What Is Common Stock and How Is It Different With Preferred Stock?
A common stock is a unit of fractional ownership in a company. The fraction depends on the number of shares issued by the company. Suppose a company issues 100 shares in the public markets representing 75 percent of the company’s total equity. Then each individual common stock is equal to a 0.75% stake in the company.
Common stock is listed under the Stockholders Equity section in a company’s balance sheet. It enables entrepreneurs and companies to raise capital from investors to expand their operations. Common stock is different from preferred stock because the former type of stock allows voting rights to the holder.
What Is Common Stock?
As noted earlier, common stock represents fractional ownership in a company. That ownership typically entitles common stockholders to a portion of the company’s profits, generally distributed in the form of dividends, and voting rights in important decisions pertaining to leadership. For example, companies that have issued common stock are generally required to hold annual meetings to nominate directors or discuss their earnings. Common stockholders are invited to these meetings and have the right to ask questions relating to operations or cast their votes during the election of directors.
Some companies issue two classes of common stock – one with voting rights and another without voting rights. Technology behemoth Alphabet is an example of such a split. Alphabet has two classes of common stock shares: Class A and Class C. Class A shares are available via the GOOGL ticker and come with voting rights. Class C shares are available via the GOOG ticker and do not carry voting rights. Both types of common stock confer ownership stakes to holders.
The typical process to issue common stock is known as an initial public offering (IPO). Once an IPO is complete, the common stock begins trading on the stock market. Like other securities, it is subject to the market forces and price swings. The biggest IPO in history was conducted by China’s e-commerce giant Alibaba Group. It issued 320.1 million shares for a listing on the New York Stock Exchange on September 18, 2020.
Advantages and Disadvantages of Common Stock
The main advantage of issuing common stock for entrepreneurs and existing organizations is that it enables them to raise capital from investors to produce goods and services. Without access to markets, issuers of common stock would have to take out loans with strict repayment terms attached to them.
For investors, common stock enables them to invest in securities that appreciate without significant effort on their part. Common stock dividends can also become an important source of income. When sold, common stock can also generate profits.
The drawback of common stock ownership for investors is that each stock is accompanied by operational risk related to the venture. It may be possible that the company fails in its mission or does not operate profitably. Either one of those consequences translates to potential losses for investors in the company’s common stock because they affect its common stock price.
The other drawback of common stock ownership is the volatility associated with a common stock trading on the stock market. Investors in common stock can lose (or gain) value associated with their holdings several times in a day due to the volatility associated with trading. If the volatility is severe, then losses can multiply. For example, stock market crashes regularly wipe out millions of dollars of common stock value.
What Is the Difference Between Common Stock and Preferred Stock?
Preferred stock is another form of stock issued by companies or entrepreneurs sourcing capital from markets. Unlike common stock, preferred stock is not accompanied by voting rights and fixed dividends. The issue and exact figure of dividends for common stock varies and is dependent on company performance. However, preferred stock owners are assured of fixed dividends as long as they are stockholders.
Another important distinction between the two types of stock relates to what happens when a company is liquidated. In the investor hierarchy, preferred stockholders are paid out first before common stockholders when a company goes bust. In other words, they have a priority claim on the liquidated company’s assets. Common stockholders may run the risk of losing their entire equity in a company because they are paid out last, after bondholders and preferred stockholders.
A History of Common Stock
The Dutch East India company was the first company to issue common stock at the Amsterdam Stock Exchange in 1602. The issue helped the company finance and offset costly risks associated with voyages to Southeast Asia for spices. The British East India company used the same practice to expand its empire. Since then, it has become a favored mechanism for entrepreneurs and companies to raise capital.
Previous stock exchanges were constrained by geography and investors in that they mainly sought capital from the upper middle class and rich classes of society. However, the growth in stock exchanges, sophisticated rulemaking that protects investor capital, and advent of technology solutions has rapidly expanded the scope and geographies for common stock issuance. Now companies from China can issue common stock to investors in the United States and vice versa as long as they adhere to the rules governing the exchange.
Common Stock FAQs
Disclaimer: The above references an opinion and is for information purposes only. It is not intended to be investment advice. Seek a duly licensed professional for investment advice.
About the Author
True Tamplin, BSc, CEPF®
True Tamplin is a published author, public speaker, CEO of UpDigital, and founder of Finance Strategists.
True is a Certified Educator in Personal Finance (CEPF®), a member of the Society for Advancing Business Editing and Writing, contributes to his financial education site, Finance Strategists, and has spoken to various financial communities such as the CFA Institute, as well as university students like his Alma mater, Biola University, where he received a bachelor of science in business and data analytics.