Common stock represents part ownership in an incorporated entity. A company’s common stock can be found under the “stockholders’ equity” section on the company’s balance sheet.
However, it’s important to note that this is the book value of equity, which is different from its market price and market capitalization.
How does common stock work?
Investing in common stock has historically delivered greater returns than fixed-income securities. Common stock generates returns in two ways: dividends and capital appreciation.
Once the company has issued common stock and it’s listed on stock exchanges like NYSE and NASDAQ, investors can buy and sell them through a broker.
Common stock comes with its fair share of risk. In the event of liquidation of a company, the common stockholders are paid off last, provided the company has assets left over after discharging its obligations to its creditors, lenders, and preferred stockholders. That said, share prices can be far more volatile than those of preferred stock or bonds.
What factors impact its price?
There are several factors that may affect the price of common stock. They include:
- Supply and demand
- The company’s earnings performance
- The company’s growth prospects
- Industry-specific events
- Macroeconomic factors
Common stock vs. preferred stock
The two primary points of distinction between common stock and preferred stock are voting rights and dividend payments. It may be helpful to think of preferred stock as a combination of common stock and bonds. Preferred stock pays dividends like common stock and is redeemable on a future date at a predetermined price like a bond.
Common stockholders have the right to vote on mergers, issues of fresh capital, and other key decisions concerning the company. On the contrary, preferred shareholders don’t have any voting rights.
Common stockholders and preferred stockholders both receive dividends, though at different rates. While the board can make a call on whether common stockholders will receive any dividend in a given financial year, preferred dividends must be paid out.
Lifecycle of common stock
A corporation issues common stock when it needs money. The entity may need funds for several purposes, including but not limited to financing the higher working capital requirement and capital expenditure.
When a company realizes it needs money, it approaches an investment bank. The investment bank takes care of all aspects of the initial public offering (IPO) and underwrites the issue. It also invites investors to subscribe to the company’s common stock.
Once the bidding closes and the common stock has been allotted to applicants, the common stock is listed on an exchange like NYSE or NASDAQ. Investors can then begin to trade their shares in real-time using their broker’s trading platform.
Often, companies split stock when its price soars. A stock split refers to the action of dividing one share into multiple shares of equivalent value. For example, if you own a share worth $20,000 and the company announces a 4-for-1 stock split, you now own 4 shares worth $5,000 each. Doing so increases liquidity in the market, thereby encouraging participation from retail investors.
Common stock remains listed unless the company decides to go private, does a buyback, or liquidates. Liquidation can be a particularly concerning event for common stockholders since they are the last stakeholders in the repayment hierarchy.
Classes of common stock
Companies may choose to issue different classes of shares at their discretion. The primary purpose of this is to retain control of the company in the hands of a select few.
For instance, a company may issue Class A and Class B shares, both of which have different voting rights. Class A shares may have 3 votes per share, while Class B may have 5. Note that the company can create classes and assign voting rights as they see fit.
However, the equity interest in the company usually remains the same across all classes of shares. All shareholders have an equal right over the company’s earnings, i.e., all shareholders are entitled to receive dividends approved by the board.
Most small investors aren’t too concerned about voting rights as long as they have confidence in top management. The lack of voting rights may become an issue if something causes them to lose confidence. However, small investors are more likely to sell the shares rather than trying to take an active part in the company’s management.
Common stock is one of the major sources of financing for companies. It provides companies the flexibility to retain their earnings that would otherwise go towards paying interest.
Common stock is a popular investment choice as equities have the potential to outperform other asset classes in the long-term. However, there is never a guarantee that investing in a company’s common stock will always lead to sizable profits.
Before investing in equities, it’s imperative to look at your entire portfolio, assess your risk appetite, and establish a time horizon.