 Hello and welcome to the session. This is Professor Farhad in which we would look at asset classes, specifically equity securities. This topic is covered on the CPABEC section, the CFA exam in an undergraduate or graduate essentials or principles of investments. As always, I would like to remind you to connect with me on LinkedIn if you haven't done so. YouTube is where you would need to subscribe. I have 1,700 plus accounting, auditing, tax, finance, as well as Excel tutorial. If you like my lectures, please like them, share them, put them in playlists, subscribe to my YouTube, connect with me on Instagram. On my website, farhadlectures.com, you will find additional resources, whether you are studying for your accounting or finance courses, or you are studying for your CPA or CFA. Check out my catalog of supplemental resources. Asset classes from a grant perspective can be broken down into three categories, fixed income, equity securities, as well as derivatives. Under fixed income, we have the money market, which are short term and the capital market. And both of these are already covered. So the fixed income is done. In this session, I will work on the equity section. Under the equity section, I'm going to keep it simple. I'm going to break it down into common and preferred stock. This is what I'm going to do. I'm going to break it down into two sections and eventually we'll talk briefly about derivatives. Now, here's what I want to tell you. Now, we spoke about fixed income. We're going to talk about fixed income much more in details when we evaluate fixed income. We're going to talk about equity today. Well, this is going to be like a short introduction. Eventually, we're going to talk about how to value stocks. When we talk about derivatives, it's going to give you a basic introduction about derivatives for now, then we'll talk about these topics later. So if you feel like I am not really going in depth, it's because later on we're going to go in depth. This is basically the beginning of the course. So just bear that in mind. But it's very important that you understand the basics before you move on into intermediate and advanced topics. So let's start with common stocks. Common stocks are basically form of ownership shares. So when you buy stocks in a company, you buy common stocks, they represent equity securities or simply equities. And what is equity? It represents ownership shares in a corporation. When you buy a stock in a certain company, in Apple computers or in Microsoft, what you become, you become an owner of the company. So what does that mean? What does each stock represent? So let's assume you bought one stock or 100 or 1000. What does that represent? Well, you pay cash and you'll get your stock. Well, each share of stocks entitles you to certain rights as an owner. Basically, you become an owner in the company and as an owner, what can and cannot do? Well, each share of stock will allow you to have one vote for any matter of corporate governance. So every once in a while, the corporation will submit some major decision for voting. And guess what? One vote, one share equal to one vote. So the more votes you have, you vote with your money. It's not democracy. The more money you are invested in, the more shares you have, the more votes you have. Also, you can vote the board of director, which is that's very important. Why that's very important? Because the board of directors are elected on an annual meeting and they technically, they represent you. The owners of the company are the shareholders. But as a shareholders, how do you express your position as an owner? You vote this group, board of directors. So the board of directors basically is in charge. And that group select managers, which is the CEO, the CFO, the VPs who run the corporation on a day-to-day basis. Then the managers would select the employees and all these people would select, I'm sorry, all these people would run the company on your behalf as a shareholder. Okay, so basically you select the board of directors. The board of directors assigns management. Management run the company and managers have the authority to make most business decision without the board's approval. So the board doesn't get involved in a day-to-day operation. They might meet on a quarterly or sometime monthly depending on the company. But usually they meet on a quarterly basis to review the performance of the company. But the day-to-day operation is run by actual managers, managers that run the company. So the board of directors are just on the top. They see the big pictures. Okay, keep in mind if you have a vote, if you have the right to vote, you don't have to vote. You can assign your right. You can vote by proxy. And here's what happens sometimes. Sometime management, they will come to you. Let's assume I own 500 shares of Apple computers. I don't. I wish I do, but I don't. If I have 500 shares of Apple computers, I might receive a request from someone at Apple from management saying, would you give us your right to vote on your behalf? Simply put, I give up my 500 right to vote to them. Or sometime large investor usually solicit proxies like Carl Icahn, this guy in this picture. If you know who he is, that's what he does. He's an active investor. He goes around, he buys companies and what he does, he solicits to. So he might buy 5% of a certain company, then he would try to solicit the additional 10% of votes. So he can convince people, look, give me your vote. I will vote on your behalf and I will vote your best interest. So if you give them that, if you fill out the form, you check a box and yes, you can have my vote, then you can give your vote up to someone else. So just know it's called the proxy voting. Also, if you have shares of