What Is Common Stock? Definition With Examples
When you think of investing, the first thing that comes to mind is the world of the stock market. Common stocks or more popularly known simply as stocks or shares allow you to partially own a company by buying these stocks.
Stocks facilitate investors to accumulate wealth by just holding on to them. Apple Inc., one of the largest tech corporations, is worth over $1 trillion. Even if you owned 0.1% of Apple, you’d be a billionaire! Does that pique your interest in stocks?
Then let us learn the definition of common stock first.
What Does Common Stocks Mean: Definition Of Common Stock
Common stock, also known as ordinary or voting share is a type of stock that represents equity ownership of a company.
Stocks enable you to own a share of a company that you are interested to invest in. These are called voting shares because it gives you certain voting rights in the company.
This does not mean that you can sit next to the CEO of the company, and demand how the company should be run.
We will discuss voting rights later in the article. For now, this is just the basic concept of common stock. We are going to delve deeper into this article to give you a much broader and clearer concept of common stock.
Moreover, we will learn why companies issue stock, the initial process of issuing stocks, how to buy common stocks, the features, and the pros and cons of common stock.
Common Stocks Example
The major thing is that one company cannot issue shares in the market more than the authorized number of shares. However, the company can issue less than the authorized number of shares.
To calculate the common stock, you have to follow a formula.
Number of outstanding shares = Number of issued shares – Treasury stocks
Suppose ALPRECTA company has 3000 authorized shares. And the treasury stock portion is 500 shares. The company has issued 1000 shares during a public offering. Here, the number of outstanding shares is 500.
Why Do Companies Issue Common Stocks?
The simple answer is to generate money. An organization, when starting, needs an initial capital to fund its operations, sustainability, growth, and expansion. The capital can be used for other purposes as well; such as acquiring another company, paying off debts, and meet other expenses.
When a company starts, it has two choices to fund its expenses. Either they take a loan and pay the debt later, or they issue stocks and meet their expenses. Often, organizations do both when the initial cost is quite high.
Using the money generated from issuing stocks, they can pay off the debts or cover other expenses. The initial issuing of stocks is done via an Initial Public Offering (IPO). Here, the company publicly issues the common stocks into the markets.
Various investors who are interested in investing in promising organizations, will invest in the one that they find to be the most lucrative. This process is a win-win for both the organization and the investors if the company booms and grows exponentially.
Let us explain IPO with the help of an example. You own a decently performing sports equipment company. It is a private company with only one branch. As an entrepreneur, you wish to expand the company and open more branches.
You decide to go public and issue shares to get investors to invest in your company. Before that, an investment bank has to handle your IPO situation. This investment bank acts as an intermediary between you (the company) and the investors.
You need to choose an investment bank as per your requirement. Popular investment banks such as JP Morgan, Goldman Sachs, etc. are well known all over the world.
The initial share price depends on the current profit, earnings, and total value of the company. Once everything is clear and determined, the shares are released.
The number of shares to be issued initially is also determined here. Say 50000 shares are released initially. The purchasers of these initial shares will own the company along with you.
In the future, more shares can be released as the company grows.
Types Of Common Stock
There are different types of common stocks that exist in the stock market. Each of these has a certain characteristic that separates them from one another.
In this section we will discuss the different types of common stock and their features:
Blue-chip stocks are paid by companies that pay dividends for a long period of time. Among common stocks, this type of stocks is the most desired.
These types of companies are less risky and offer sustained dividends over a prolonged period of time.
Companies that pay high dividends from its Net Income (Income after-tax) offer income stocks. These companies are usually in the mature stage of their industrial life cycle.
Companies that offer public utilities such as water, electricity offer income stocks to the investors.
Defensive stocks are issued by industries such as food, drugs, beverages, etc. The stock prices of these stocks don’t dwindle even in the times of the bear market.
These are necessary goods and thus have constant demand throughout the year.
Cyclical stock prices are directly linked with the economic cycle. When the economy is booming and flourishing, the value of these stocks increases and vice versa.
