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What are Common Stocks?
Common stocks can be defined as securities that represent individuals’ ownership in a said corporation and their claim on the venture’s accrued profits. Such stock option offers individuals a power to elect the company’s board of directors and further extends them voting rights to formulate corporate policies.
Usually, in the long term, common shares are said to generate returns at a high rate. Common stockholders are compensated with dividend income, which is paid to them after distributing the accrued profits to the preference shareholders.
In the event of bankruptcy, creditors, preference shareholders and bondholders are likely to receive their share before those who have invested in a company’s common stocks. They are more likely to receive the remaining assets after others have been paid accordingly. Such stocks are issued in the market through an initial public offering.
Common Stock can be expressed as –
Number of Outstanding shares = Number of Issued Shares – Treasury Stocks
Why are Common Stocks Issued?
Typically, issuance of common stocks is an alternative option for selling debt bonds or issuing preference stock. The primary reason behind the issuance of common stocks is to raise capital.
The capital thus raised can be used for several purposes like –
- Acquisition of a promising company
- Paying off debts
- Creation of a cash reserve for future use
Issuance of more common stocks in the market tends to dilute the holding power of existing stockholders. This is why company owners are often wary and tend to weigh the pros and cons of share issuance before making the final call.
Features of Common Stocks?
- Stock rights
Common stock offers certain rights to its shareholders. For instance, individuals who invest in these shares are entitled to these following rights.
- Dividend Right – Entitled to earn dividends.
- Asset Rights – Entitled to receive remaining assets in the event of a liquidation.
- Voting Rights – Power to elect the board of directors.
- Pre-emptive Rights – Entitled to receive consideration.
Common stocks allow its investors to generate earnings in two ways, namely, in the form of capital gains and through dividend income. Investors are likely to earn higher capital gains when the company’s stock valuation increases. Similarly, if the company is left with substantial revenue after paying off maintenance charges and other expenses, they may declare dividends for its investors.
- Investment option
Generally, individuals can invest in common stocks in these following ways.
- Through a direct stock plan.
- Via dividend reinvestment plan.
- Through stock exchange.
- By investing in a mutual fund.
Benefits of Common Stocks?
Check out the following list of benefits of common stocks.
- Voting rights
Each investor is vested with one voting right per share of common stock held. Notably, such rights pertain to corporate policies and partaking in business decisions. For instance, investors receive the right to elect a company’s board of directors through their voting right or may decide the fate of a strategic policy. Notably, investors with substantial common stocks would be able to make the most of such a power.
- Potential profits
In terms of performance, common stocks are known to generate higher returns than deposit certificates, bonds, etc. among other investment tools. Also, there is no limit up to which investors can benefit from their investment in common stock shares.
Similarly, common stocks prove to be a more feasible and less expensive alternative to debts. It is because companies do not have to pay interest to their investors and may choose to pay a reward in case of excess profits.
- Limited legal liabilities
Being passive holders, the obligations of common stock investors are limited as well. They do not need to be concerned about the events that happen beyond financial investment. Further, such stocks ensure a safe financial future in case a company is generating substantial returns and is growing at a steady rate.
Also, investors are not exposed to the risk of losing more money than what they had invested in. All of these tend to help investors make the most of the growth aspects of common stocks without being tangled in unwarranted legal liabilities.
Though common stockholders are entitled to earn a return, its frequency is uncertain. For instance, a company may not have enough earnings to offer dividends to its shareholders. Alternatively, a company may decide to reinvest its profits into the venture for expansion purposes. All of these make the scope of generating returns uncertain. Nonetheless, common stockholders are more likely to generate substantial returns when compared to other investment options.
Common stocks are liquid and hence, can be efficiently invested in or surrendered by the investors. It helps investors to buy more shares and increase their shareholding in a particular company. Similarly, they can readily surrender it if their investment is not turning out to be profitable enough. Additionally, as such shares can be purchased at a fair price without undergoing any hassles; this makes it a viable investment tool for many.
Limitations of Common Stocks?
- Market-linked risk
Since the prices of common stocks are subject to market volatility, stock prices tend to fluctuate often. Further, the valuation of common stocks tends to undergo an abrupt change, which makes the process of performance evaluation quite challenging. Additionally, in the case of bankruptcy, common stockholders are more exposed to lose their entire investments.
- Profits are not guaranteed
As the market forces tend to influence revenue generation for this stock option, income is often not fixed. No such certainty is assured when it comes to generating profit at all. It proves to be a significant drawback for individuals who invested in common stocks for its growth potential.
- Lacks control
The scope of profiting from common stock investment largely depends on the business strategies and associated policies, which means investors have no control whatsoever on it. Also, the fact that investors do not have the right to partake in policymaking sessions or scrutinise the company’s books of accounting or business plans limits their power.
Who Should Invest in Common Stocks?
Since common stocks have a significant risk associated with them, it may not be suitable for risk-averse investors. Additionally, the prices of these shares are subject to volatility and thus tend to fluctuate frequently. Nonetheless, common stocks come with significant growth potential, and investors can make the most of it if they park their funds in these investment options for the long-term. Hence, it can be said that investors with strong risk appetite and a significant investment horizon would find common stocks a viable investment option.
The table below serves as an overview of both advantages and limitations of common stocks –
|Voting rights||Lack of control|
|Potential profits||Market risks|
|Limited legal liabilities||Fluctuating prices|
Common Stocks and Balance Sheet
Typically, information regarding the common stocks of a company is recorded under the header of a stockholder’s equity section in its Balance Sheet. Individuals who intend to determine the book value, also known as the net worth of a company’s shares, would gain valuable insights from this section of the Balance Sheet. Notably, stockholder’s equity is the book value of a company’s stock and tends to highlight a company’s intrinsic value. Such an amount helps estimate the amount shareholders would receive in the case of a liquidation.
However, stocks don’t need to be traded at this amount. Growing companies often trade several times more than their book value. Conversely, companies that are struggling may opt to trade below their share’s book value.
Common Stocks vs Preferred stocks
Both preferred stocks and common stocks represent ownership in a particular company. Further, both serve as potent tools for generating substantial returns on their shares. However, there are specific differences that set one from another in several ways.
The following highlights a few differences between preferred stocks and common stocks.
- When it comes to special privileges, preferred shareholders do not enjoy voting rights. It means they do not play any decisive role in formulating the vital policies or strategies of a company.
- Preferred shareholders are given more priority when it comes to allocating profits to a company’s shareholders. It means that common stockholders would be paid dividends before the preferred shareholders.
- Likewise, in the event of liquidation, preferred shareholders are paid their share before the common shareholders. Common stockholders are paid with the remaining share of assets once all other shareholders have been paid out.
The accompanying table serves as one of the potent preferred stock vs common stock examples.
|Factor||Preferred Stock||Common Stock|
|Potential||Its potential is limited to redemption value, except the convertible preference shares.||Common stocks come with substantial potential for returns.|
|Risk||Its value is less likely to fall to zero.||The value may fall to zero.|
|Volatility||The price does not fluctuate dramatically.||The prices tend to fluctuate drastically at times.|
|Suitability||Suitable for high-yield dividend investors.||More suitable for long-term growth investors.|
|Classifications||Usually multiple.||Mostly one or more types of common stock under extraordinary circumstances.|
Investors who wish to invest in a company’s common stocks should make it a point to conduct a thorough common stock analysis. Additionally, they should factor in things like a company’s growth potential, track record and soundness of strategies to make an informed decision regarding investments.