stocks, you are entitled to share in the financial benefit of ownership. What does that mean? It means if the company makes a profit, they decided to distribute the shares. I'm sorry, they decided to distribute the profit. You get proportional share in that profit. The right to any dividend, that's exactly what I'm trying to say, that the corporation may choose to distribute. So you share in that financial benefit of ownership. But also remember, you share in the financial benefit, but you also share in the financial risk. So if the company bellies up, you also carry the risk. But here, we're trying to put a positive spin. But remember, as an owner, you bear the ultimate risk because you're the owner of the company. You're the shareholder. That's your company. And also, you have the right to sell your stock. That's an obvious. That's not really obvious unless we are talking about public companies. Private companies, it might be a little bit harder to sell your stock. But you could always have the right as an owner to sell your stock as long as someone else on the other end is willing to buy it. Now, for publicly traded company, that's not an issue whatsoever. More characteristic about common stock. And remember, when the word stock is thrown out, that's what we mean by stock. When we say characteristic of stock, what we mean is common stock. Because shortly, we're going to see we have common stock and preferred stock. But here, we're talking about common stock because that's the most common. So when you think of stock, you think of common stock. The two most important characteristics of common stock is they have claimed to the residual value and they have limited liability. And you need to understand what does it mean claim to residual value? Claim to residual value means you're the last person in line if the company bellies up. So if the company go out of business, you're the last person who have claim on the asset, also on the income of the corporation. Simply put, the corporation will operate. They'll have to pay older expenses before you get anything from the income. In case the company liquidate in a liquidation scenario, the firm's asset, the shareholder have claim of what's left after paying off all other claimants. Who are they? You have to pay your taxes. You have to pay your employees, your supplier, your bondholders and your creditors. And your preferred stockholders. So the common stock people usually are last. And if the company usually fell for bankruptcy, the common shareholders generally speak and they don't get anything. Because by the time you pay all of these, and there's an order, there's a packing order who gets paid first. And you'd learn about this in your business law. So you usually get anything. And a going concern situation, basically going concern means as long as the company is running versus liquidation. Liquidation means going out of business. Shareholders have claim to the part operating income left after you pay interest, taxes and operating the business. So you need to operate the business. You need to pay your interest onto that. You need to pay your taxes and anything left. That's what net income is. And you can, you have part of that net income. You have claim on that. Okay. Management either can pay its residual claim as cash. So they can pay you this whatever's left and income in cash to shareholders. Or they reinvest, reinvest means they don't pay you anything. They keep the money at the company. Why? Because they have other plans. They have better plans on your behalf. They keep, they reinvest. Reinvest, it means they keep it. Pay it out. It means they pay it out as dividend. So those are basically what means by residual claim. What's left in case of liquidation? You get anything. What's left in case of profit? You get anything. Okay. What's left? That's why it's residual. What's left is yours. Also, what's important about investing in common stock? It means it has limited liability. It means the most shareholder can lose is what they invested. So that's why people, they find easier time investing in stocks rather, rather than starting their own business. I mean, you could also start your own business and have limited liability, but also investing in stocks. You don't have what's called an agency problem and not agency problem. You don't, you're not an agent of the company. Forget about it. Forget I said agency problem. We'll talk about agency problem later on, but you are not an agent of the company. So you are an owner in the company, but you don't have to work for the company. Okay. For example, if you invest in your own company, if it's your own company, you can have protection. You could incorporate your company, but you have to work. You have a limited liability. If you own stocks and Apple computers, you don't have to work for Apple. You could just kind of get the profit without working. So kind of in a sense you are passive, but you have limited liability. So shareholders are not like owners. Okay, because you don't have to do any work whose creditors can lay claim to the personal asset of the owner, such as homes, cars and furniture. So simply put, you don't have to work for the company and the creditors, they cannot come after you. So if Apple computers went belly up and the creditors goes after Apple computers, they cannot go after your personal asset. When you own your own business, they might. It's not true if you incorporate properly. So you do have the limited liability. If you choose to, even if you act as a sole proprietary, if you have your own business, you just have to incorporate as a C corporation. In the event of a bankruptcy, corporate stockholders at worst have worthless stocks. So that's the maximum you would lose. So you have your liability