Differentiating between common and preferred stocks

- Understanding other labels that are given to stocks

- Exploring the major trading markets for stocks and other financial instruments One of the biggest challenges of investing in the stock market is just understanding what writers, brokers, commentators, and other investors are saying because so many of the terms are unfamiliar. You will hear a fair amount about brokers in this article. If you choose to use professional help with your investments, your first point of contact very likely will be a broker, a licensed intermediary between buyers and the stock market. With few exceptions, all stock purchases must be handled by stockbrokers even on the Internet. For more info on brokers, check out Chapter 8. As a beginning investor, you may hear statements like, “Multiples are way too high,” or “It’s time to get out of cyclicals. We’re due for a recession.” How do you make sense out of this jargon? By the time you finish this article, you will know more than enough to begin sorting intelligently through the many choices that face new investors. You may be asking, “Why should I bother myself with all this terminology?” The answer is straightforward: You need a basic investing vocabulary so that you understand what you read and so you can eventually make intelligent choices when you’re ready to invest in stocks.

The Many Varieties of Stocks

A stock is a share in the ownership of a company. Stocks can be divided into a variety of classifications. You should be familiar with two classifications in particular: legal (or formal) classifications, and descriptive (or popular) classifications. Legal classifications define your rights as a shareholder. Descriptive classifications do not have specific, legal meaning but are convenient terms that brokers, financial writers, and others use to explain different types of stock.

Legal classification: Common or preferred stocks

In formal or legal terms, the two main classes of stocks are common stocks and preferred stocks.

- Common stock is, well, the more common type. Ownership of common stock usually entitles its holders to a share of the company’s dividends and voting rights at company meetings based on the number of shares held. Owners of common shares are also entitled to a proportionate share of the company’s assets, if the organization is liquidated. However, common stocks offer no guarantee that any dividend will be paid.

- A stock is designated as preferred when it gives its owner preference over the holders of common stock in receiving dividends and also in being paid a share of the company’s assets, if the company is liquidated. Preferred stocks generally do not confer any voting rights. All companies offer common stock. Relatively few also offer preferred stock. Most preferred stocks have fixed, or stated, dividend payments. A few preferred stocks have a varying dividend and are called adjustable rate preferred. A preferred stock is a more conservative, that is, less risky investment than common stock. The downside of preferred stock is that the holders receive only the stated dividend and do not participate in the company’s growth in the same way common stock shareholders may.

The stock reports printed every day in The Wall Street Journal, Investor’s Business Daily, and other larger publications identify when a stock is preferred. Because the large majority of stocks are common stocks, there are no listing notes when a stock is common.

Descriptive classification

After you get past the legally correct terminology used to categorize shares of a corporation (common and preferred stock), you come to a great variety of additional ways to label or talk about stocks outside of common and preferred. Descriptive is a broad term that encompasses all of the other labels you can put on stocks. In the rest of this section, I tell you about some of the other labels or categories you will run across when researching stocks. Three basic descriptive categories are widely used to classify stocks:

- Total market value: Stocks are categorized by size, based on the total market value of company stock

- Anticipated performance: Categorized by perceived investment potential of the stock

- Industry group: Categorized by the nature of the company’s business

Total Market Value

A widely used category to classify stocks descriptively is based on the total market value of the shares of the company whose stock is being traded. Total market value or market capitalization is a number derived by multiplying the current market price of one share of the company’s stock times the total number of outstanding stocks. For example: Current market price × number of outstanding shares = Total market value.

$50/per share × 100,000,000 outstanding shares of stock = $5,000,000,000

Total market value

Stocks of companies whose total market value is under $ 1.5

billion are referred to as small cap. Companies whose share value totals between $1.5 and $5.0 billion are called mid cap, and those above $5.0 billion are referred to as large cap.

Actually, you don’t need to calculate the total market value of any company on your own because the work has already been done for you. The best place to get this information is on the Web. Heavy-duty publications like Value Line and Standard & Poor’s Stock Reports also give this information, and so will company quarterly and annual reports. Almost all the Web sites that provide stock prices will also give constant updates on total market value because this will change every time the market price of the stock changes (see CliffsNotes Resource Center for a list of Web sites). It is not important to know the precise total market value of a company at any given moment, but you should be aware of whether you are looking at the stock of a small company, a large company, or something in between.

Please note that no universal agreement on the precise boundaries of these cap categories of stocks exists. Moreover, the numbers that define category boundaries are constantly being revised. Why is it important to know whether the companies whose stock you’re considering is considered to be small, mid, or large cap? The labeling of stock by dollar size provides useful clues to risk and to growth possibilities. The smaller the company, the more risky its stock is likely to be. Conversely, large cap stocks tend to be less risky, to be more likely to pay dividends, and to grow steadily but not rapidly. If you’re looking for stocks that are less risky than the small cap but with greater prospects for rapid growth than the mature, large cap companies, you would do well to concentrate your search on mid cap stocks.