What Is Common Stock and How Does It Work?

Common stock allows individuals to own a portion of a company. It enables investors to participate in the financial growth and decision-making of publicly traded entities. This equity security is a recognized investment vehicle.

Understanding Common Stock

Common stock is an equity security representing ownership in a corporation. When an individual purchases common stock, they become a part-owner, holding a proportional claim on its assets and earnings. This ownership stake provides investors with a direct interest in the company’s performance and future prospects.

Common stockholders possess voting rights, allowing them to influence corporate governance and strategic decisions. These rights are exercised to elect the board of directors, approve major company actions like mergers or divestitures, and vote on policy changes. Votes are cast electronically or by proxy, with each share entitling the holder to one vote, ensuring proportional representation.

Common stockholders have a residual claim on the company’s assets and earnings. In a company’s liquidation, common stockholders are paid only after all creditors, including bondholders and other debt holders, and preferred stockholders have been paid. This position carries the highest risk among capital providers but also offers the greatest potential for long-term financial gain if the company succeeds.

Common stock’s primary attraction is the potential for capital appreciation, where its market price increases over time. This increase can occur as the company grows, demonstrates consistent profitability, develops new products, or as overall market demand for its shares rises due to positive investor sentiment. Investors realize capital gains when they sell their shares for a price higher than their original purchase price, often subject to capital gains taxes.

Common stockholders may receive dividends, distributions of a company’s profits. The declaration, frequency, and amount are at the discretion of the company’s board of directors and are not guaranteed. Companies can choose to retain earnings for reinvestment into the business, which can fuel future growth, rather than distributing them as dividends, impacting the immediate cash flow to shareholders.

Limited liability protects common stockholders. It ensures an investor’s personal assets, such as their home or savings, are shielded from the company’s debts or financial failures. The maximum financial loss is limited to the amount invested in the common stock itself. This protection encourages investment without undue personal risk.

Common Stock Versus Preferred Stock

Preferred stockholders receive dividends before common stockholders. These dividends are fixed and paid at a predetermined rate, offering a predictable income stream for investors seeking stability. Some preferred stocks also possess a cumulative feature, meaning any missed dividend payments must be paid out to preferred shareholders before common stockholders can receive any distributions. This provides an added layer of security for preferred investors.

In a company’s liquidation, preferred stockholders hold a higher claim on the company’s assets than common stockholders. They are paid out before common stockholders but after all other creditors, such as bondholders and banks, have been satisfied. This senior position in the capital structure reduces their overall risk exposure compared to common equity holders, who stand last in line.

Preferred stock typically does not carry voting rights. This means preferred shareholders cannot vote on corporate matters, such as electing board members or approving major corporate actions, unlike common shareholders who actively participate in governance. The absence of voting power is compensated by their preferential dividend and liquidation rights, making them more akin to debt instruments with equity characteristics.

Preferred stock offers less potential for significant capital appreciation compared to common stock. Its market value is more stable and often influenced by prevailing interest rate movements, similar to how bond prices fluctuate. Common stock, conversely, offers greater upside potential for substantial price growth, driven by factors such as company earnings performance, market sentiment, and overall economic conditions. This difference in growth potential is a key consideration for investors.

Issuing and Trading Common Stock

Companies initially issue new common stock in the primary market to raise capital for various corporate purposes, such as funding new projects, expanding operations, or reducing existing debt. This process frequently involves an Initial Public Offering (IPO) when a private company first offers its shares to the general public. Investment banks play a significant role in underwriting these offerings, advising on pricing, managing regulatory filings with the Securities and Exchange Commission (SEC), and distributing shares to investors, facilitating capital formation.

After initial issuance, common stock is traded among investors in the secondary market, primarily through major stock exchanges. Examples include the New York Stock Exchange (NYSE) and Nasdaq. The company receives no proceeds from these transactions; funds flow between buying and selling investors. The market price reflects ongoing supply and demand dynamics, influenced by company performance and economic outlook.

Individual investors access the secondary market and execute trades through brokerage accounts. These accounts provide the platform to place buy and sell orders for common stock at market prices, often through online trading platforms. Brokerage firms facilitate these transactions, charging commissions or fees for their services, which vary depending on the firm and account type, ranging from flat fees (e.g., $0 to $10) to complex structures based on volume. These fees reduce overall returns.