is limited. You are not personally liable for the firm's obligation. Also if the firm is sued, the maximum you would lose is your stocks. The company got a business, you lost your stocks. That's the end of it. Now, if you buy stocks in a company, you have to know how to read this information. And this is an example of Microsoft Corporation at 2.43 p.m. on June 15th. At this moment, it was trading at $190.03 pennies. The previous close, it means this is from Yahoo Finance. It means the prior day, it closed at 187.74. It opened today at 9.30 at 184.58. Again, here we have talked about the bid and the ask. Remember, this is from a dealer's perspective. Bid means they will buy it from you. They will buy it from you. If you have Apple, I'm sorry, if you have Microsoft, they will buy it from you. Ask is they will sell it to you. Notice they will buy it from you at $190.31 pennies. If they want to buy it, they will buy it for that much. If they want to sell it to you, they sell it for $190.33 pennies. Notice there's two pennies difference. That's the bid ask price. Now, if you're asking what's that, multiply by $1,100, multiply by $800, this is the size of the order. Don't worry, we'll talk about this later on. But this is basically the size. It means the last time they bought it, they bought it at $190.31, and they bought a size. The size was $1,100 shares. As of this moment, the stock range from $184.01 to $190.82. This is the day's range. The 52-week range is from $130 as low as the past 52 weeks to the maximum is $198. Notice Microsoft is trading at its highest, you know, at the high end. The volume today is 21.2 million shares. Usually the average volume is 46, so it's not trading a lot today. Market capitalization is what is the size of Microsoft? What's the size of Microsoft? How do you find the size of Microsoft? You'll find how many shares are outstanding, and you multiply the shares by the price. Today, Microsoft is worth $1.44 trillion. This is huge. I mean, when Microsoft passed the trillion, it was a big deal. We only have few companies that are trillion-dollar. Microsoft, Apple, Think Google, I can't think of them, but there's like four or five companies that are a trillion-dollar company. Microsoft is one of them. At the beta, we'll talk about the beta later on. It's 0.93. PE ratio, price earnings ratio. Again, we'll talk about this, 31.65. Earnings per share. It means if you take net income, simply put, and you divide net income for Microsoft divided by the number of shareholders, each shareholder will get $6 per share. Now, the one this number to be as high as possible, again, we'll talk about this later on. Earnings date, July 16th, 2020 to July 20th. So they're going to report their earnings, next earnings, approximately a month from now. Forward dividend and yield. That means they pay per year based on forward-looking. They pay $2 per share. That's pretty good. And not really. It doesn't matter what you do. You want the yield. The yield is 1.09. How do you find the yield? If you buy Microsoft today, you'll get $2.04. And you pay $190.03. Okay? Or basically, if you want to buy it, they will sell it to you at $33, actually, if you want to buy it at this moment. So $2, you'll get $2.04. It should be approximately given you 1.09. So you will earn only from the dividend based on the forward-looking is 1.09. Now, if you wait for tomorrow and the price is 180, your dividend yield goes up. Now, if you wait for tomorrow and the price of Microsoft goes to 200, your yield goes down because you're getting $2 for investing 200 versus you're getting $2.04 for investing 180. So as the price of the stock goes down, its dividend yield goes up. Ex-dividend date. We'll talk about this later. It means by May 20th, if you buy it, you're no longer going to get the last dividend. The one-year target estimate, 1.99. This is based on how yeah, who does it? But basically based on a group of analysts projecting the price. And usually they compute the average price. And they think based on all these averages, the price could go up to 1.99. But this is, again, this is an average estimate. So this is how you do so. Now, if you go to the Wall Street Journal or to Reuters or to Bloomberg, it's basically the same information presented differently. But that's how you read the price of a stock. Now, also, we're going to be talking next about preferred stock. Preferred stock are also quoted, but they're not heavily traded as common stock. So basically, you read them the same way. So let's talk about preferred stock. What is preferred stock? It's a second type of stock. So when we think about equity, when we think about equity investments, again, we have common. We just talk about common or simply stocks and we have preferred. Now, the preferred stock must be preferred. Must be somehow they are treated differently. They are treated better. This is, you know, kind of preferred, right? You want to be preferred. Why? Because you get treated differently. They are preferred in certain way and they are not preferred in other ways. So let's talk about the preferred stock. The first thing we need to understand about preferred stock, they have the features similar to both equity and debt. So preferred stock act as if it's that and equity at the same time. What does that mean? We're going to explain this in a moment. But bear in mind, it's an equity. It's an equity from an accounting perspective, from a finance perspective, preferred stock is equity. It promises to pay a fixed stream of income each year. So when you buy a preferred stock, here's what happened. What that stock comes, something called a par value. So they will tell you the par value, let's assume $100 and they will tell you it's a par value of 6%. It means by buying the