So, investors mainly buy and sell stocks depends on the prediction of changes in economic factors
Speculative stocks are issued usually by new companies that have promising potential. These stocks are high-risk high-reward in nature due to their volatility.
So these stocks will either make you rich quick or you will lose money on them.
This is a unique kind of common stock that rarely pays dividends to its investors. The companies that issue these stocks have a high growth and earnings rate.
These stocks sell at a high price to earnings ratio.
These are low-value stocks that are priced lower than $1. The companies that issue these stocks are usually low-performing companies that aren’t too profitable.
Penny stocks are usually traded on OTC markets. Since the prices are low, even a small increase in prices will drastically increase the rate of return.
Features Of Common Stocks
Common stocks have certain characteristics that make it different from bonds and preferred stocks. Here are the salient features of common stocks:
Common stockholders are entitled to a dividend payment whenever the company has a profitable turnover.
Although their priority to receive these dividends comes after bonds and preferred stockholders have been paid.
Even if common stockholders are not paid dividends, they can sell the stocks at a higher price than they paid for. When this happens, it is called capital gain.
When the stock prices skyrocket, common stockholders can earn huge profits.
Common stockholders have the privilege to weigh-in their say in company decisions.
This doesn’t mean they can direct how day-to-day operations should be run, but they can take part in electing the directors on the board.
Not all common stockholders get this right, however. Stockholders holding a considerable percentage of stocks have a larger influence in these situations.
If the company the common stockholders invested in decides to liquidate, the company first pays off the debt holders, preferred stockholders, and bondholders.
From the remaining assets, the common stockholders are paid proportionately to their investment.
A common stockholder cannot lose more than he invested. If the company can’t pay him, he receives nothing. He only loses his initial investment and nothing more.
Advantages Of Common Stocks
Common stocks offer several advantages that make them attractive to invest in. If you are investor wondering if common stocks would be the right kind of investment for you, then read below to know the benefits that common stocks offer:
Can’t Lose More Than You Invest:
Due to limited liability, you can only lose the amount you invested buying the common stock.
For example, if you invested in 2000 shares of a tech startup and the company goes bankrupt, you will lose only the amount you spent in purchasing those shares.
Compared to preferred stocks, common stocks are not limited to fixed dividend payouts. The return of investment for common stocks is limitless. It is more than bonds and preferred stocks.
No Legal And Company Obligations:
Once you invest in common stocks, all you’re required to do is hold on to them. You are not responsible if the company performs poorly.
As long as the company functions, you can relax with your passive investment.
You can easily buy and sell your stocks as per your needs. If you think you have made enough from the stocks, you can easily sell them.
Or if you think the stock price will rise even further, you can buy some more for more gains.
Exercise Voting Rights:
As a common stockholder, you have the right to cast your vote when it comes to electing company board panel.
The number of shares you own of a company represents your voting influence.
Disadvantages Of Common Stocks
Along with the benefits, there are certain cons of owning common stocks.
High Level Of Risk:
Stock prices are volatile. That means their prices constantly go up and down. There’s always a risk of losing money in stock investment.
And not only that, the company that you invested in may even go bankrupt and you could lose all your investment.
Therefore, you need to we wise when selecting which company to invest your money in.
No Guarantee Of Dividend Payment:
Common stockholders only get paid if the company is profitable. Therefore, when the company has a negative quarter, common stockholders don’t get paid dividends.
Even when the company is profitable, it first pays the debt and preferred stockholders which brings us to our next point.
Last One To Be Paid:
This is probably the biggest disadvantage of owning common stocks. First, the creditors, employees, and bondholders are paid.
Then preferred stockholders are paid. And finally, if there is anything left, common stockholders are paid from it.
Therefore, buying the right stocks at the right price is extremely important to safeguard your investment.
In this article, we learned about the basics of common stock. The world of stocks and the stock market can be an intimidating one.
Investing in the right company at the right time is a daunting task for even the most experienced investors. This is why if you are keen on becoming a stock investor, you need to be equipped with the knowledge of common stocks.
Now, you know what they are, how they function, why companies issue these kinds of stocks, and the pros-cons of owning common stocks.
You can read our article on how to calculate common stock to evaluate its value and performance.