a preferred share, what
you are essentially buying is a cash flow, i.e., the promise of a fixed dividend
payment on a regular basis.
So let’s say you paid $25 for a preferred share that pays a $1.50 dividend per year.
That’s a yield of 6% ($1.50 / $25). What happens if the general level of interest
rates rises well above 6% all the way to 10%? The value of your investment isn’t
worth as much as it was when interest rates were lower since you still only receive a
$1.50 dividend. Let’s say I wanted to buy your preferred share.
How interested do you think I would be in paying you $25 to buy something that
gives me a return of only 6% when I know I can probably find a short-term interest-
bearing security that pays closer to the going market interest rate of 10%? There’s
no way I’d pay you $25. In fact, you’ll have to drop your price significantly so that
$1.50 fixed dividend represents a greater return on the price of the shares. In other
words, you might have to drop your preferred share sale price as low as $15 in order
to attract my attention ($1.50 / $15 = 10%). If the preferred share yields
somewhere near the current market interest rate of 10%, I might consider buying
your shares.
So one of the most important considerations when buying preferred shares is the
yield and current level of market interest rates.
16. How do interest rates affect preferred share prices?
The price of a preferred share reacts to interest rates the same way bonds do, and
for the same reason.
If you own a preferred share with a par value of $25 and it pays a fixed dividend of
5% (or $1.25 annually), consider what happens if market interest rates jump to
10%. Investors can find securities that are paying returns of 10%, while your
preferred share is paying only 5%.
How much would you be able to sell your preferred share for, considering the buyer
will want a return near 10%? You would have to drop the price of your preferred
share to near $12.50 in order to attract other investors (keep in mind this is an
exaggerated example). As such, when interest rates rise, preferred share prices fall.
17. What does pari passu mean?
With respect to pari passu, what you need to know is that certain shares can be
grouped together as ranking the same in terms of preference to assets, and it’s the
issuer who decides the ranking. Shares that rank the same are described as ranking
pari passu.
18. A cumulative preferred feature is said to be an advantage for the investor. Why
would it be an advantage to the investor to allow the issuer to skip dividend
payments?
Surely it is in the investor’s best interest to have a cumulative feature when you
consider the alternative: non-cumulative preferred share.
Imagine you advise your client that it’s to their advantage to look for a preferred
share with a non-cumulative feature: the issuer then skips a payment and your
client finds out the feature you recommended means the issuer can skip a dividend
payment and NEVER have to pay that skipped payment to the investor. In the
meantime, I advise my client to look for a preferred share with a cumulative feature:
the issuer then skips a payment to my client, but the payment accumulates and will
have to be paid at some point as long as my client holds those shares. Our clients
meet in a coffee shop and discuss their preferred shares – one client is going to be
pretty happy, and the other client is going to be calling their advisor to ask for an
explanation as to why the advisor would recommend a non-cumulative preferred
share and suggest that the feature was an advantage to the client.
The argument that one investor can sell shares and lose out on the accumulated
dividends holds for just about any securities feature – you sell at the wrong time and
you miss out. But that doesn’t mean the issuer has gained an advantage, since the
issuer must still make payment at some point to someone. And it doesn’t negate
the advantage that investors have as a whole. It just means the one person who
sold is choosing to forego the advantage of the cumulative feature.
19. What is the difference between a callable and redeemable preferred share?
From the issuer’s perspective, callable and redeemable shares carry the same
meaning. You’ll sometimes hear of a company making a redemption announcement
for their preferred shares. This essentially means the issuer is calling back all of the
stock in exchange for cash. In most cases, an issuer that is calling back shares (i.e.,
an issuer that is redeeming shares) is paying cash to the investors based on some
predetermined formula or specification that was spelled out in the terms of issue.
20. Why does dilution occur when more shares are offered to investors?
Dilution occurs when new shares are issued, increasing the number of shares
already outstanding. The dilution refers to the effect that occurs to the ownership
stake that each owner shared in the company. When new shares are issued to the
public, ownership stakes generally shrink in size. In other words, the piece of the pie
that each owner enjoyed gets smaller.
21. Can you please explain equity dilution?
Dilution of equity occurs when a company issues more shares to the investing
public. The size of the company’s equity doesn’t change much by the issuance of
more shares, which means the additional shares result in owners sharing a smaller
piece of the pie in terms of ownership. This smaller size of equity per share is
referred to as dilution of equity.
