Contents
What’s it: Common stock or ordinary stock is a security representing ownership in a company. Therefore, buying it makes us a shareholder. And as long as we hold it, we have the right to earn profits distributed as dividends without limit.
Unlike preferred stock, common stock generally carries voting rights. It, for example, allows us to elect management at a shareholder meeting. How significant our voting rights are, depends on how much we own. In addition, it also depends on the class of shares we hold. For example, class A gives us more voting rights than any other class.
Where do we buy common stock? They are usually available on the stock exchange. Companies offer their shares to the public through an initial public offering.
And the number of shares outstanding and available for purchase on the exchange depends on the corporate action. For example, the company conducts a stock split or distributes stock dividends. These corporate actions increase the outstanding shares, allowing more shares to be available for purchase. On the other hand, stock buyback reduces the outstanding.
Not all common stock is available to the public. For example, private companies such as startups require us to buy directly. Unlike shares on an exchange, their shares are usually only sold to accredited investors.
How do common stocks work?
Common stock is widely available to the public. What we find in the stock market is mostly common stock. Each share sold there represents fractional ownership. And its holdings are mostly spread out among many investors. As a result, the company is owned by many investors.
Each share provides a claim on the company’s profits. When management decides to distribute dividends, each common stockholder is entitled to receive them.
In addition, common shares usually often carry voting rights. Thus, ordinary shareholders can participate in voting during shareholder meetings. But, of course, their votes can significantly impact only if they hold a sizable stake.
Reason for issuing shares
Why do companies issue shares if their decisions can be influenced by other parties (investors)?
Issuing shares is one way to raise funds in addition to issuing debt securities. Big companies like Apple, Alibaba, Amazon, Alphabet, Microsoft, Tesla, and Meta do that. For example, Apple raised more than $100 million from its initial public offering in 1980 when the company sold 4.6 million shares at $22.00 per share. Likewise, Alibaba Group Holding Limited raised $22 billion in initial public offerings in 2014.
In addition to raising funds, issuing shares can be a way to lower financial leverage. While debentures incur future financial obligations, stocks do not.
Companies must spend regular money to pay coupons when issuing debt securities. And at maturity, they have to pay the principal. Failure to pay coupons and principal will lead to default.
Then, when leverage is high, the company’s capacity to borrow is lower. High financial leverage increases financial risk. Large debt makes the company’s ability to repay low, resulting in a higher risk of default. As a result, it is difficult to take out new loans without high interest.
Meanwhile, shares do not have default consequences. That’s because shares represent ownership rights, not debt. Thus, a company does not need to spend regularly paying coupons or the principal at maturity. Therefore, unlike debentures, issuing shares does not result in increased financial leverage. Rather, it increases equity capital.
What happens when a company sells common stock
When companies issue common stock, their holdings become more dispersed. If, before the initial public offering, the shares are owned by a few parties, usually the founders, then after selling them to the public, many investors can buy them. Eventually, those who buy become shareholders in the company.
For example, a company has 100 outstanding shares. Around 90 shares were sold to the public through an initial public offering. However, 10 shares are still owned by the founders. Say there are 90 investors with each buying 1 share. As a result, this corporate action added 90 new shareholders with 1% (1/100 share) ownership in the company.
Then, when the company sells additional common stock to the market, the total outstanding shares increase. As a result, it dilutes existing shareholder holdings. For example, the company issues 100 new shares. Thus, there are 200 outstanding shares. After this corporate action, 1 share no longer represents 1% ownership, but the percentage has decreased to 0.5% (1/200 share).
Difference between common stock and preferred stock
Common stock has different characteristics from preferred stock. For example, it allows us to participate in voting within the company because it usually carries voting rights. So, we can participate in the company’s operating performance.
In contrast, preferred stock does not offer that because it carries no voting rights unless it is explicitly permitted to be issued.
Although they cannot participate in the voting, preferred stockholders have a higher priority than common stockholders in receiving dividends. So, when distributing it, the company distributes it to preferred stockholders first before to common stockholders. And preferred dividends are generally higher than common stock dividends and are fixed at a certain rate.
Such priority also applies to claims against assets. For example, if the company is liquidated, preferred stockholders have a higher priority to claim. Thus, sequentially, creditors are the first to receive liquidating assets. After that, preferred stockholders receive the remainder. And common stockholders are the last to receive.
Common stock class
Companies can issue different classes of common stock. Each usually has voting rights and different ownership. Likewise, each is entitled to different claims when the company is liquidated.
