Let us find out what are common stocks in this guide and go deep into their types, benefits, and risks, as well as see how is common stock calculated and reflected on the balance sheet.
For company investors, there has to be evidence that shows that they have an investment in a company and possess a certain share and level of control over it. In pursuit of this goal, common stocks are issued.
Is there a reason they are called “common” stocks? Does that mean there are “uncommon stocks” or other types of stocks? Maybe these types of stocks are peculiar to some set of people or not. Let us find out in this guide that digs deep into the definition of common stock, its types, and its calculation.
Common Stock Defined
Common stock equates to ownership in a company represented by shares issued to the public in exchange for investing in an entity. After buying common stock, an individual becomes a part-owner of the company with a partial claim to a part of its assets and earnings. Apart from reflecting investors’ right of partial possession of a company, it also signifies the amount of company shares that are found on its balance sheet.
Understanding Common Stock
Primarily, companies that issue common stocks want to raise funds to help the business grow and expand. The capital generated from the sale of common stocks also goes into acquisition and other operations towards the company’s goal and vision.
An initial public offering (IPO) is the first process for a company to issue stock. The public offering requires that the establishment works with an underwriting investment banking firm, which offers help in determining the prices and other related matters concerning the stock. Upon the completion of the initial public offering, the general public now has access to purchase the stock.
Investors expect benefits in exchange for their financial commitment to a company, and this is where the common stock comes into play. Also, common stock is known for some peculiar features listed below:
- Volatility. The value of common stock on the balance sheet depends on the business performance. The value of shares may go up, resulting in high returns for investors, and investors may suffer huge losses if the shares go down or the company goes bankrupt. The price of common stock is not static. Rather, they fluctuate based on the demand and supply situation in the market.
- Voting rights. Investors can potentially benefit from the long-term growth of a company. Common stock gives voting rights to its holders, meaning they can elect the board of directors. At the same time, the common stock received due to one’s investment in a company permits the investor to vote on corporate policies and contribute to major decisions concerning the company.
- Ownership. Common stock is a security that represents an investor’s ownership in a corporation. This means that common stockholders have some rights to a portion of the company’s earnings and assets.
- Tradability. Another feature of common stock is its ability to be bought and resold. Since they can appreciate over time, holders may decide to sell their shares for more than the amount they purchased, resulting in gains.
- Liquidity. The fact that common stocks can be bought and sold makes it a liquid investment. Investors may decide to sell off their ownership in the company to raise funds.
- Dividends. Companies share a portion of their profits to shareholders in the form of dividends. The amount distributed varies, depending on the financial performance of the institution and the number of shares each investor possesses.
Types of Common Shares
There are different types of common shares an investor may buy, choosing any type that suits their preference.
- Ordinary shares. With an ordinary share, an investor has the right to a single vote in electing the company board and for corporate decisions. This is the most common type of common share, and companies may categorize their ordinary shares into different classes, such as Class A and Class B. Also, each class of shares has its unique rights.
- Non-voting share. While ordinary shares give voting rights, non-voting shares, as the name implies, mean their holders have no voting rights. Non-voting shares are a rare type of common shares.
- Supervoting shares. Holders of supervoting shares have superior power to other shareholders because this type of common shares means one share may be worth more than a single vote.
Formula
Companies often authorize specific amounts of common shares they want to make available to the public. At the same time, the company may issue less than the authorized amount.
Common stocks are represented in the stockholder equity section on a balance sheet and can be calculated in two ways:
- First case: when total equity, treasury socks, additional (paid-in) capital, preferred stocks, and retained earnings are given.
Common Stock = Total Equity + Treasury Stocks – Additional (paid-in)
- Second case: when only total equity and retained earnings are given:
Common Stock = Total Equity – Retained Earnings
Outstanding Shares = Number of Issued Shares – Treasury Stocks
In the formulas described, outstanding shares are the number of shares available to the company owners who hold a portion of the business, retained earnings represent the amount of profit left after a company pays dividends to shareholders, issued shares are the shares that a company issues to the public, and treasury stocks are the portion of shares that a company keeps in its treasury. These stocks could be repurchased from shareholders or the issued stocks.
Common Stocks vs Preferred Stocks
It is essential to know the differences between common stocks and preferred stocks and their distinct features.
- Voting rights. While common stocks give voting rights to holders, preferred stocks do not have any voting rights. Instead of being able to participate in important elections concerning the company, owners of preferred stocks enjoy more monetary benefits than common stockholders. Companies pay higher dividends to preferred stockholders than common stock investors.
- Convertibility. Holders of preferred stocks may be able to convert them into common stock. However, common stock is generally not convertible.
- Dividends. Preferred stock owners receive dividend payments on their investments before common stock shareholders. They are among the first category of people who would receive their payments when a company goes bankrupt. Meanwhile, investing in common stock means the investor is last paid when a company goes bankrupt.
- Dividend amount. The dividend paid for common stocks varies and depends on the company’s financial performance. However, dividend payments to preferred stockholders are fixed and regular.
- Risk. Common stock has higher risk with higher potential return, while preferred stock has lower risk and lower possible return.
- Volatility. The fact that preferred stock has a fixed dividend makes it less volatile than common stock.
Why Invest in Common Stocks?
As its name suggests, common stocks are the most common and popular ones, being the preference of a lot of investors because of their benefits. No investment is risk-free, but many believe investing in common stock has more pros than cons. The reasons people choose to invest in common stocks differ.
Firstly, investing in common stocks gives some kind of power, especially if its holders have substantial investments. Holders are able to vote and participate in some decision-making. It is important to know that the voting rights common stock offers become more powerful based on the number of shares a person has.
Secondly, common stock is a major source of returns for investors through capital gains. Although there is no guaranteed profit, they have the potential to perform better.
Thirdly, there is almost no restriction to buying and selling shares of publicly traded stock. This makes it easy for people to access common stocks of top companies. At the same time, it is easy to sell the shares, especially at a higher price, resulting in gains for the investor.
Despite the benefits of common stocks, which make many delve into the market, investment is a critical decision that requires careful deliberations.
How to Invest in Common Stocks
The first step to investing in common stocks is to open a brokerage account. Common stocks are available on exchanges, which are marketplaces where financial instruments are traded, or online trading platforms. Also, anyone can practically buy them as they are always publicly traded.
Exchange-traded funds and index mutual funds let people buy individual stocks in a single investment. On the other hand, some companies allow investors to buy directly from them.
Above all, conducting due diligence tops the list when preparing to invest in common stocks. Investment could yield both profits and losses, so the advice is to make weighted decisions when deciding to invest.
Bottom Line
It is possible to own a part of top companies with records of yearly earnings. While it sounds so easy and profitable, it is also highly risky as it could lead to huge losses.
There are common stocks and preferred stocks. Common stock is the go-to investment for many but not entirely the safest. Stock investment and the type of investment to adopt is entirely a personal decision after deep research and understanding of associated risks.