What is common stock? The most typical way to invest in a company and profit from its growth

John Rambow

Nov 24, 2020, 22:29 IST

What is common stock? The most typical way to invest in a company and profit from its growth

When people talk about "the market" and "stock shares," it's usually common stock they're referring to.Rawpixel/Getty Images

Common stock is a popular type of financial asset, in which investors buy shares in a publicly traded company.
Common stockholders typically receive quarterly dividends and voting rights in major corporate decisions.
Common stocks vary greatly in their riskiness and price performance but tend to appreciate in value over the long term.

When it comes to investments, the first thing that comes to mind is stocks. In fact, more than 50% of Americans own stock — either directly, via shares of individual companies, or indirectly, through mutual funds and exchange-traded funds.

And when it comes to stocks, what most readily comes to mind is common stock. Or more precisely, common shares of stock: a particular class, or type, of equity (ownership) in a public company. Common stocks get their name because they trade on the common — or public — market and are, well, more common than other types of shares or equity stakes.

In today's financial markets, millions of common stock shares are being traded at any one time. Read on for the basics of how they work and what you need to know about them.

What is common stock?

Also known as ordinary stock, common stock is a type of investment asset or security. Each share of stock represents a tiny portion of ownership of a company.

Although you can own shares in any sort of company or business/investment enterprise, the term "common stock" mainly refers to stock in a publicly traded company, as opposed to a privately held one.

Of course, common stock shares can be as varied as the thousands of public companies out there. However, most common stocks have the following characteristics:

They are sold, purchased, and resold in a common market, better known as a stock exchange. This gives them a transparent, publicly listed price, making them very liquid (easy to buy and sell).
They pay dividends, usually on a quarterly basis in the US; the exact amount per share fluctuates, though companies try hard to keep it moving upwards or at least constant.
They give you a vote in company policies and procedures, such as who gets appointed to the board of directors. Votes like these are typically done during or in advance of annual board meetings.

What type of investors are common stocks best for?

Investors buy common stock for essentially two reasons:

For income, via the steady trickle of dividends the shares pay
For appreciation: the chance that they'll be able to profit by reselling the stock later

Of the two, appreciation has the edge. People primarily invest in common stock because they want to share in a company's growth. As its earnings and profits increase, so will the price of its stock shares.

In terms of risk, common stocks run the gamut, from blue-chip stocks, which are highly stable and secure, to penny stocks, which are extremely volatile. You can find a stock to suit just about any investment need or time-frame.

In general, though, the less time you have to hold your stocks, the riskier they are. Compared to bonds and other investments, stocks are more secure over longer periods of time. Historically, the equities market has appreciated. But while stocks, in general, have tended to increase in value over the long term, the stock market may stay down for years. And shares in individual companies can always tumble or become worthless, even in robust markets.

So investors with a smaller window, such as those who are older or who need their money sooner, are better off investing elsewhere or at least diversifying their portfolios with other assets.

How common stock is created, sold, and traded

So how do companies create common stock? The first step is an initial public offering, which is usually done by partnering up with an investment bank, which helps price the stock and decides just how many shares will be made available.

By taking a company (and shares in it) "public," those with early access to the stock — founders, employees, venture capitalists, and other private investors — can more easily sell their existing shares, hopefully at a profit. That's because the world of potential buyers immediately grows so much larger once a stock is publicly available and starts trading on a stock exchange, like the New York Stock Exchange or the Nasdaq.

Why voting rights matter to shareholders

Common stock gives shareholders shares are a way of giving partial ownership of a company, and voting rights allow them to express their say on matters of corporate policy. There's no law that common stock has to have voting rights, although not doing so leads investors to be wary.

That's what happened to Snap, the company behind Snapchat, whose Class A shares came without voting rights when issued in 2017. Institutional investors in particular worried that this might encourage the company to ignore the wishes of those who had invested in it. The shares sank in price.

Management in other companies has tried to keep control by issuing "super shares" with extra voting rights for themselves. For instance, Google's founders hold a special version of its common stock that comes with 10 times the voting rights of a normal share.

The significance of dividends

Common stock often issues dividends, and companies use these dividends as a way to distribute profits to their stockholders, essentially rewarding them for sticking around. Stockholders can usually choose whether to receive their dividends as cash or to instead use them to buy additional shares of stock.

The company's directors decide how much money will be distributed as dividends each quarter in the US (and twice a year in the UK). Although companies can and do cancel dividends when earnings are down, they are reluctant to do so, since investors take this as a signal that the company is in serious trouble.

Common stock vs preferred stock

The other big class or category of corporate stock is the posher-sounding preferred stock.

While the same company can issue both types of stock, they are each their own animal.

Though they also represent ownership, preferred stocks have no voting rights, and companies can buy them back when they want to. So there's less chance they will drastically rise in value the way common shares might.

Preferred stocks do tend to pay out higher dividends than their common counterparts, though.

For instance, Capital One Financial's common stock (COF) traded around $77 from November 2019 to 2020. In early November it awarded a quarterly dividend of just $0.10 a share, or $0.40 annually — a yield of about 0.5% (0.40/77) per share. But one kind of Capital One preferred stock (COF.PRI), which trades around $26, has a dividend of about $1.22 a share, making for a yield that's almost 10 times larger, nearly 5%.

The downsides of common stocks

The biggest risk of owning common stock is that you will lose all or most of your money if the company goes bankrupt, falls on hard times, or just fails to prosper. Common stock isn't backed or guaranteed or insured by any entity or government agency.

Nor are its dividends. Companies aren't even obligated to pay them. So, while common stock can be a source of investment income, it's not as sure a thing as, say, a bond's interest payments.

In addition, many common stocks tend to be volatile, meaning that their prices can change a lot, in unpredictable ways. As mentioned earlier, these bumps get smoothed out, and prices do tend to rise, over the long haul. But that's scant comfort if you need money right away or were planning to cash out — for retirement, say — during a downswing. You could be forced to sell at a loss.

The financial takeaway

Common stock is what most people think of when talking about stocks: a type of investment that offers ownership in a company, is uniquely accompanied by voting rights, and that allows you to participate in and profit from a company's growth, providing dividends while you hold the shares and capital gains when you sell them.

Although common stocks are among the most important ways in which people build wealth, there's no guarantee they'll make you money. Whether or not to invest in them depends on your time frame, investment goals, and risk appetite. Don't invest in common stock — or anything else — without thinking about how you'll stay diversified, and don't invest money you can't afford to lose, or that you might have an immediate need for.