What Is Common Stock and How Does It Work?

Common stock represents a fundamental form of ownership in a corporation. When an investor purchases common stock, they acquire a fractional stake in the company, signifying a claim on a portion of its assets and earnings. This security is widely prevalent in financial markets and forms the backbone of many investment portfolios. Common stock serves as a primary vehicle through which companies raise capital and investors participate in the potential growth and profitability of businesses.

Defining Features

Common stockholders generally possess voting rights, which allow them to influence corporate governance. These rights typically include the ability to elect the board of directors and vote on significant corporate policies, such as mergers or major operational changes. The number of votes an individual shareholder has usually correlates directly with the number of shares they own.

Shareholders of common stock may receive dividends, which are distributions of a company’s profits. However, these dividend payments are not guaranteed and are subject to the discretion of the company’s board of directors. Companies may choose to pay dividends in cash or sometimes in additional shares of stock.

Common stockholders hold a residual claim on the company’s assets and earnings. This means that in the event of a company’s liquidation, common shareholders are last in line to receive payment, after all creditors, bondholders, and preferred stockholders have been satisfied. While this position carries higher risk, it also offers the potential for greater rewards.

Common stock offers the potential for capital appreciation, where share value increases over time. If a company performs well, its stock price may rise, allowing investors to sell shares for more than the original purchase price. This potential is a significant attraction for long-term investors.

Common Stock Versus Preferred Stock

A primary distinction between common and preferred stock lies in voting rights. Common stock grants shareholders voting rights, allowing them a voice in company decisions and board elections. Preferred stock generally does not carry voting rights, meaning preferred shareholders have no say in corporate governance.

Regarding dividends, preferred stock usually offers a fixed, often higher, dividend rate paid out before common stockholders. Preferred stock dividends can also be cumulative, meaning missed payments must be paid before common stockholders receive any dividends. Common stock dividends are variable and not guaranteed.

In the event of a company’s liquidation, preferred stockholders have a higher claim on the company’s assets and earnings than common stockholders. Preferred shareholders are paid after creditors but before common shareholders receive any remaining assets. This preferential treatment makes preferred stock generally less risky than common stock in a liquidation scenario.

The potential for capital appreciation also differs. Common stock generally has greater potential for price appreciation, allowing investors to share in a company’s long-term profitability. Preferred stock, with its fixed dividend nature, typically has less potential for significant gains.

Why Companies Issue Common Stock and Investors Buy It

Companies issue common stock primarily to raise capital for various corporate purposes, such as funding growth initiatives, managing operations, reducing existing debt, or financing acquisitions. This method allows businesses to acquire necessary funds without incurring debt obligations, which provides greater financial flexibility. Issuing common stock means a company does not have fixed interest payments or principal repayments, unlike debt financing.

For companies, common stock can also serve as a tool to attract and retain talent through stock options or grants, aligning employee interests with the company’s success. By offering ownership, companies can incentivize employees and foster a sense of shared purpose.

Investors are motivated to buy common stock for several reasons, including the appeal of ownership and potential influence. Owning shares grants voting rights, enabling participation in decisions that shape the company’s direction.

Common stock offers the potential for significant returns through capital appreciation and dividend income. It is generally liquid, easily bought and sold on stock exchanges, providing investors flexibility. Over the long term, common stocks can act as a hedge against inflation, as company earnings and dividends can grow with rising prices.