Question

Discuss the importance of stocks to both a company and shareholders. Why do companies issue stock? What is the importance of intrinsic value of a stock? List one pro and one con of why a company would issue stock compared to a company issuing bonds.

Answer 1

Discuss the importance of stocks to both a company and shareholders.

When a company goes public, it means it has decided to sell shares of equity to the public rather than just privately to investors. These stocks are important to the business for a number of reasons, but the decision to go public can also come with risks that are sometimes not worth the benefits to shareholders.

When companies are first formed, they are almost always privately owned. If and when they become incorporated, this means they will be owned by one or more shareholders, each of whom will own some portion of the company's stock.

Upon incorporation, the corporation must tell the Secretary of State the total number of shares it has authorized to be distributed among the shareholders. These shares indicate a percentage of ownership, and the number of shares a person has in the company will represent his total equity in the corporation. If one person owns over 50 percent of the shares, he is considered the majority shareholder and can make important decisions about the business.

When a company is private, this means that the business owners and investors are the only ones to hold shares, and the value of the corporation and the value of its shares are equal. At the initial meeting, the directors will issue shares to initial shareholders in exchange for money or other investments in the new company to be used as startup capital. This can limit the company's ability to raise capital, as it can only take on loans or take on additional investors in exchange for more shares, which requires the owners to give up more control of their company. This is why most private companies do not take on additional investors once they are fully up and running.

Many people wonder why a company would even care about the price of its stock if the company cannot directly earn money after its IPO.

For one thing, companies can issue new stock and can buy back stock, so since they can trade their own stock, the value will affect these purchases. Of course, the shareholders who own the company and tend to make most of the major decisions regarding the company's future care about the stock prices because their wealth is directly dependent on the value of the shares.

High stock prices can also result in the company receiving positive press and are often used as validation of the company's leaders and business practices. Finally, stock prices are often viewed as an indicator of a company's financial health, so a high stock value is a good indicator that the company is doing well.

Why do companies issue stock?

Corporations issue stock to raise money for growth and expansion. To raise money, corporations will issue stock by selling off a percentage of profits in a company. Issuing stock can also be referred to as equity financing, because the shareholder gives the company money in exchange for a portion of voting rights and profits of the company.

Becoming a shareholder in a company also comes with the risk that the company may not increase in value and you might lose the amount of money that you invested in the stock. If a company completely fails you do have the ability to claim your portions of the assets of the company after all debt has been satisfied. The banks and bondholders will have the first claim on the assets which is referred to as absolute priority.

There are two ways for you to obtain shares of stock in a corporation. You can purchase stock when the stock is first offered through the company's IPO or Initial Public Offering. This would be considered a primary market, which is when the business offers shares of stock when they are looking to start or grow a ;business. You can also purchase stock in a secondary market through stock exchanges where the stock is bought and sold.

There are many reasons that a company would issue stock to raise money. Some of the common reasons include:

• The development of new products
• To purchase equipment
• To buy new buildings
• To increase inventory
• To expand and grow staff
• To reduce debt
• To prepare for a merger or acquisition
• To improve the value of a company
• To provide for greater flexibility

What is the importance of intrinsic value of a stock?

"Intrinsic value" is a philosophical concept, wherein the worth of an object or endeavor is derived in and of itself—or, in layman's terms, independent of other extraneous factors. A company's stock also is capable of holding intrinsic value, outside of what its perceived market price is, and is often touted as an important aspect to consider by value investors when picking a company to invest in.

Some buyers may simply have a "gut feeling" about the price of a stock, taking into deep consideration its corporate fundamentals. Others may base their purchase on the hype behind the stock ("everyone is talking positively about it; it must be good!") However, in this article, we will look at another way of figuring out the intrinsic value of a stock, which reduces the subjective perception of a stock's value by analyzing its fundamentals and determining the worth of a stock in and of itself(in other words, how it generates cash).

Why does intrinsic value matter to an investor? In the listed models above, analysts employ these methods to see if whether or not the intrinsic value of a security is higher or lower than its current market price, allowing them to categorize it as "overvalued" or "undervalued." Typically, when calculating a stock's intrinsic value, investors can determine an appropriate margin of safety, where the market price is below the estimated intrinsic value. By leaving a 'cushion' between the lower market price and the price you believe it's worth, you limit the amount of downside that you would incur if the stock ends up being worth less than your estimate.

For instance, suppose in one year you find a company that you believe has strong fundamentals coupled with excellent cash flow opportunities. That year it trades at $10 per share, and after figuring out its DCF, you realize that its intrinsic value is closer to $15 per share: a bargain of $5. Assuming you have a margin of safety of about 35%, you would purchase this stock at the $10 value. If its intrinsic value drops by $3 a year later, you are still saving at least $2 from your initial DCF value and have ample room to sell if the share price drops with it.

For a beginner getting to know the markets, intrinsic value is a vital concept to remember when researching firms and finding bargains that fit within his or her investment objectives. Though not a perfect indicator of the success of a company, applying models that focus on fundamentals provides a sobering perspective on the price of its shares.

List one pro and one con of why a company would issue stock compared to a company issuing bonds.

Preferred stocks, like bonds, are usually callable, which gives the issuing company the right to call back the shares. Should interest rates fall, the company can call back the preferred shares and then issue new ones based on the lower rate.

For the issuer, preferred stocks can be more advantageous to stocks if the company runs into financial problems. Interest payments on bonds are legal obligations that are payable before taxes, while stock dividends are not. If the stocks are non-cumulative, the issuer doesn't have to pay those dividends in the future, however, if the stocks are deemed as cumulative, they will have to be paid back eventually.

Investors may be more skeptical of preferred stocks compared to bonds because they have a lower claim on company assets in the event of liquidation. Related to this higher risk, preferred stocks usually pay more, resulting in a higher cost to the company. Institutions, however, do like to invest in preferred stocks because, unlike the interest earned on bonds, 70% of dividend income can be excluded from corporate income tax.

Issuing preferred stocks is often seen as a sign that a business has a lot of debt. Companies can be limited in the amount of additional debt they can raise, leaving preferred stocks as one of their few options. With the exception of financial and utility companies, which routinely issue preferred stocks, investors are often hesitant to buy them.