Take Google as an example. In addition to offering 100,000,000 preferred shares, the company also offers the following three classes:
- Class A Common Stock has one vote per share;
- Class B Common Stock has 10 votes per share
- Class C Capital Shares have no voting rights unless otherwise provided for by law.
Callable and puttable features
Common stock may embed callable and putable features. What feature is it?
The callable feature allows the issuing company to have the right to buy back its shares from investors. It’s not an obligation. So, the company may not do it. But conversely, if executing this feature, the company buys back the shares at a certain price, determined at the time the shares were first issued.
This feature offers several advantages for the company. First, when the company’s stock price continues to appreciate, companies can buy back their shares more cheaply. This is because appreciation makes their market price higher than the purchase price. Second, if the shares are repurchased, the number of outstanding shares decreases. Thus, the company can save on dividend payments.
For example, before executing the callable feature, they distribute a $1 dividend per share with 100 outstanding shares. Thus, they pay a $100 dividend ($1 x 100 shares). However, once activated, let’s say the outstanding shares are reduced to 90 shares. So, they pay only $90, assuming the dollar per share is fixed.
Meanwhile, the puttable feature gives investors the right to resell their shares to the issuing company. Like callable features, puttable features represent rights, not obligations. Thus, investors may activate this feature and may not.
Say an investor executes this feature. They will sell the shares they hold to the issuing company at a predetermined price (when the shares are issued).
This feature allows investors to limit losses. For example, suppose the stock price continues to fall. In that case, they can resell the stock to the issuing company before it drops further.
Are common stocks a good investment?
Investing in common stock allows investors to grow wealth along with the company’s success. When a company achieves a sustainable competitive advantage, we expect its share price to continue to rise. The company also continues to generate high and sustainable profits, encouraging them to continue to pay dividends.
To answer the question above, is common stock a good investment? Let’s break down the advantages and disadvantages of investing in common stocks.
Advantages of common stock
First, we have the potential to get capital gains. If the stock we buy rises in price, we can sell it at a profit. We buy them at a lower price than the market price when we sell them. In general, stocks usually offer higher returns than government or corporate bonds.
Second, we have the right to receive dividends. Some companies regularly pay dividends. Examples are utility and consumer goods companies. They operate in non-cyclical industries. Their business is relatively steady and not significantly exposed to the business cycle.
Earning capital gains and dividends is the main reason why investors buy common stock. Nonetheless, some may be more pursuing capital gains. Others may pursue dividends more for a steady cash inflow.
However, not all companies regularly pay dividends. For example, cyclical companies like airlines sometimes pay dividends, but sometimes they don’t. They may pay dividends when the business is profitable, usually during a prosperous economy. On the other hand, during a difficult economy, such as a recession, they may not distribute dividends.
Likewise, mature companies are more likely to pay dividends than younger ones. Startups, for example, rarely pay dividends because they are raising capital to grow their business. In contrast, mature companies pay dividends because they have a more stable income stream.
Third, the common stock often carries voting rights. Thus, we can participate in key decisions such as selecting management, policy changes, and corporate actions. This feature allows us to ensure the company continues to work in our interests by generating growth and profits in the long term.
Fourth, investing in common stock also gives us the right to claim a residual claim on the company’s net assets when liquidated. So, when the company goes bankrupt, we may be able to recover our investment.
Disadvantages of common stock
First, the common stock carries a high risk. As the saying goes, high returns come with high risk in investing. We have the potential to bear the risk due to the company’s stock price falling. And in general, stocks are at higher risk because their prices are more volatile than government and corporate bonds.
Second, not all companies distribute dividends regularly. So, we have to select them. And again, looking at the company’s track record of paying dividends might guide us.
This contrasts with bonds, which pay out coupons regularly. And if the company doesn’t pay the coupon, they default.
Then, the stock investment will lose more if, at the same time, the company’s stock price falls. As a result, we do not receive dividends and see our investment value fall due to falling stock prices.
Third, our voting rights are limited. Our holdings may be small compared to other investors, especially institutional investors. As a result, our vote is also minimal to influence decisions in the company. Instead, we may just follow the majority shareholder.
Fourth, even though we have residual claims on liquidated assets, we only get them at the very end. Usually, the company will distribute first to creditors. Then, if still remaining, preferred stockholders get a share before common stockholders. So, if the assets have been distributed to creditors and preferred stockholders, nothing is left for us.
What to read next
- Stock: Types, Risk, Return, Advantages, and Disadvantages
- Common Stock: How it Works, Types, Features, Advantages, and Disadvantages
- Preferred Stock: Meaning, Characteristics, Pros and Cons
- Stock Dividend: Definition and Brief Explanation
