On May 17, 1792, twenty-four stockbrokers gathered under a buttonwood tree on Wall Street and signed an agreement to trade securities only among themselves and charge minimum commissions. That moment—the Buttonwood Agreement—created what would become the New York Stock Exchange.
Today, the global equity market holds over $100 trillion in value. Understanding how stocks work isn't just academic—it's the foundation of everything else on your Series 7 exam.
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Section 1: Common Stock Basics
Why This Section Matters
Companies need money to operate. They can borrow it (debt financing) or sell ownership stakes (equity financing). When you buy stock, you're buying a piece of a company—literally. This section covers the mechanics of how that ownership works: what shares are, how they're tracked, and what happens when they change hands.
Common Stock Is Equity
The word "stock" comes from the old English word for a tree trunk—the solid base from which everything else grows. A "share" of stock meant you shared in that growth. The terminology has survived for centuries because the concept is simple: you own a piece of something.
A common stockholder (or shareholder) owns a piece of a corporation. This ownership represents equity in the company. Beyond corporations, investment companies like mutual funds also issue common stock. Common stockholders hope to share in the company's growth through increases in the share price.
Authorized Stock and Par Value
When a corporation is formed, its corporate charter specifies the maximum number of common shares the company may issue. This ceiling is called authorized stock.
Each share is assigned an arbitrary par value—perhaps $1 or even $0.01 per share. Here's what trips up many test-takers: par value for common stock has absolutely no bearing on market price. It's purely an accounting artifact. Market value is based on investor expectations about the company's future.
Test Tip: Don't confuse par value for common stock with par value for bonds or preferred stock. For common stock, par is meaningless for pricing. For bonds and preferred, par matters enormously.
Issued Stock
To raise capital, a corporation will issue (sell) stock to the public. Here's the strategic reality: most companies don't issue all their authorized shares at once. They hold some back. Why? Because issuing more shares later—without amending the corporate charter—is much easier than going back to shareholders for permission to increase authorized shares.
A corporation is authorized to sell 1,000,000 common shares. It issues only 400,000 shares initially, keeping 600,000 in reserve:
| Issued Shares | Unissued Shares |
|---|---|
| 400,000 | 600,000 |
| Total Authorized: 1,000,000 Shares | |
Outstanding Shares
Once issued, shares are said to be outstanding. These outstanding shares can be freely traded between investors. The number of outstanding shares times the current market price gives you the company's market capitalization (market cap).
If a company has 400,000 shares outstanding at $10 per share, its market cap is $4 million. This is how investors quickly compare company sizes: Apple's market cap exceeds $3 trillion, while a small-cap company might have a market cap under $2 billion.
Treasury Stock
After issuing stock, a corporation may choose to buy back some shares. Repurchased shares are called treasury stock (or treasury shares).
Stock buybacks became popular in the 1980s when the SEC provided a safe harbor from manipulation charges. Today, companies buy back stock for several strategic reasons: to boost earnings per share (fewer shares means earnings are divided among fewer pieces), to signal that management believes shares are undervalued, to fund employee stock purchase plans, or simply because they have excess cash and no better investment ideas.
Treasury shares are different from outstanding shares in two critical ways:
- Treasury shares cannot vote — Only outstanding shares vote
- Treasury shares do not receive dividends — Dividends go only to outstanding shares
(Whether those buyback decisions consistently add value for shareholders is a debate that has launched a thousand academic papers and at least one congressional hearing.)
Transfer Agents and Registrars
Corporations hire specialized firms to maintain ownership records:
| Role | Function |
|---|---|
| Transfer Agent | Records ownership changes, cancels and issues certificates, maintains shareholder list |
| Registrar | Audits the transfer agent, verifies shareholder information |
| Paying Agent | Handles distributions like dividends (often the same firm) |
Regular Way Settlement
Equity securities trade on exchanges (listed) or over-the-counter (unlisted). Listed securities meet stringent requirements set by exchanges like the New York Stock Exchange (NYSE) or Nasdaq. OTC securities are typically smaller companies that don't meet listing standards.
When you buy a stock, you immediately become the economic owner—if the price drops five minutes later, that's your loss. But you're not the official owner of record until the trade settles. The distinction matters because dividends, votes, and other rights go to the owner of record, not necessarily the economic owner.
Settlement occurs when securities and money officially change hands. At that point, the buyer becomes the owner of record. For equities, regular way settlement is T+1—one business day after the trade date.
