Common Stocks and How They Work

How Common Stocks Allow You to Own a Piece of a Corporation

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Common stocks are one form of a piece of ownership of a corporation. They are the type of stock that most people are thinking of when they use the term "stock." Since stocks are partial ownership of a corporation, they are also known as "shares." Common stocks allow stockholders to vote on corporate issues, such as the board of directors and accepting takeover bids. Most of the time, stockholders receive one vote per share. Stockholders also receive a copy of the corporation's annual report.

Many corporations also give stockholders dividend payouts. These dividend payouts will change based on how profitable the company is.

Stock Market Basics

Stocks are bought and sold throughout the day on a stock exchange. The two stock exchanges in the United States are the New York Stock Exchange and the NASDAQ. For this reason, the price of a share of a stock goes up and down depending on the demand. Stock prices can, therefore, be affected by corporate earnings, public relations announcements, and the health of the U.S. economy overall.

Therefore, you can make money from stocks in two ways: from dividend payments, or by selling it when the price of the stock goes up. You can also lose your entire investment if the stock price plummets.

What drives demand for a stock? Underlying it all is expected earnings. If investors think the company's earnings will rise, they will bid up the price of the stock. Second is whether the current price is low compared to the company's earnings. The Price to Earnings Ratio measures this. Third, is expected growth of revenue, even if the earnings aren't there yet. This can happen with a new company that has a lot of promise. Investors may have a lot of irrational exuberance over being in on the ground floor of this type of company, and bid up the stock price.

This can create a bubble, which becomes a self-fulfilling prophecy.

Stocks are first issued in a company's initial public offering. Before the IPO, the company is usually privately held and finances itself through internal corporate profits, bonds and private equity investors. It will decide to "go public" for several reasons. First, it may wish to expand and needs the massive amount of capital received in an IPO. Second, many companies offer stock options to their early employees as an incentive to come on board. That's because many start-ups don't have the cash flow to pay highly skilled executives.

The promise that they will make millions once the company goes public can be enough to bring them on board.

Third, the founders may wish to cash in on their years of hard work. They award themselves large amounts of stock in an IPO, which is typically worth millions of dollars. Of course, they are prohibited from selling it right away. Furthermore, they don't want to sell their stock all at once, since this would be interpreted as a loss of confidence in the company. Over time, they can sell their stock. 

A third reason a company goes public is to allow the owners to diversify their financial portfolio. In other words, they don't have all their personal finances tied up with their companies.

Common Stock Versus Preferred Stock

The other type of stock is preferred stock. The main difference is that preferred stock does not allow voting rights. It also pays a set dividend that does not change. Furthermore, preferred stockholders will receive their set dividends before the company decides how much they will spend on dividends for common stock. If the company goes out of business or is restructured in a bankruptcy, the assets are distributed to bondholders first. Preferred stockholders are next, and common stockholders are last.

In most cases, the common stockholder will receive nothing.