What Is Common Stock?

Most references to "stocks" refer to common stocks. But those new to investing might be wondering "what is common stock?". 

Common stock is a type of security that gives you partial ownership in a corporation. As an owner of the corporation, you have certain rights and benefits.

These include a residual claim on future profits, the right to vote on important company matters such as electing board members and approving acquisitions, and receiving dividends from the company's cash flow from operations.

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Although the existence of common stock dates back to 2000 BCE with the Assyrian people in Mesopotamia (present-day Middle East), the modern record considers the common stock issued by the Dutch East India Corporation in 1602 to be the first example of an actual printed document indicating proof of ownership.

In 1611, the Amsterdam Stock Exchange was created, the world's first stock exchange. Here in the U.S., the earliest example of an organized stock exchange was in 1792, when the Buttonwood Agreement was signed by 24 prominent stockbrokers and merchants of the day.

It would eventually become the New York Stock Exchange in March 1817. Today, there are more than 2,000 companies whose common stocks are traded on the NYSE.

How does common stock fit into a company's capital structure?

The two elements of a company's capital structure are debt obligations and total shareholders' equity. This is a company's invested capital, the funds used to finance its operations, purchase assets and grow.

A company's shareholders' equity consists of common and preferred stock and retained earnings. When combined with outstanding debt, you have the entire capital structure of a business, the invested capital.

The mix between debt and equity depends on several factors, including, but not limited to, a company's cost of capital, business strategy, future revenue estimates, investment requirements, debt rating, the valuation of its common stock and many more.

When companies grow quickly, they're more likely to hold higher debt levels on their balance sheet, comfortable knowing that they will generate significant future cash flow, thus enabling them to pay down the debt more quickly. Companies growing more slowly will be less open to significantly leveraging their balance sheets, knowing cash flows will be insufficient to repay the debt promptly.

These decisions regarding capital structure are part of a company's broader capital allocation strategy, which includes investing in its existing business, making acquisitions, paying dividends, repaying debt and repurchasing its stock.

The decisions regarding a company's capital structure and allocation go hand in hand.

What is common stock vs preferred stock vs retained earnings?

The section above discusses shareholders' equity and its role in financing a company's business plans. It also represents one of the three main parts of a balance sheet, the others being liabilities and assets. A company's assets are equal to shareholders' equity and liabilities.

As stated, shareholder equity combines common stock, preferred stock and retained earnings. 

Preferred stocks are considered "hybrid" securities because they have a face value and pay regularly scheduled income to investors in the same manner as fixed-income bonds. However, they trade on stock exchanges just like common stocks, but don't come with voting rights.

There are two significant benefits of owning preferred shares.

First, if a company liquidates its business, once the debtholders are paid in full, any funds left over go to the shareholders. Preferred shareholders, as the name implies, take precedence over the owners of common stock. If there are any funds remaining, the common stockholders get paid.

Secondly, preferred shareholders must be paid their stated dividend income before any payments are made to owners of common stock. Unfortunately, like common stock, a company is not required to pay dividends. During the COVID-19 pandemic, many companies paused, cut or eliminated monthly or quarterly dividends to save cash. Both types of stocks were affected.

Retained earnings are a company's cumulative profits not paid out as dividends or used for stock buybacks. This figure changes from quarter to quarter.

For example, Apple (AAPL), the largest U.S. company by market cap, had $4.3 billion in retained earnings at the beginning of its fiscal third quarter in 2023. It finished the three-month period with $1.4 billion in retained earnings after paying out $3.8 billion in dividends and repurchasing $18.1 billion of its stock.

The risks of owning common stock

While investing in common stocks can deliver significant capital appreciation – Apple, Nvidia (NVDA) and Adobe (ADBE) are just three examples of impressive long-term gains public companies can return to shareholders – there are also legitimate risks.

Common stocks are volatile. Their prices do not go up in a straight line, routinely exhibiting periods of correction. Investors uncomfortable with risk are better suited to fixed-income investments, such as Treasury bills, where the principal is guaranteed.

Other potential risks of owning common stocks include lack of diversification, foreign exchange, interest rates and country and company-specific issues.

Many investors buy exchange-traded funds (ETFs) to diversify their common-stock portfolios more easily. By avoiding a concentrated portfolio, investors reduce the company-specific risk from each holding.

An example of country and foreign exchange-specific risk would be investing in the common stock of a Latin American company listed on a U.S. stock exchange. South American countries often have very precarious political structures. When combined with the region's highly volatile currencies, the investor adds additional risk beyond the business.

Lastly, when a company's assets are liquidated due to insolvency, the creditors and bondholders are paid first, followed by preferred stockholders. Common stockholders are the last to receive any proceeds from a liquidation. In bankruptcy proceedings, common stockholders often end up with nothing for their ownership.

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