22. Are preferred shares quoted in the financial press?
Preferred shares are quoted like common shares in the media. The current price of
the stock depends ultimately on supply and demand. However, in the case of
preferred shares, supply and demand is determined largely by what happens to
interest rates. As interest rates rise, preferred shares that pay fixed dividends
become less attractive, so their prices fall and their yields rise. Yield can be quickly
calculated by dividing the dividend by the current market price per share. Trading
on a yield basis essentially means that interest rate movements play a very large
role in the price movement of preferred shares.
23. I don’t understand why a variable rate dividend leads to different pricing
considerations than a fixed rate dividend. Please explain?
If an investment is very sensitive to interest rate changes because the investment
pays a fixed dividend, what happens when you let the dividend amount adjust to
changes in interest rates?
You take away the reason why the fixed-dividend investment moved so much in
price. As a result, the investment that changes its payments based on changes in
interest rates will be less inclined to change in price versus an investment that
maintains fixed payments.
24. What’s the difference between accruing and compounding?
Accrue means the money owed to you accumulates. If it is not compounding, that
means the money that is owed to you is not earning any money. There’s a big
difference between the following two scenarios (taxes are excluded).
You give me $1,000 and each year I will place into an account 10% of your principal
and will do so for 10 years. At the end of 10 years, you will have $2,000 (your
original $1,000 plus 10 years of interest that did not compound). In this case, the
money I’m giving you is accruing but not compounding.
You give me $1,000 and I will give you a compounded rate of return of 10% per year
for 10 years. At the end of 10 years, you would receive $2,593.74. The reason why
this is so much higher is that each year you earned 10% on the total amount owing,
rather than just 10% on the original $1,000. In this case, the money I’m giving you
is accruing and compounding.
STOCK INDEXES AND AVERAGES
25. I’m confused by the definition of “index” in the text. I don’t see how it differs
much from an average with respect to a time series that allows you to calculate
percentage changes. Please explain.
The definition given in the text regarding indices has a very specific meaning that
differs from a basic average calculation. A value-weighted index, for example, is
constructed by deriving the initial total market value of all stocks used in the series.
The initial figure is used to establish a base and assigned an index value (usually
100 though some might use 1,000 or some other base value). After the base period
is established, a new market value is computed for all securities in the series, and
the current market value is compared to the initial base value to determine the
percentage of change, which is then applied to the beginning index value. So if the
initial market value of an index is $200 million and a base value of 100 is assigned,
what would happen if the next market value calculation were $227 million? The new
index value would rise from 100 to 113.5 based on the following calculation: ($227
million / $200 million) x 100. So you can look at this time series and conclude that a
move from 100 to 113.5 represents a move of 13.5%. The definition in the text is
referring to this percentage characteristic of an index construction. An average is
simply a sum of the values of stock divided by the number of stocks in the sample.
So the definition in the text for an index applies specifically to an index and not an
average.
26. How is it possible that a point change is greater than a percentage change on an
index?
Here’s the gist. Most indices have a base value of 100 or 1000. A percentage
change is usually less than a point change if you look specifically at the number
involved. It’s important to keep that in mind because you may serve clients one day
who have little knowledge of the market and don’t understand that a 5% change in
an index that was trading at 5,400 is actually a significant point change.
27. Can you give me an example of how to construct an index?
Here’s an example of constructing an index base value:
Consider stock A trading at $10 with 1,000 shares outstanding.
Consider stock B trading at $12 with 10,000 shares outstanding.
Consider stock C trading at $20 with 5,000 shares outstanding.
Market capitalization value for:
 Stock A = $10,000 ($10 x 1,000)
 Stock B = $120,000 ($12 x 10,000)
 Stock C = $100,000 ($20 x 5,000)
Total Value = $230,000
If I want to set the base year of $230,000 to 1,000 points, I would divide the number
by $230:
$230,000 / $230 = 1,000
In order to calculate an index from day to day or year to year, I would need to
calculate the market capitalization of each stock and divide the sum of those
market caps by 230:
One year later:
 Stock A increased to $14
 Stock B increased to $20
 Stock C increased to $22
Assuming the number of shares didn’t change, the market capitalization total for
these three stocks would now be $324,000. If I divide this by my divisor of $230, the
index value has increased from 1,000 to 1,408.69.
An index is a statistical indicator that provides a representation of the value of the
securities that constitute that index (I borrowed this definition). The real purpose of
the index is to act as a barometer for the given basket of stocks that are included in
the index. The index essentially reports the value change for the selected basket of
stocks in question and provides one with insight into the general trend of that
basket of stocks.
So when the index in my example above increased from 1,000 to 1,408.69, one
might say that the market increased by 40.86% in the year. If you compare the
starting market capitalization of $230,000 to the ending value of $324,000, you’ll
see that the increase in value is 40.86%.
