Common Stock Definition
WRITTEN BY PAUL BOYCE | Updated 5 July 2022
What is Common Stock
Common stock is a financial asset which represents ownership of a company. Those who have common stock have voting rights and an ability to have a say in how the company is run. This includes appointing the board of directors, selling the company, or other major business decisions.
Also known as ‘shares’, common stocks offer the owner potential dividend payments and equity gains. In other words, shareholders may benefit from an increase in the stock price.
Common stock is a popular method by business owners to raise capital to help it fund investment. It’s a cheap solution by which the owner gives up a share in the company in return for an investment. However, in the long-term, the original owners may face issues with shareholders. For instance, some may want the business to go in one direction, whilst the owner may want to take it another way.
- Common stock represents ownership of a company.
- Although common stock presents higher risks, they can also present higher rewards.
- In the event of company collapse, common stock owners receive their investment last.
Common Stock Explained
Common stock represents an investors ownership share of a company. For example, Mr Bloggs owns 100 shares of his company and is looking for an investment. He issues 100 new shares that four new investors purchase. They each own 25 shares, which represents 12.5 percent of the company. Mr Bloggs owns 100 shares, but has issued 100 additional shares. This therefore reduces his ownership from 100 percent to 50 percent. This is because there are now 200 shares in circulation, but he only owns half of those.
So common stock represents ownership of the firm. This allows business owners such as Mr Bloggs to access a new revenue of credit. Perhaps money is needed for a new factory or extra staff. By selling a proportion of the company, it is able to grow at a rate which might otherwise be impossible.
The downside of common stocks for the business is that investors will have a say in how the business is run. This won’t be to the level of deciding whether the office should have a coffee machine, but on big business decisions such as mergers or huge company wide lay-offs.
A common stock investment is not without its risks. For instance, during the event of a bankruptcy, the company will go into liquidation. During this process, bondholders will be paid first alongside other creditors. Next, preferred shareholders will receive their investment, followed lastly by common stock owners. In the event of bankruptcy, it pretty much means that they won’t see any of their investment back.
Key Characteristics of Common Stock
- Represents ownership of the firm
- Influence over decision making
- Stockholders may receive a dividend
- Last one to receive investment in liquidation
- Potential for highest reward through equity gains
Common Stock Rights
When an investor purchases common stock, they receive a number of rights that they are entitled to. This specific detail of which can vary from country to country and business to business. However, there are a number of common stockholder rights which are universal.
Common stockholders have the right to claim dividends in the event that the board of directors issue dividend payments. However, this right is superseded by that of preferred stockholders.
Common stockholders have the right to a companies assets. That means in the event of bankruptcy and liquidation, owners have a claim to the companies assets. However, this claim is rather low down the pecking order. Bondholders, creditors, and preferred stockholders all have a higher claim.
3. Preemptive Rights
If an existing public firm chooses to issue more public shares, owners of common stock have first refusal of these shares. Also known as a ‘rights offering’, investors receive the option to buy a number of shares which would equal the existing percentage of stocks they had. These are usually offered to investors at a discounted price and are tradable.
4. The Right to limited liability
As a common stockholder, investors are not liable for any malpractices that the company has undertaken. For instance, a company may lose a significant lawsuit, but any financial penalties are taken by the company itself. If the company cannot pay such fees, then the company may go bankrupt. However, the shareholders are not liable to pay for those fees.
5. Transfer of Ownership
Common stockholders are due the right to be able to dispense of their stocks at any stage and without discrimination. Usually this occurs through stock markets such as the S&P 500 or FTSE100.
6. The Right to Inspect Corporate Documents
Companies that are public, i.e. offer common stock, must provide stockholders with detailed financial records. This includes items such as an income statement, balance sheet, statement of cash flows, and statement of stockholders’ equity. In addition to the financial records, stockholders have a right to the notes from shareholder meetings.
7. The Right to Sue for Wrongful Practice
Common shareholders have the right to bring a legal case against management. This might be for mismanagement or even fraud. Some executive officers may ‘overcook’ the books, overstating profits, assets, or revenue. This paints a different picture to reality, so can create significant loss of value to shareholders.
8. Voting Power
Those with common stocks are able to vote on key decisions. This includes appointment members to the board, the sale of the company, executive pay, mergers and acquisitions, and the removal of directors. However, there are many other decisions that will take place during shareholder meetings which involve a voting process.
