What is Common Stock?

Kathleen Chaykowski
Covered finance and business at Forbes and The Wall Street Journal. BA, Stanford University.
Definition:

Common stock is a breed of stock that gives investors ownership in a company, usually with some voting rights.

🤔 Understanding common stock

Common stock is a major type of security that lets investors buy a portion of a company with each share. Common stock often has perks like giving investors the right to vote for a company’s board of directors or even votes in decisions to change corporate policies. But, common stock has its caveats, like how owning shares can sometimes be riskier than owning bonds. Common shares are also different from preferred shares, which put investors first in line to receive income (aka dividends), based on how many preferred shares they own. Common stockholders can sometimes also earn this dividend income, but only after preferred shareholders have been paid theirs.

Example

The most commonly traded stocks are issued by publicly traded companies. On Robinhood, some of the most popular stocks are GE, Aurora Cannabis, Apple, and GoPro. Private companies, including startups, also have common shares, but they tend to be owned by a small number of founders and investors.

Takeaway

Common stock is like general admission at a concert, while preferred shares are the VIP passes...

Both types of stocks are slices of ownership in a company, and typically come with voting rights, or even perks like income paid back to shareholders (aka dividends). But, the second major category of shares — preferred shares — have a prioritized spot in line to receive dividends before common stockholders do.

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What are the characteristics of common stock?

Common stock has a few key features :

  1. Availability: It’s the most common way investors get to own part of a company.
  2. Voting rights: These shares usually come with voting rights that give investors a say in decisions like selecting members to a board of directors, as well as certain corporate events, like mergers, acquisitions, or stock splits.
  3. Dividends... maybe: Not every company doles out dividends. But, when companies do, there’s a chance common stockholders can get them — once preferred shareholders have been paid first.

What’s the difference between common stock and preferred stock?

Common stock and preferred stock both give investors the chance to own part of a company. But like the name suggests, preferred stock comes with some VIP-like perks:

  1. Dibs on dividends: If a company pays dividends, preferred shareholders get paid first, before common stock shareholders see any dividend money that might be leftover. If a company ends up suspending its dividend, the dividends intended for preferred shareholders accumulate. If the company reinstates its dividends, the preferred shareholders get paid first, before common stockholders get a penny. Common stockholders do not accumulate any missed dividends.
  2. Dividend amount: The dividend paid to preferred shareholders is fixed (similar to how the interest payment on a bond is fixed), while the dividend paid to common stockholders is variable, changing based on the decisions of the company’s managers.
  3. Less risk: If a company goes under, preferred shareholders have a higher claim on the company’s remaining assets than common stockholders do (assuming there’s any money left at all and after creditors are paid).
  4. Share class conversion: Preferred stockholders sometimes have the opportunity to convert their preferred shares into common stock, which is known as convertible preferred stock. It’s a flavor of stock that means that in the future, either the owner of the stock, the company’s board of directors, or the company on a planned date could convert the preferred shares into common shares. This conversion can lead to a profit or a loss for investors, depending on the difference between the value of any dividends a shareholder can receive from those preferred shares and the market value of the stock.

How can you make money from a conversion?

Let’s look at a hypothetical example: If you bought 10 shares of convertible preferred stock in a dog food company (let’s call it Hungry Harry) at $100 per share, the total value of your investment is $1,000. If your preferred stock pays $5 to you per share of your investment each year in dividends, your dividend yield (dividend amount per share divided by the cost of each share) is 5%. Then, if the company gives you the option to trade each of your preferred shares into 50 common shares, your cost of completing the conversion is the cost of the preferred stock, $100, divided by 50 shares of common stock, which is a $2 per share conversion rate. If the common stock in the company is worth less than $2, then you’re probably better off keeping your preferred stock. However, if the common shares are worth more than $2, then you could make money in this illustrative example.

How is the value of common stock calculated?

On balance sheets, common stock is typically reported in the shareholders’ equity section. It appears on balance sheets along with other types of stock such as preferred stock and treasury stock. Treasury stock is usually a corporation's previously issued shares of common stock that have been purchased from the stockholders, but the corporation has not retired the shares. The value of common stock is calculated by dividing the total common stockholders’ equity minus preferred stockholders’ equity by the average number of common shares outstanding. Accountants and financial analysts call this “book value.” The book value of common stock rarely matches the market value of common stock. The market value is driven by stock market investors; book value is driven by the assets of the company and accounting.

What’s the history of common stock?

Some of the first known “common stock” was created about 400 years ago by the East India Company in 1602, debuting on the Amsterdam Stock Exchange. In the US today, common stocks are most frequently traded in the US on the New York Stock Exchange and the Nasdaq, the two biggest stock exchanges in the world.

Why does a company issue common stock?

Both private and public companies typically have common stock. However, within private companies, common stock of private companies is typically reserved for founders, investors, and even some employees. When private companies become public, they can go through an initial public offering (IPO) in which they similarly sell shares in exchange for raising cash — But then their shares are publicly available to be traded.

For companies, issuing more common stock (aka making more common shares available) or going through the IPO process can be a means of raising money, and an alternative to taking on debt. Companies can use money from selling common shares to invest in their growth, pay off their debts, buy another company, or simply keep more cash on hand. Issuing common stock can be an attractive alternative to taking on debt, because instead of getting stuck paying interest on debt, companies can pay dividends to common shareholders instead when they have the cash — the catch is that by selling its stock, a company is selling part of its ownership (potentially even voting rights) of itself. And selling stock dilutes the ownership of all the other stock, kind of like cutting 1 pizza into 8 slices instead of 6.

How can an investor buy common stocks?

Common stocks can be purchased on the public markets, as well as through private marketplaces (FYI, private markets are less flexible, less accessible, and less easy to buy or sell compared to public markets). In public markets, stocks can be bought and sold throughout the day on stock exchanges. Most often, investors buy stock through a broker (a person or a firm that connects buyers and sellers) who typically charges a fee called a commission for this service. (Note: Robinhood is a brokerage firm, but doesn’t charge a commission for completing trades).

Ready to start investing?
Sign up for Robinhood and get your first stock on us.Certain limitations apply

The free stock offer is available to new users only, subject to the terms and conditions at rbnhd.co/freestock. Free stock chosen randomly from the program’s inventory.

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