Corporate profits that are passed on to stockholders are called "dividends." Dividends are what stockholders are waiting for when they invest in a corporation.
A corporation does not ordinarily pay a dividend until two conditions have been met. First, the gross receipts must be larger than is required to meet all expenses, including taxes and paying interest on borrowed money. The remainder is the corporation's net income or net profit, sometimes called "earnings."
Second, the management must decide how much of the profits is needed for such things as expansion of the business or as a cushion for possible bad years in the future, and how much of the net income can be spared for dividends to stockholders. Sometimes, when current income is poor, dividends are paid from the undistributed profits of previous good years.
When a corporation's gross receipts are smaller than its expenses, so that there is no profit, its stockholders suffer by receiving no dividends, and the market value of a share drops, possibly to zero. But a stockholder is not assessed, as a partner often is, to help pay the firm's debts. There may be some rare exceptions to this statement, so that a cautious investor needs to inquire before he buys.
Every corporation has "common" stock; and in the simplest form of equity ownership, a company has only this one class of stock. A company with two classes of stock is likely to call one class "preferred"; or maybe there are a first preferred and a second preferred.
Preferred stock is a compromise between a loan and an equity.
A preferred dividend is scheduled at a uniform rate per share, such as five dollars a year, thus resembling interest on a bond. But in contrast to bond interest, a corporation pays a preferred dividend only if earnings have been adequate and the management decides to pay. This uncertainty of dividends causes more fluctuation in the market price of preferred stock than on bonds issued by corporations, although probably not as much as on the common stock of the same corporations.
When a company's net income goes up, the dividend on a share of preferred stock remains at the scheduled rate, while on a common share the increased profits are probably reflected in a larger dividend, and the market price of a common share rises more than on the preferred. In a prosperous period, both the dividend and market value on a share of common may be higher than on the preferred, thus leaving a preferred stockholder in a state of genteel poverty! When profits are poor, maybe dividends will continue on the preferred but not on the common; or maybe dividend payment will stop on both classes of stock. Usually the only thing sure about preferred stock is that the dividend will not be higher than the scheduled rate!
For an amateur investor, a simple way to meet this confusing situation is just not to own any preferreds. And because the presence of a preferred class complicates the normal relation between company earnings and common-stock dividends, an amateur had better be skeptical of common stock in a corporation that also has preferred stock. A majority of the large American corporations have only common stock, and the type especially recommended by this author issue only common stock. So in the remainder of these chapters, the discussion of stock is limited to the common class.
Early in this century a corporation customarily sold a new issue of stock at the par value, usually $100 a share, so that par value had some meaning for an investor. But today the par value of a share of common stock indicates neither the original price nor the present selling price. It has become merely a legal technicality, and a number of corporations specify that their stock has "no par value." To an investor, the market price of a share is what matters, and on common stock in a prosperous period this value is likely to be a good deal higher than the par value.
In short, an investor would do well to seek the advice of a professional if he is unaware of the meaning of these terms. Investors should always be wary of a corporation that offers both preferred and common stock, and perhaps avoid investing there altogether.