When you see these kinds of numbers on TV, you should realize that the market
value of the stocks as a whole has increased, and you should be aware of the
general trend of the value change over the time period.
28. What does the consumer discretionary sector refer to?
Consumer refers to consumer purchases of goods and services. Discretionary refers
to items that are not a necessity. An example of a company that is included in the
Consumer Discretionary sector: Leon Furniture. The company makes and sells
furniture for the consumer or household purchaser, but the items are not a
necessity for the consumer.
29. What does a floating number of stocks in an index mean?
A floating number of stocks means the number of stocks that make up the index is
not fixed. The number can increase or decrease depending on whether a company’s
stock meets the criteria or not for being included in the index.
30. Can you elaborate further on how an index differs from an average?
An index is essentially a ratio derived from a series of observations whose numerical
scale can be used to make relative comparisons between any particular values with
a reference number, revealing relative changes over any period of time.
For example, an index with a base of 100 that changes in price from 125 to 130
represents a relative change of 5% (this differs from the percentage calculation you
are assuming, which would look something like [130 - 125]/125 = 4% – a calculation
that is not inherent in the index values themselves).
The same information is not revealed by an average because an average does not
provide a beginning reference number with which relative comparisons can be
made. The index reveals relative percentage changes over any time period simply
by looking at two values and knowing the base value. An average does not.
31. I thought the DJIA was not weighted, but I read that it is a price-weighted
average. Is that correct?
The Dow Jones Industrial Average is a simple average. In the beginning, the prices
of the companies were added up and then divided by the number of companies. You
are correct that the average is price weighted, but no special weightings are applied
in the actual calculation of the average. In the Dow Jones Industrial Average, equally
weighted items means no special treatment of the stocks was given in carrying out
the average calculation (the special divisor used for the Dow Jones Industrial
Average is a result of stock splits over the years and is a necessary component for
making appropriate adjustments). This is very different from an index where weights
are applied to each stock, and a base year is used as a starting point for
comparison.
32. If an average is price weighed, how can you say the average is unweighted?
An unweighted average means that you, the individual who constructs the average,
do not apply any particular weighting. You simply add up all the stocks and then
divide by the number of stocks.
But if you play around with averages for a minute or two, you’ll realize that there is
a naturally occurring weight among prices, one that you cannot avoid. A stock with
a very high price will have a greater influence over the average than a lower priced
stock. So while a simple average has no special weighting applied, the very nature
of numbers will bring its own weighting to the calculation. However, this natural
weighting does not mean that a weighting has been applied to the average.
33. I hear people often referring to the DJIA as an index. Is this correct?
Many people talk about ‘checking the indexes’ after the market closes, and the Dow
Jones is often discussed in the same vein. Despite this, it would be good to know
that the Dow Jones Industrial Average is calculated as a simple average.
34. How is the divisor for the DJIA calculated?
To calculate the DJIA, the current prices of the 30 stocks that make up the index are
added and then divided by the Dow divisor, which is constantly modified.
To demonstrate how this use of the divisor works, we will create an artificial index,
and we will call it IMA. The IMA is composed of 10 stocks, which total $1,000 when
their stock prices are added together. The IMA quoted in the media is therefore
100.00 ($1,000/10). Note that the divisor in our example is 10.
Now, let’s say that stock ABC corp. in the IMA average trades at $100 but
undergoes a 2-for-1 split. Its price then reduces to $50. If our divisor remained
unchanged, the calculation for the average would give us 95.00 ($950/10). This
would not be accurate because the stock split merely changed the price of ABC
Corp. but not the value of the company. To compensate for the effects of the split
we have to adjust the divisor downward to 9.5. This way, the index remains at
100.00 ($950/9.5) and more accurately reflects the value of the stock in the
average.
35. What does it mean when the DJIA under performs?
Under perform in this context means the DJIA does not perform as well (i.e., does
not rise as much in percentage terms) as other broader market indices.
36. How do you calculate the percentage change in an index between two given
values?
Example: At the start of the time period the index value was 9,143 and at the end of
the time period the index value was 9,927. Here is how you calculate the
percentage change for the index over this time period:
[(Ending Value - Beginning Value) / Beginning Value] x 100
[(9,927.20 - 9,143) / 9,143] x 100 = 8.6% (rounded off)
37. What are subscription rights?
‘Subscription rights’ are more commonly referred to as just ‘rights.’ Rights are given
to existing stockholders that allow them to buy shares in the company at a specified
price within a specified period of time. When the investor exercises his or her rights,
money is paid to the issuer and shares are issued to the investor.