stocks, you'll get $6 per year. So you'll take the par value times a percentage. So you are promised a certain amount of income. It's like a bond. You remember when you talked about fixed income? About bonds, you get a specific amount of money. In comparison to common stock, what do you get in common stock? You may not get anything. Why? Because if the company don't make a profit, you don't get anything. If the company makes a profit and the board decides not to pay the profit, you don't get anything. If the company makes a profit, the board decides how much you're going to get the profit. So for the preferred stock, there's a number that you are promised. So that's why it acts like that. That's one thing. But it does not give the shareholder the voting right. Remember in the common stock, you can vote. Here you don't have a voting power. Although it's still considered an equity investment, an equity investment. Now where does that preference go? So here we go. So you always get your money. That's plus, but you cannot vote. That's minus. So what is special about preferred stock? What are some special things? The firm retains discretion to make the dividend payment to the preferred shareholders. It has no contractual obligation. So just like also common stock, they don't have to pay you. They don't have to pay you. Listen to me carefully. Instead, you might buy preferred stock that's cumulative. Now what does cumulative mean? And this is kind of the preference features of preferred stock. This is really the true preferred stock kind of because your dividend is cumulative. Remember, we talked about this preferred stock and you are entitled to $6 per year. Let's assume year one went by, the company did not make any profit. If they did not make any profit, they're going to pay zero dividend because they did not make any profit. Year two, the company did not make any profit. Also, you're not going to get anything. Year three, the company made a load of money. Now here's what's going to happen. If the preferred stock is cumulative, they're going to pay you year one, year two. Then they're going to pay you year three and you do have the preference. So here's what the preference comes. You get your dividend first. You get your dividend before Google City. You get your dividend before the common shareholders get their dividend. So this is where it's preferred. It's preferred in that sense. And cumulative. So unpaid, simply put, unpaid dividend, cumulate and must be paid before any dividend must be paid to the common shareholders. This is where the preference comes into place. You are standing in line before the common shareholders. That's where the preference is. But if the preferred is non-cumulative, so we have preferred non-cumulative, you don't have this right. So remember, we said it's a fixed payment, right? We said it's a fixed payment. They don't have to pay you. It's not a contractual obligation to make, like if you have a bond, you have to make timely payment on the interest. What happens if you don't make the payment on the interest? If you don't make the payment on the interest, the lenders or the creditors will take you to the court and they will put you out of business. So failure to make payments on your bonds will put you into a bankruptcy. But failure to make payment on your preferred stock, you have no obligation. Once you make the money, maybe five, six, seven years down the road, if it's cumulative, they will come back and they will pay you. But you cannot sue them. You cannot force them to pay you unless the company makes a profit. More about preferred stock. Preferred stock are treated as dividend as far as the tax concern. So if it's treated as dividend, it doesn't give the firm any tax deductibility. So therefore, the company that's paying the preferred, the dividend, they don't get a tax deduction. In contrast to the bond, if you are paying interest on the bond, the firm that's paying the interest can get a tax deduction. So that's basically a disadvantage for the paying firm. However, the receiving corporation, listen to me carefully, not the individual, the receiving corporation. So if one corporation invests in another corporation and that corporation pay them dividend, they may exclude, sometime they may exclude more, 50% from taxes. So they will get the dividend, they don't have to pay taxes on it. Sometimes they can exclude 100%. And again, this is a tax issue. If you're interested, go to my YouTube about the dividend received deduction and you would learn about it. But know that you do get some deduction if you're a corporation. Now individuals, if you own preferred stock and you get the dividend, you don't have that exclusion. And that's what makes preferred yield unattractive relative to other available assets. That's why, because it's not, it's for individual, it's taxable, just like any other dividend. Preferred stock ranks after bonds in terms of priority. Again, if you want to have a priority, we have bondholders, then preferred, then common. What does that mean? It means bondholders are paid first in terms of liquidation. If a company goes out of business, you will satisfy them first. If any money left, the preferred shareholder gets. And if any money left, this group gets last. Now, why am I gonna talk about this? And why do I have the picture of, I hope you know who this is. This is Warren Buffett. Because Warren Buffett, when Bank of America, when Bank of America was almost going out of business in 2008, they called Warren Buffett. They called him and they asked him if he's interested and they're trying to solicit him to buy stocks in Bank of America. And Warren Buffett, yeah, sure, I will invest in your company. So the guy asked him about his email and Warren said, what's