Talking Shop with David Koch: What is a stock?

By David Koch, CFP®, AIF®, CFA, Senior Wealth Advisor

Part 1:  Shares outstanding, IPOs, and Buybacks

No really, what is a stock?

A stock is a fraction of actual ownership in a company. Every public company has shares that are available to be traded on either a stock exchange or over the counter by designated dealers; the number of shares they have issued is called the number of shares outstanding. Tesla, for example, has about 199 million shares outstanding. This means that by buying 1 share of Tesla, you literally own about 0.0000005% of Tesla.

Once you buy a share of stock, you are a shareholder and you, by and large, usually get to vote as a shareholder. The most notable exception is Facebook, whose public shares are non-voting. As a shareholder, you’ll receive your share of a dividend if the company pays one. There may be other perks, like being able to attend the Berkshire Hathaway Shareholders Meeting each year in Omaha – except in the 2020 pandemic year of course. I hear the SWAG there is off the charts.

On the downside, stockholders have the last claim to a company’s assets if they get into bankruptcy. This places stocks among the riskiest investments.

Initial Public Offerings

Keep in mind, most companies are not public, they’re private, like your neighborhood dry cleaner or your favorite burger spot. However, when the owners think there might be enough nationwide or global interest in owning shares of their company, they have the option to go public. This is usually accomplished by doing an Initial Public Offering (IPO): Shares in a private company are first offered for sale to the public. At the end of this blog, for those who are interested, I’ll go into somewhat deeper detail in talking about the impacts of “right-pricing” IPOs for the public markets.

Once shares of the company “go public,” they’re traded on an exchange like the New York Stock Exchange (NYSE) or the National Association of Securities Dealers Automated Quotation System (Nasdaq) or over the counter by designated dealers. Once on an exchange, the shares are traded among investors through broker-dealers and market-makers like Fidelity and Schwab.

The daily price fluctuation of its share price doesn’t affect a company much. The shares have already been issued and sold, and they’re free-floating out there on the exchanges for investors to trade among themselves.

Share prices do affect the compensation of companies’ employees, however – tremendously. Especially the C-Suite executives. The average CEO’s total compensation, for example, is only 10% salary. The rest is in stock and stock-related bonuses. This makes CEOs highly focused on the price of the stock, even though it typically doesn’t impact the company itself on a short-term basis.

Companies can create new shares and sell them in the open market, but this is rare. And because this dilutes ownership for the existing shareholders, investors tend to punish companies that use equity as a means to raise capital – except as a last resort. In a strange twist of events recently, Hertz filed to issue new shares and sell them in the open market after they filed for bankruptcy – and the SEC essentially blocked them. Once a company goes bankrupt, the likelihood that shareholders will receive anything is slim. What Hertz was trying to do was arguably – albeit fully disclosed – fraud.

Like I mentioned before, after the IPO, shares are rarely created and sold in the open market, but they are still frequently created out of thin air in the form of employee stock options. In this case, the company creates the shares, and gives them to employees as compensation. The employees can then choose to sell them in the open market or not.

Buybacks

Sometimes shares are also destroyed. A company may buy their stock in the open market from investors and then destroy the shares so that the number of shares outstanding becomes smaller. This is called a buyback.

When a company is conducting buybacks, all their financial ratios with “per share” will increase because the denominator is smaller (price/share, sales/share, free cash flow/share, etc.). This is often done when a company is cash heavy and could be a sign that they don’t have other, more promising, avenues in which to reinvest.

A buyback is similar to a dividend that has been reinvested (in lieu of taking the dividend as cash), except they can be more tax-efficient because the taxes are deferred until the shares are sold. With a dividend, you owe the taxes whether you reinvest or not. If a company chooses to pay extra dividends instead of conducting buybacks, at least investors can choose whether they want more shares, or cash.

Up next

I’ll take on What is a Stock: Large Cap, Small Cap, International, Emerging and Frontier Markets in Part 2 of this series.

Deeper Dive: Who benefits when IPOs are mispriced?

As promised, for those of you who enjoy more context:

Consider you want to take your company public. You’ve been slaving at the helm for 10 years and it’s time to cash out. You talk to an investment banker and they say, “we think you can get $40/share for your IPO.” You say “great, let’s do it.” Your company IPOs and the shares immediately skyrocket to $80. Most people would say, “Wow, what a successful IPO,” but this is wrong. This is a complete failure and that i-banker may even get fired.

As the owner, you toiled and sweat. You were advised to offer shares to the public at $40 – but once they hit the exchange you come to find out that people would have been willing to buy them for $80, not just $40. As the owner, you could have had twice the payday, but the bankers didn’t correctly price the public’s appetite.

Of course the opposite is true as well. If prices tumble down after an IPO, that investment banker should get promoted. They pre-sold the IPO, hyped it up, and maximized their client’s cash-out.

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Disclaimer: 

The views contained herein are not to be taken as an advice or recommendation to buy or sell any investment. Any forecasts, figures, opinions or investment techniques and strategies set out are for information purposes only, based on certain assumptions and current market conditions and are subject to change without previous notice. This material should not be relied upon by you in evaluating the merits of investing in any securities or products mentioned herein. In addition, the Investor should make an independent assessment of the legal, regulatory, tax, credit, and accounting and determine, together with their own professional advisers if any of the investments mentioned herein are suitable to their personal goals. Investors should ensure that they obtain all available relevant information before making any investment.