Common stock shares derive their value from market sentiment regarding the value of the underlying company.
Northfielder, CC BY 2.0 via Flickr
What Is Common Stock?
Common stock is a type of tradable equity issued by a company that represents partial ownership of the underlying business. This partial ownership comes with certain rights—namely, the ability to vote in the elections of the board members who make important decisions about the company’s direction and operations.
Most investors don’t buy common stock specifically for the voting rights they come with. More commonly, they buy it because they think the company it represents will increase in value over time, resulting in capital gains for shareholders like themself. That being said, shareholders do have a vested interest in the decisions of a company’s board of directors, as these decisions impact company success, which in turn impacts share value.
Shares of common stock were once actual paper documents, but nowadays, they are mostly traded virtually via digital brokers like Fidelity, Charles Schwab, and Robinhood.
4 Features of Common Stock
Ownership: Common stock represents partial ownership of a company. Were a company dissolved and its assets liquidated, common stockholders would be entitled to their portion of the proceeds (if any remained after creditors, bondholders, and preferred shareholders were paid). Voting rights: Common shareholders have the right to vote in elections pertaining to company leadership, which can affect a company’s operations. Fungibility: All shares of a company’s common stock are worth the same amount at any given time. Additionally, each share represents ownership of the underlying company in the same amount. In other words, like a dime or nickel, any one share of common stock could be replaced by another without any change in rights or value.Volatility: Common stock (an equity security) is more volatile than preferred stock (a hybrid security) or corporate bonds (a debt security). This means it is more likely to change significantly in price over time. A share of common stock has no minimum or maximum market value.
How Does Common Stock Differ From Preferred Stock?
While common stock and preferred stock both represent company equity, they behave very differently and have different characteristics. For instance, preferred shares do not typically come with voting rights. That being said, they do usually come with a fixed, regular dividend. Common stockholders are dividend-eligible as well, but preferred shareholders are all but guaranteed a dividend of a fixed amount at regular intervals and take precedence in terms of dividend distribution.
These regular dividend payments are sort of like the regular interest payments received by corporate bondholders, and this contributes to yet another difference between common and preferred shares: Preferred stock—like corporate bonds—is far less volatile than common stock because it provides owners with regular, fixed income payments, so its market value is less likely to fluctuate dramatically.
Another big difference is that preferred shareholders have priority over common stockholders when it comes to asset distribution. If a company dissolves, preferred shareholders are paid out before common stockholders but after bondholders.
Additionally, preferred stock is often callable, meaning that after a certain date, it can be exchanged (given back to the issuing company) for its par (face) value.
Common Stock vs. Preferred Stock at a Glance
Why Do Companies Issue Common Stock?
Companies issue common stock for a variety of reasons. First and foremost, stock is issued to raise interest-free capital that can be used for business operations like expansion, hiring, research, and product development.
Additionally, issuing stock adds to company’s equity, which reduces its reliance on debt. The money raised by issuing stock can even be used to pay down existing debt. The lower a company’s debt compared to its equity, the more attractive it can appear to investors.
When a company issues common stock to the public for the first time, this is called an initial public offering (IPO) and is usually a sign that a business is growing and wants to fund its continued growth with investor capital.
What Are the Risks Associated With Common Stock?
The value of common stock is theoretically based on the value of the underlying company, but in reality, its value is determined by the open market. Good news or bad news can send a stock’s price skyward or cause it to tumble to dangerous lows. Even if a particular business is doing well, macroeconomic factors can lower the value of stocks across the board. This is the primary risk associated with common stock—it could theoretically lose 100 percent of its value.
Additionally, should a company go bankrupt, not only would its stock likely lose all of its value, but common stockholders would be the last to be paid out when the company’s assets were liquidated. Creditors, bondholders, and preferred shareholders would be paid first, so there may not be anything remaining for stockholders.
What Are the Advantages of Owning Common Stock?
Common stock also comes with a myriad of advantages. While it does carry more risk than most other types of investment vehicles, its volatility also comes with more potential upside. In the long term, common stock tends to outperform preferred stock and corporate bonds in terms of returns. When an investor identifies a company with strong intrinsic value and plenty of growth potential, the can generate very substantial returns, especially in the longer term (e.g., multiple years).
Additionally, many companies share their profits with common stockholders by paying dividends either on a regular basis or when earnings outperform expectations. That being said, not all stocks pay dividends, and preferred shareholders are paid instead of or before common stockholders if profits are limited. Finally, common stock comes with voting privileges, which allow shareholders to participate in board elections, stock split decisions, and merger and acquisition decisions. These privileges vary by company and may or may not be proportional to the number of shares owned.
Frequently Asked Questions (FAQ)
Below are answers to some of the most common questions investors have about common stock that were not covered in the sections above.
Where Is Common Stock Traded?
The most popularly traded stocks are usually listed on major stock exchanges like the Nasdaq and New York Stock Exchange (NYSE). Smaller companies that are publicly traded but have not uplisted to a major exchange can be bought and sold via brokers on the over-the-counter (OTC) market. Stocks like these are commonly referred to as “pink sheets.”
Where Does Common Stock Appear in the Balance Sheet?
Common stock is typically listed in the “Shareholders’ Equity” section of a company’s balance sheet.
Is Common Stock an Asset or a Liability?
Common stock is neither an asset nor a liability—it is an equity. A company’s assets should always equal its liabilities plus its equity.
Does Common Stock Have Par Value?
Par value refers to the face value of a stock, which is the price it cost when it was first issued. These days, most stocks do not have an official par value. Back when stocks were issued and traded physically, a par value would often be listed on a share’s certificate.
Is Common Stock Callable?
When preferred stock is callable, that means it can be exchanged by its owner (an investor) for its par value after a certain date. Common stock is occasionally callable, but when this is the case, it means that the stock’s issuer or a third party has the right to purchase shares back from the investor for a predetermined price on or after a particular date.
Can Common Stock Be Converted to Preferred Stock?
Some preferred stock can be converted into common stock at a predetermined ratio, but common stock cannot usually be converted into preferred stock. Once preferred stock is converted into common stock, it cannot be converted back.