an email, right? He doesn't even know what an email is. So to make the long story short, Warren Buffett agreed to invest, I do believe, $6 billion in Bank of America. But here's what he did. He told them, I will buy preferred stock. Why? Because Warren Buffett wanted to hedge his options because the preferred shareholder are before the common shareholders. Not only that, he told them exactly what interest rate he wanted. I don't remember, 5% or 6%. Quite a bit. Then he also asked them for more stock options in case the company does better. He can buy the Bank of America stock. And he did very well actually. But the reason I am showing you this, just to tell you that preferred shareholders, they have some priority, right? They have some priority. Because of the higher risk of the preferred would tend to result in a higher yield than those by the bondholders. Obviously because you are taking more risk than the bondholder, you would expect to be compensated. Because remember, we talked about risk and return. The more risk you take, the higher the expected return. And buying preferred stocks is higher risk than bond. But buying common stock is higher risk than preferred. And you will expect to yield more. Now as I said, there is a variation of preferred stock. Usually I am going to use the term contract, but please don't take it all the way legally. Preferred stock is like a contract. Because think about Warren Buffett. Warren Buffett told Bank of America, issue me preferred stock and here's the terms that I want. So basically, in a sense, it's a contract. And this contract could come in various variations. So we have many different type of preferred stock. The preferred stock can be callable. Just like we talked about bonds, it means the company can buy it back from you. Usually they pay you a premium. They pay you more than what you bought it for. But it's callable. The company decides to buy it back. It's convertible. Convertible by the shareholder. Like Warren Buffett, he was able to, if he wanted to, he also had a convertible feature. He could convert his preferred into common stock at some specified ratio. For example, for every preferred, he'll get five common, or for every five preferred, he'll get one common, or for every five preferred, he get 10 common. It doesn't matter. Some specified ratio. So you could switch teams, basically, being a preferred shareholder to a going from a preferred to a common. And there is a relatively recent innovation. It's adjustable rate preferred stock. And again, this is kind of basically, it's called like you share in the profit. It's like adjustable rate bond ties the dividend to the current market interest rate or to the income of the company. So sometimes, again, the preferred could come in many different variation. I'm not sure if we're going to revisit the term preferred down the road or we'll talk about preferred, but know that preferred comes in different variation. A third type of equity, it's called depository receipt or ADRs, American depository receipts, are certificates traded in the U.S. that represent ownership and share of a foreign company. Think of Sony. Sony is a Japanese company, but if you like Sony, you don't have to have an account in Japan. You can buy Sony in America. You will buy what's called Sony's ADR, American depository receipt. So you will buy shares in Sony and the New York Stock Exchange. So each ADR may correspond to ownership of a fraction of a foreign share, one share or several shares of a foreign corporation. Now, when you buy one ADR, they all have some sort of arrangement. What does it represent in terms of ownership? Because you are an owner in the company. So ADRs were created to make it easier for foreign firms like Sony to satisfy U.S. security registration requirements. And in the U.S. we have many companies. It's basically an honor or like a privilege for foreign companies to be listed in the U.S. because when you are listed on Wall Street, you have access to U.S. dollar and you have access to the American market. The American market is rich and everybody wants to be listed, but you have to meet U.S. security registration. And I'm not really sure if you follow the news these days. The President, Trump, which is we are in 2020, he wanted to delist Chinese companies from the market. So Chinese companies, what they do is they sell their stocks as ADRs and he went to delist them. By delisting them, they can no longer trade. And that's, you know, if you are a U.S. investor and you put money in those stocks, well, that's not good because basically if they're delisted, what are you gonna sell your stock? And usually, you know, it's bad news for the company. That's that. They are the most common way for U.S. investors to directly invest in trade and shares of foreign corporations. Yes, exactly. It's just like, if I want to buy a German company, I don't have to, you know, go to Germany or open an account in Germany because sometimes there's a certain regulation. I can buy a German ADR like Adidas or like Mercedes-Benz. I can buy Mercedes, but, you know, like BMW or whatever, any German company that's listed as an ADR in the U.S. And this is basically what I wanted to talk about in the next session. We would look at stock and bond market indexes. We'll talk about the Dow, the S&P 500 and bond indexes. Then we'll talk later on about derivatives. As always, I would like to remind you to like this recording. Share it. If you think it's helping you, it might help other people. Subscribe to YouTube. And don't forget to check out my website farhatlectures.com for additional resources, whether you are studying for your accounting or finance courses. Study hard. Good luck. And if you are still living through this coronavirus, stay safe.