Test Tip: T+1 settlement was implemented in May 2024, replacing the older T+2 standard. If you see older study materials referencing T+2, ignore them—the exam tests current rules.
| Concept | Key Details |
|---|---|
| Par Value | Arbitrary accounting value; irrelevant to market price for common stock |
| Authorized Stock | Maximum shares allowed by corporate charter |
| Issued Stock | Shares actually sold to the public |
| Outstanding Stock | Issued shares held by investors (can vote, receive dividends) |
| Treasury Stock | Repurchased shares (cannot vote, no dividends) |
| Market Cap | Outstanding shares × price per share |
| Settlement | T+1 for equities (one business day) |
Section 2: Distributions
In 1626, the Dutch West India Company paid the first dividend in what would become America—a return to shareholders from the profits of the fur trade. Nearly four centuries later, dividends remain one of the fundamental ways corporations share profits with their owners.
Why This Section Matters
Investors buy stock for two reasons: growth (the price goes up) and income (they receive cash along the way). Understanding how corporations distribute value to shareholders—through cash dividends, stock dividends, stock splits, and rights offerings—is essential for advising clients and passing your exam.
Cash Dividends
Cash dividends allow a company to share profits with shareholders. The board of directors declares dividends, typically paid quarterly to shareholders of record.
Young, growing companies often reinvest all their profits back into the business rather than paying dividends. The logic: if the company can earn 20% returns by expanding, why give that money to shareholders who might only earn 5% in a savings account? This is why many tech companies pay no dividends. Mature companies like utilities typically pay higher dividends because their growth opportunities are limited.
Stock Dividends
Stock dividends give additional shares to existing stockholders instead of cash. When a company issues stock dividends, the total number of shares outstanding increases, but the value of each share decreases proportionally.
Here's the key insight: there's no immediate economic value to shareholders who receive a stock dividend. The company's total value hasn't changed—it's just been sliced into more pieces.
Test Tip: Stock dividends are defined as distributions of less than 25% of outstanding shares. Anything 25% or larger is classified as a stock split, not a dividend.
Stock Splits
Stock splits increase (forward split) or decrease (reverse split) the number of shares outstanding using a ratio.
An investor owns 100 shares at $50 each = $5,000 total value.
After a 2:1 split: 200 shares at $25 each = $5,000 total value.
Same pizza, twice as many slices.
Why would a company split its stock? A lower share price makes shares more accessible to small investors. A 10:1 split brings a $1,000 stock to $100—psychologically more accessible.
An investor owns 1,000 shares at $0.50 each = $500 total value.
After a 1:10 reverse split: 100 shares at $5.00 each = $500 total value.
Companies do this to meet minimum exchange price requirements or to appear more "respectable" to institutional investors who avoid penny stocks.
When a company executes a stock split, the par value per share adjusts proportionally, but total par value stays the same.
Example: ABC has 1 million shares at $1.00 par = $1 million total par value. After a 2:1 split: 2 million shares at $0.50 par = $1 million total par value.
Uneven Stock Splits
Before: 300 shares at $30 = $9,000
Step 1 (Shares): 300 × (5/4) = 375 shares
Step 2 (Price): $30 × (4/5) = $24 per share
After: 375 shares at $24 = $9,000
Note: For price, use the inverse of the split ratio.
Test Tip: Neither stock dividends nor stock splits are taxable when received. They result in a cost basis adjustment, not a taxable event. Cash dividends, however, are taxable upon receipt.
Preemptive Rights
Preemptive rights protect shareholders from having their ownership diluted when a company issues new shares.
Imagine owning 10% of a company. The board decides to issue shares only to their friends at a bargain price. Suddenly your 10% becomes 1%. Preemptive rights ensure existing shareholders get first crack at new shares to maintain their proportional ownership.
Companies fulfill preemptive rights by issuing rights (also called subscription rights). Rights are short-term securities (typically 30-60 days) that give shareholders the option to buy new shares at a discount.
A shareholder receiving rights has three choices:
- Exercise — Buy new shares at the discounted price
- Sell — Transfer the rights to another investor
- Do nothing — Let the rights expire worthless
| Distribution Type | Key Features |
|---|---|
| Cash Dividends | Declared by board, typically quarterly, taxable |
| Stock Dividends | <25% of outstanding shares, not immediately taxable |
| Stock Splits | Forward increases shares, reverse decreases; par adjusts; not taxable |
| Rights | Short-term, below-market price, can exercise/sell/expire |
Section 3: Rights of Common Shareholders
In 1602, the Dutch East India Company became the first corporation to issue stock to the general public. The concept was revolutionary: ordinary people could own a piece of a massive trading enterprise. But ownership without rights is meaningless.
Basic Rights of Common Shareholders
| Right | Description |
|---|---|
| Inspect books and records | Corporations must provide audited annual reports |
| Transfer ownership | Shares are liquid—can be bought and sold freely |
| Preemptive rights | Maintain proportional ownership when new shares issued |
| Receive distributions | When dividends declared, all shares in class receive same dividend |
| Residual claim on assets | In liquidation, receive what's left after debts paid |
| Vote | Approve certain corporate decisions |
One crucial protection: shareholders enjoy limited liability. Their losses are capped at their investment. If a company goes bankrupt owing billions, creditors can't come after shareholders' personal assets.
