What Is Common Stock?

The Basics and How They Work

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Common stocks are shares of ownership of a corporation. They allow you to own a portion of the company without taking possession. They are the type of stocks that most people are thinking of when they use the term "stock." The other kind is preferred stock.

Like other securities, stocks are traded on a secondary market called the stock market. That makes them liquid as well as easy to price. As a result, they are excellent indicators of the underlying value of the assets. The other common type of security is a bond.

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. Individual stock prices are affected by corporate earnings and public relations announcements. All stocks are affected by 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.

Why Companies Issue Stocks

Stocks are first issued in a company's initial public offering. Before the IPO, the company is usually privately held. It finances itself through internal corporate profits, bonds and private equity investors. It will decide to "go public" for four 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. They are prohibited from selling it right away. They rarely sell all their stock at once, since this would be interpreted as a loss of confidence in the company. Instead, they sell it gradually over time. 

A fourth reason a company goes public is to allow the owners to diversify their financial portfolio. It is risky for them to have all their personal finances tied up with their companies.

Is Common Stock an Asset?

Common stock is an asset for the shareholder. Like any other asset, such as a house, gold, or diamonds, the owner will receive payment when it is sold.

Common stock is listed as an asset on a corporation's balance sheet. The amount reflected on the balance sheet is its par value. It's an arbitrary number, often one cent per share. The difference between the par value and the amount received under the IPO is called capital surplus. Neither figure is the stock's market value, also known as market capitalization. That figure changes along with the stock price. It's the stock price times the number of outstanding shares.

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. Corporations will pay the set dividends to preferred stockholders first. Then they will decide how much to spend on common stock dividends.

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.