Common stock is a type of asset or security investment that represents the investor’s stake in a company. It gives investors voting rights towards corporate policy decisions and also the right to choose a company’s board of directors.
Common stocks, also known as common shares, can fetch faster returns for investors. Common shareholders also enjoy the right to claim a company’s assets in case of its liquidation after paying to preferred shareholders, bondholders, and other creditors in full. One can purchase common stocks through a company’s initial public offering (IPO). Common stocks are reported in a company’s balance sheet under the stockholder equity section. By subtracting the total number of treasury stocks from the total shares issued, one can arrive at the number of stocks offered by a company.
Why do companies issue common stocks?
The main reason why companies issue common stocks is raising capital for purposes such as business expansion, clearing of outstanding debts, establishing future cash reserves, acquisitions, etc. Another major reason why a company may issue common stocks is to allow the market to dilute the power of existing shareholders.
What are the advantages and disadvantages of common stock?
Issuing common stock comes with several advantages, some of which are summarized below:
In comparison to bonds and deposit certificates, common stocks are known to perform better as investment avenues. Investors can fetch returns through capital gains and dividend income from common stock investments. Common stocks can fetch higher capital gains in case the company’s stock valuation rises. Also, if a company has substantial revenue remaining after taking care of priority commitments, it can declare dividends for common stockholders.
An investor can enjoy one voting right per common stock, or share held. These allow investors to participate in business decisions and decisions surrounding corporate policies. Investors may also enjoy the right to elect the company’s board of directors by exercising their voting rights.
Since common stocks are highly liquid, these can be easily bought or sold by investors, depending on personal investment decisions and preferences. Liquidity allows the flexibility of modifying an investment at any time without any hassle.
Limited legal liability
Common stockholders are passive investors and their obligations are limited since they can easily dissociate themselves from any events beyond financial investment. This allows investors to enjoy a safe financial future as long as a company is able to fetch substantial returns with a steady growth rate. There is also no risk of losing any additional amount of money than the original investment.
Here are some of the disadvantages of issuing common stock:
Market risk arises in case a company underperforms over a period. A significant decline in a company’s performance may result in profits being taken off from the shareholder’s earnings and no dividends received as against expectations. This is an important factor to consider since common shareholders do not receive priority payouts even if a company performs extremely well.
Although common shareholding may be considered as a fixed-income alternative, there is no guarantee of returns. When a company begins allocating dividend payouts, common stockholders receive payouts only after preference shareholders and bondholders receive their full dividends. Hence, there is a certain level of uncertainty and lack of control as far as the profitability of common stocks is concerned.
Why do investors buy common stocks?
Here are the top reasons why investors may prefer to invest in common stocks:
- To earn income through the steady flow of dividends that the shares may pay
- To gain profits through resale.
- To take part in a company’s growth. As the earnings and profits of a company increase, the share prices may rise too.
Difference between common stocks and preferred stocks
Common stocks and preferred stocks represent ownership in a company. Both these offer investors an opportunity to fetch substantial returns. However, each has specific characteristics that differentiate one from the other. Here are the noteworthy differences between common and preferred stocks:
- Preferred shareholders do not enjoy special privileges like voting rights. Thus, these shareholders cannot play a decisive role in policy formulation or influencing the company’s strategies. Common shareholders, however, can enjoy voting rights in a company.
- Preferred shareholders are prioritised while allocating the company’s profits to its shareholders. Common stockholders are paid dividends before the preferred shareholders only if the company makes substantial earnings.
- If a company is liquidated, preferred shareholders get their share before common shareholders. Common stockholders can get their due only if there are assets remaining after all other shareholders have been paid.
|Fixed at a pre-defined interval
|Variable depending on management’s decision
|Risk and returns
Some of the common stocks, such as blue-chip stocks, offer stability and security to investors, whereas others like penny stocks are often extremely volatile. An investor can choose to invest in a stock that is best suited to specific investment needs or investment time-frame.
As a general rule, the less time an investor holds a stock, the riskier the investment. These are best suited for longer investment horizons. So investors with a smaller investment window are better off investing in alternative avenues or may consider diversifying their investment portfolio by including other assets.
Companies that offer preferred shares in place of bonds can achieve a lower debt-to-equity ratio, allowing them to access more financing from new investors in the future.
Beginner investors can consider blue-chip or large-cap stocks to curtail the overall risk element involved in stock investments. Before investing, an investor must consider the stock trends and historical returns to have a better idea about stock selection.
Common stock lets investors participate in a company’s profits over time. Thus, these make for good long-term investments. Common stocks offer investors the right to vote for corporate directors and policy changes apart from stock splits.
An investor who is starting off with stock market investments must weigh personal budget against prices of selected stocks before investing in them. It is important to be clear on investment decisions, time horizons, and risk factors before investing in stocks.
Yes, you can invest as little as Rs. 100 in share markets as long as the price of a stock is limited to or lower than Rs. 100.