Voting Rights and Methods
| Requires Shareholder Vote | Does NOT Require Vote |
|---|---|
| Stock splits (forward or reverse) | Cash dividends |
| Issuing convertible bonds or preferred stock | Stock dividends |
| Stock options to officers | Preemptive rights distributions |
| Most mergers and acquisitions | Treasury stock repurchases |
Shareholders must approve actions that could dilute their ownership or fundamentally change the company. They don't need to approve things that benefit them directly. Treasury stock buybacks don't require approval because they benefit remaining shareholders.
Voting Methods
Statutory Voting (most common): Votes must be evenly distributed.
Three board seats open. Shareholder with 100 shares has 300 total votes (100 × 3). They can cast exactly 100 votes for each candidate—no more, no less.
Cumulative Voting: Shareholders can allocate votes however they choose.
Same scenario: 100 shares, three seats, 300 total votes. The shareholder could cast all 300 votes for one candidate, or split them any way totaling 300.
Test Tip: Cumulative voting benefits small investors because they can concentrate their votes to help elect at least one director who represents their interests.
Proxy Voting
Most shareholders don't attend annual meetings. Companies send proxies—ballots that grant power of attorney to cast votes on the shareholder's behalf.
Nonvoting Stock
Some companies issue common stock with no voting rights. These shares receive dividends and have the same residual claims—they just can't vote. This lets companies raise capital while founders maintain voting control.
(Silicon Valley loves this arrangement, which explains why many tech founders control their companies long after their economic ownership has been diluted to single digits.)
| Topic | Key Details |
|---|---|
| Limited Liability | Maximum loss = amount invested |
| Voting Triggers | Splits, convertibles, stock options, mergers require votes |
| No Vote Needed | Cash/stock dividends, rights, treasury stock purchases |
| Statutory Voting | Votes evenly distributed (most common) |
| Cumulative Voting | Votes allocated freely (benefits small investors) |
Section 4: Preferred Stock
In 1836, the Baltimore and Ohio Railroad issued the first American preferred stock to finance westward expansion. The railroad needed capital but didn't want to dilute voting power. The solution: a new class of stock with better dividend treatment but no vote.
Preferred Stock Basic Features
Preferred stock is called "preferred" because it gets preferred treatment over common stock in two key situations:
- Dividends: Preferred shareholders receive full year's dividends before common shareholders get anything
- Liquidation: If company dissolves, preferred paid before common shareholders
Preferred stock is typically issued at $100 par with a stated dividend rate.
A company issues $100 par 10% preferred stock.
Annual dividend = 10% × $100 = $10 per share per year
Dividends typically paid quarterly ($2.50 per quarter). This rate is fixed regardless of market price.
Unlike common stock, preferred stockholders cannot vote and have no preemptive rights—the trade-off for their preferential treatment.
| Difference | Preferred Stock | Bonds |
|---|---|---|
| Maturity | Indefinite (no maturity date) | Set maturity date |
| Priority in Liquidation | After bondholders | Before preferred stockholders |
| Payment Obligation | Only if declared by board | Legal obligation |
Types of Preferred Stock
Cumulative Preferred
If the issuer skips dividend payments on cumulative preferred, missed payments accumulate. All must be paid before common shareholders receive any dividend.
Company has $100 par 8% cumulative preferred. Misses dividends for 2 years, then wants to pay common dividend in year 3.
Must pay first: Year 1 ($8) + Year 2 ($8) + Year 3 ($8) = $24 per share
Adjustable-Rate Preferred
Adjustable-rate preferred pays dividends tied to a benchmark rate (like Treasury bills). Income fluctuates, but share price remains relatively stable, providing preservation of capital.
Callable Preferred
Callable preferred can be redeemed by the issuer after a set date. Companies call when interest rates fall—retire old higher-rate shares, issue new at lower rates. Callable preferred pays higher dividends to compensate for call risk.
Test Tip: Common stock is never callable. Only preferred stock and bonds can be called.
Convertible Preferred
Convertible preferred can be exchanged for common stock at a predetermined conversion ratio. If common stock rises significantly, convertible preferred rises with it.
Test Tip: The price of convertible preferred is primarily driven by the underlying common stock, not by interest rates like regular preferred.
Participating Preferred
Participating preferred receives fixed dividend plus potentially additional dividends when declared. Allows participation in company profits during strong earnings years.
