Common stock

What Is Common Stock?

Common stock represents an ownership interest in a corporation and is a fundamental component of equity securities within the broader realm of capital markets. Holders of common stock, known as shareholders, typically have voting rights on corporate matters, such as the election of the board of directors and other significant company policies. This form of ownership gives investors a claim on a proportional share of the company's assets and earnings, albeit one that is subordinate to other claims in the event of liquidation. The primary ways common stock investors seek returns are through dividends and capital appreciation from an increase in the stock's market price.

History and Origin

The concept of fractional ownership in business ventures, which underpins modern common stock, dates back centuries. The direct ancestors of today's corporations and their common stock were "joint-stock companies" formed in Europe as early as the 13th century. These early entities allowed multiple investors to pool capital for large, often risky, undertakings like trade expeditions or colonial ventures. A notable example is the Virginia Company, chartered in 1606, which played a pivotal role in financing early English settlements in the New World by selling shares to investors.⁴ Initially, shareholders in these companies often faced unlimited personal liability for the company's debts. However, over time, the principle of limited liability became a defining characteristic of corporate structures, greatly encouraging investment and facilitating the growth of capital markets.

Key Takeaways

• Common stock represents fractional ownership in a company, granting shareholders a claim on assets and earnings.
• Holders typically possess voting rights on key corporate decisions.
• Returns are primarily sought through capital appreciation and dividends.
• Common stock carries the highest risk among a company's securities but offers the highest potential for long-term growth.
• It is a core instrument for individual and institutional portfolio diversification.

Formula and Calculation

While common stock itself doesn't have a singular "formula" in the way a bond's yield might, its value is often analyzed using various financial metrics. One fundamental valuation multiple is the Price-to-earnings ratio (P/E ratio), which relates the company's share price to its earnings per share.

The P/E ratio is calculated as:

Another important calculation related to common stock is a company's market capitalization, which represents the total value of all its outstanding common shares.

These calculations help investors and analysts assess a stock's current valuation relative to its profitability and overall size.

Interpreting the Common Stock

Interpreting common stock involves understanding both its intrinsic value and its market-driven price. A higher price-to-earnings ratio might suggest investors have high growth expectations for the company, or that the stock is considered overvalued. Conversely, a lower P/E ratio could indicate an undervalued stock or a company facing challenges. Investors often compare a company's P/E ratio to its historical averages, industry peers, and the broader market to gain context. Beyond financial ratios, interpreting common stock requires an understanding of the company's business model, competitive landscape, management quality, and macroeconomic factors. The relative value of common stock is a dynamic concept, continuously influenced by supply and demand on a stock exchange.

Hypothetical Example

Imagine Sarah is considering investing in "GreenTech Innovations Inc." (GTI). GTI has 10 million shares of common stock outstanding, currently trading at $50 per share. Last year, GTI reported total earnings of $50 million.

1. Calculate Earnings Per Share (EPS):
   EPS = Total Earnings / Number of Outstanding Shares
   EPS = $50,000,000 / 10,000,000 = $5.00 per share

2. Calculate Price-to-Earnings (P/E) Ratio:
   P/E Ratio = Current Share Price / EPS
   P/E Ratio = $50 / $5.00 = 10

This means investors are willing to pay $10 for every $1 of GTI's earnings. Sarah would then compare GTI's P/E of 10 to its industry average and competitors to determine if it's a reasonable valuation. If the industry average P/E is 15, GTI might appear relatively undervalued, suggesting potential for capital appreciation.

Practical Applications

Common stock is central to many facets of finance and investing. Individual investors buy common stock to build wealth over time, aiming for long-term growth through rising share prices and regular dividends. Institutional investors, such as mutual funds and pension funds, also heavily invest in common stock to meet their investment objectives. In corporate finance, companies issue new common stock to raise capital through an initial public offering (IPO) or subsequent secondary offerings, funding expansion, research and development, or debt repayment. Regulatory bodies, such as the U.S. Securities and Exchange Commission (SEC), oversee the issuance and trading of common stock to protect investors and ensure fair and orderly markets. The SEC's Investor.gov website provides extensive information for the public regarding stock investments.³

Limitations and Criticisms

While common stock offers significant growth potential, it comes with inherent limitations and risks. The value of common stock can be highly volatile, fluctuating based on company performance, industry trends, economic conditions, and investor sentiment. Investors can lose their entire investment if the company fails. Unlike bondholders, common stockholders have the lowest priority claim on a company's assets in the event of bankruptcy, meaning they are paid only after all other creditors. Furthermore, companies are not obligated to pay dividends, and can cut or suspend them at any time, impacting income-focused investors. For instance, the historical stock price of a company like Thomson Reuters Corporation demonstrates how share values can fluctuate significantly over time, reflecting market dynamics and corporate performance.² Critiques also sometimes arise regarding corporate governance, particularly concerning the effective exercise of voting rights by small shareholders or the potential for executive compensation to disproportionately benefit management at the expense of broader shareholder interests. International bodies like the Organisation for Economic Co-operation and Development (OECD) develop principles for corporate governance to address such concerns, promoting transparency and equitable treatment of shareholders.¹

Common Stock vs. Preferred Stock

The primary distinction between common stock and preferred stock lies in the rights and priorities granted to their respective holders. Common stock confers ownership and typically includes voting rights, allowing shareholders to influence company management and policies. Common stockholders are the last to receive payments in the event of a company's liquidation, but they benefit most from a company's success through unlimited capital appreciation.

In contrast, preferred stock usually does not come with voting rights. However, preferred shareholders have priority over common shareholders when it comes to receiving dividends and asset distribution in a liquidation. Preferred stock dividends are often fixed and paid out before common stock dividends, providing a more stable income stream similar to bonds. While preferred stock generally offers more stability and predictable income, it typically has limited capital appreciation potential compared to common stock.

FAQs

What are the main benefits of owning common stock?

The main benefits of owning common stock include the potential for significant capital appreciation if the company performs well, the receipt of dividends (if declared), and the ability to influence company decisions through voting rights.

Is common stock a good investment for everyone?

Common stock can be a suitable investment for individuals with a higher risk tolerance and a long-term investment horizon, as its value can fluctuate considerably in the short term. It plays a key role in building a diversified portfolio diversification for growth.

How do I buy common stock?

Common stock can be purchased through a brokerage account. After opening and funding an account, you can place orders to buy shares of specific companies traded on a stock exchange.

What happens if a company goes bankrupt and I own its common stock?

If a company goes bankrupt, common shareholders are among the last to receive any proceeds from the liquidation of assets, after creditors and preferred shareholders have been paid. It is common for common stockholders to lose their entire investment in such a scenario.