Section 2.1: Equity Securities — Common and Preferred Stock

Estimated study time: 60 minutes

Content:

Equity securities represent ownership interests in a corporation. Because Products and Their Risks constitutes 44% of the SIE exam — the single largest section — a thorough understanding of equity securities is essential.

Common stock is the most basic form of corporate ownership. Common shareholders receive voting rights (typically one vote per share on matters like board elections and major corporate actions), the right to receive dividends if declared by the board, and a residual claim on assets in the event of liquidation — but only after all creditors and preferred stockholders have been paid. Because common shareholders are last in line in a bankruptcy, common stock carries the highest risk among a company's capital structure. It also carries the highest potential return: common shareholders benefit from unlimited price appreciation and have no ceiling on dividend growth.

Preferred stock is a hybrid security that combines characteristics of both equity and debt. Preferred shareholders receive a fixed dividend that must be paid before any dividends are paid to common stockholders. In liquidation, preferred shareholders rank ahead of common shareholders but behind all creditors (bondholders). Most preferred stock is non-voting under normal circumstances. Preferred stock is generally more stable in price than common stock because of its fixed income component, but it does not participate in the company's growth the way common stock does.

Several variations of preferred stock appear on the SIE exam. Cumulative preferred requires that any unpaid dividends accumulate as "dividends in arrears" and must be paid in full before common shareholders receive any dividends. Convertible preferred gives the holder the option to convert shares into a fixed number of common shares — providing upside participation in the company's growth while offering downside protection through the preferred dividend. Callable preferred allows the issuing company to redeem (call) the shares at a predetermined price after a specified date, giving the company flexibility to refinance if interest rates fall.

Equity securities carry several types of risk. Market risk (also called systematic risk) is the risk that overall market movements will affect stock prices regardless of the company's fundamentals — this risk cannot be diversified away. Business risk (also called company-specific or unsystematic risk) is the risk specific to a particular company or industry — poor management, product failure, competition — and this risk CAN be reduced through diversification. Liquidity risk is the risk that an investor cannot sell a security quickly at a fair price; most exchange-listed stocks have minimal liquidity risk, but small-cap and thinly traded stocks carry more. Legislative/regulatory risk is the risk that changes in laws or regulations will adversely affect a company's business.

For exam purposes, remember the priority order in liquidation (highest to lowest priority): (1) secured creditors, (2) unsecured creditors and bondholders, (3) preferred stockholders, (4) common stockholders. This hierarchy drives many SIE exam questions about "who gets paid first" in a corporate bankruptcy scenario.

Key Terms:

• Common stock: Equity ownership in a corporation with voting rights and residual claim on assets; last in liquidation priority.
• Preferred stock: Equity with fixed dividends and liquidation priority over common; typically no voting rights.
• Dividends in arrears: Accumulated unpaid dividends on cumulative preferred stock that must be paid before common shareholders receive any dividends.
• Cumulative preferred: Preferred stock where missed dividends accumulate and must be paid before common dividends are declared.
• Convertible preferred: Preferred stock that can be converted into a specified number of common shares at the holder's option.
• Callable preferred: Preferred stock the issuer can redeem at a set price after a specified date.
• Market risk (systematic risk): Risk affecting all securities in the market; cannot be eliminated through diversification; examples: recessions, interest rate changes, geopolitical events.
• Business risk (unsystematic risk): Company-specific risk; can be reduced through diversification; examples: poor management, product failure, industry disruption.
• Liquidation priority: Order in which claims are paid in bankruptcy: secured creditors → unsecured creditors → preferred stockholders → common stockholders.

Quiz Questions:

Q1. A company files for bankruptcy and liquidates its assets. In what order will the following claimants be paid?

I. Common stockholders II. Secured bondholders III. Preferred stockholders IV. Unsecured creditors

A) II, IV, III, I B) I, III, IV, II C) III, IV, II, I D) II, III, IV, I

Answer: A — The correct order from highest to lowest priority in bankruptcy is: (1) Secured creditors/bondholders, (2) Unsecured creditors, (3) Preferred stockholders, (4) Common stockholders. Common shareholders bear the most risk and are last to receive anything — which is why they also have the highest expected return over time.

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Q2. An investor holds cumulative preferred stock in XYZ Corporation. XYZ has not paid dividends for the past two years. This year, XYZ's board declares a dividend. Which of the following is correct?

A) Common shareholders will receive their dividend simultaneously with preferred shareholders B) Preferred shareholders will only receive the current year's dividend C) The two years of unpaid preferred dividends must be paid in full before common shareholders receive anything D) Preferred shareholders lose their claim to past dividends after two years

Answer: C — Cumulative preferred stock requires that all accumulated unpaid dividends (dividends in arrears) must be paid to preferred shareholders before any dividend can be declared for common shareholders. Non-cumulative preferred stockholders would lose their claim to past dividends, but the question specifies cumulative.

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