Interest Rate Movements and Preferred Stock Prices
There is an inverse relationship between interest rates and preferred stock prices:
- When interest rates RISE, preferred stock prices FALL
- When interest rates FALL, preferred stock prices RISE
The logic: if new preferred offers 8% and you hold preferred paying 6%, your shares must fall in price to offer buyers a competitive yield.
Current Yield Calculation
10% preferred stock ($100 par) trades at $90 per share.
Annual dividend = $10 ($100 × 10%)
Current Yield = $10 ÷ $90 = 11.1%
Current yield exceeds stated rate because investor bought at a discount.
| Type | Key Feature |
|---|---|
| Standard Preferred | $100 par, fixed dividend, senior to common, no vote |
| Cumulative | Missed dividends must be paid before common dividends |
| Adjustable-Rate | Dividend floats with rates; price stays stable |
| Callable | Issuer can redeem; pays higher dividend to compensate |
| Convertible | Can exchange for common; price follows common stock |
| Participating | May receive extra dividends in good years |
Section 5: Special Securities
Beyond common stock, preferred stock, and rights, two other equity-related securities appear frequently on the Series 7 exam: warrants and American Depositary Receipts.
Warrants
In 1911, AT&T issued the first publicly traded warrants to make a bond offering more attractive. A warrant gives the holder the right to buy stock at a fixed price—typically set well above current market price. Warrants only become valuable if the stock price rises above the exercise price.
Company issues bond with one warrant attached. Stock trades at $20. Warrant allows purchase at $30, expiring in 5 years.
At issuance, no immediate value—why pay $30 when shares cost $20? But if stock rises to $50 within 5 years, that warrant lets you buy at $30 for instant $20 profit.
| Feature | Rights | Warrants |
|---|---|---|
| Exercise Price | Below current market | Above current market |
| Duration | Short-term (30-60 days) | Long-term (5-10 years) or perpetual |
| Intrinsic Value at Issue | Yes (below market) | No (above market) |
| Time Value | Minimal | Significant |
Test Tip: Warrants, rights, and convertible securities are not considered equity until exercised or converted. Until then, they're derivative securities.
American Depositary Receipts (ADRs)
Foreign companies wanting U.S. investors face a challenge: listing directly on U.S. exchanges is expensive. American Depositary Receipts offer a workaround.
How ADRs Work:
- U.S. bank purchases foreign stock, holds it in trust in country of origin
- Bank issues ADRs representing those shares
- ADRs registered with SEC, trade in U.S. markets, priced in U.S. dollars
ADR holders receive dividends (converted to dollars) but don't have voting or preemptive rights—the bank handles those.
Although priced in dollars, ADR value depends partly on exchange rates. This exchange rate risk (currency risk) means:
- Foreign currency weakens → ADR value falls
- Foreign currency strengthens → ADR value rises
ADR investors face two risks: company performance AND currency fluctuations.
(Currency risk is why many U.S. investors wake up to find their international holdings moved 2% overnight while they slept—the company did nothing, but the yen did.)
| Security | Key Features |
|---|---|
| Warrants | Exercise above market, long-term, no intrinsic value at issue |
| Rights | Exercise below market, short-term, has intrinsic value at issue |
| ADRs | Foreign shares in U.S. wrapper, dollar-denominated, currency risk |
Chapter 1 Key Terms Glossary
| Term | Definition |
|---|---|
| Authorized stock | Maximum shares a corporation can issue per its charter |
| Par value | Arbitrary value assigned to stock for accounting |
| Issued stock | Shares sold to the public |
| Outstanding shares | Issued shares currently held by investors |
| Treasury stock | Repurchased shares (cannot vote, no dividends) |
| Market capitalization | Outstanding shares × market price |
| Transfer agent | Records ownership changes, issues certificates |
| Regular way settlement | T+1 for equities |
| Cash dividend | Distribution of profits (taxable) |
| Stock dividend | Distribution of additional shares (<25%) |
| Stock split | Increase/decrease shares via ratio |
| Preemptive rights | Right to maintain proportional ownership |
| Limited liability | Shareholder losses capped at investment |
| Statutory voting | Votes evenly distributed per item |
| Cumulative voting | Votes allocated freely |
| Proxy | Authorization to vote on shareholder's behalf |
| Preferred stock | Senior equity with fixed dividend, no vote |
| Cumulative preferred | Missed dividends accumulate |
| Callable preferred | Issuer can redeem at set price |
| Convertible preferred | Can exchange for common stock |
| Current yield | Annual income ÷ market price |
| Warrant | Long-term right to buy above market |
| ADR | Foreign shares traded in U.S., priced in dollars |
| Exchange rate risk | Risk from currency fluctuations |
Master these foundational equity concepts before moving to Chapter 2: Debt Fundamentals, which builds on similar concepts like par value, yields, and the inverse price-rate relationship.