Public Offering of Common Stock
If a company wishes to seek investment from the public, it will undertake what is known as an initial public offering (IPO). This is a great way for businesses to obtain significant levels of cash to help build the company and invest for the future. Obviously, for the existing owners, this means giving up part of the company. However, they may expect the subsequent growth to more than make up for this.
In order for a company to undertake an IPO, it must first work with an underwriting investment firm. This helps establish a suitable price for the firm, as well as the type. For instance, it might be advisable for them to offer preferred stock instead.
During the IPO phase, the investment bank will seek and target institutional and wealthy investors. This is because they are able to buy and hold a large number of shares. The idea behind this is that they will be able to assume the financial risk and hold on to the investment for the long-term. This way, short-term traders have little influence over the share price once it goes public. Therefore, the level of volatility should be limited, with a stable stock price ensuing.
Common Stock Examples
On June 29, 2010, Tesla ‘went public’ with its initial public offering (IPO). At launch, it introduced 13,300,000 common stock at a price of $17 a share. Despite the company struggling to turn a profit for the next ten years, the firms share price continued to grow, reaching a high of $1,222 in 2021.
Tesla managed to raise $226 million from the IPO, helping it fund a significant part of the companies development. However, by 2013, the firm was struggling with the Model S and was close to running out of cash. The tides turned for the firm and a surge in demand helped it weather the storm.
As it stands, roughly 42 percent of the company is now public, with Tesla issuing subsequent rounds of common stock to the public. Following the IPO of 13.3 million of common stock, this has since increased to 440 million.
Going back to 1986, Microsoft went public with its IPO, generating $61 million for the firm. Demand was so strong during the initial phase, that Microsoft issued an additional 295,000 shares over and above the initial listing of 2.5 million.
After initially listing for a price of $21 a share, the stock price rose to over $28 by the end of the first day. It was such a successful offering, many analysts named it as ‘IPO of the year’.
Although Microsoft sold less than 3 million shares, it has gone on to introduce more and more common stock onto the market. As of April 21, 2022, there was close to 7.5 billion shares on the market.
On December 12, 1980, Apple went public, floating 4.6 million common stock at a cost of $22 per share. On the opening day, the share price increased by 32 percent, with the stock finally closing at $29.
Since then, Apple has gone on leaps and bounds, becoming the first business to reach a $1 trillion valuation and the first US company to reach $2 trillion. This is in part thanks to it’s large re-investment in the company. Although it makes close to $150 billion in profit, a sizeable amount of that is put back into the company. Shareholders receive only a small dividend less than 1 percent, but are more than compensated by the firms equity growth.
As the firm grew, Apple released more and more common stock onto the market, with 16.17 billion in circulation as of July 2022.
Preferred Stock vs Common Stock
There are two main types of stock: common and preferred stock. Each has its own unique advantages and disadvantages. Both are traded on the stock market, although common stocks are more widely traded due to the high volumes.
There are many similarities between the two stocks. Both represent ownership of the firm and have a claim to dividend payments. However, preferred stockholders have a higher claim. That is to say, common stockholders are only eligible for dividend payments once preferred stockholders receive theirs.
Common stockholders also face higher risk. This is because in the event of bankruptcy and liquidation, they are among the last to be compensated. Preferred stockholders receive their investments before those who own common stock.
Whilst there are some seemingly major drawbacks of common stock, they have a massive potential upside. Owners can benefit from increases in the share price. These gains do not filter through to preferred stocks due to their similarities to a bond. So whilst preferred stockholders value remains stagnant, those who own common stock can benefit enormously from equity gains.
Common Stock Definition FAQs
A common stock is NOT an asset. Instead, it is an equity, which represents a stake or ownership of an asset.
Common stock can be found under the ‘Stockholder equity’ section of a balance sheet. It reflects neither an asset nor a liability to the company. This is because an equity just represents the ownership of the company. The company does not owe money to shareholders, nor do shareholders owe money to it.
Some of the main disadvantages of common stocks include:
– Last to get paid in event of liquidation
– Dividends aren’t guaranteed’
– Could lose significant part of investment in event of a market crash
– Lack of control over decision making
– Gains may take a while