What Is Common Stock?

ByI. Mitic
March 25, 2022

Understanding stocks is an important part of securing a profitable future. Many people begin their entrepreneurial journey with common stocks. So, what is common stock?

In short, this is a form of equity ownership in a company that gives the holder the right to vote on corporate issues and may entitle them to dividends.

In this post, we’ll tell you more about this standard stock and compare it to some alternatives that you may want to consider.

Common Stock Definition

Common stock is a financial security that represents an equity stake in a firm. Common stockholders do not manage companies directly. Instead, they hire a board of directors to act on their behalf.

Generally, common stockholders receive good rates of return in the long term. That said, these shares are more vulnerable to market volatility. 

In most situations, companies treat common stockholders the same way as other classes. However, in the event of company liquidation, holders of common stock are lower down on the list of people with rights to the company’s assets after bondholders and preferred shareholders. 

How a Common Stock Works

Most common shares are traded on public exchanges, such as the New York Stock Exchange and the NASDAQ. The stock price is affected by demand, the company’s earnings as well as forecasts about future growth.

When shares of a company are in demand, the value of its common stock goes up. Likewise, when demand falls, the share price drops. 

Similarly, when a company issues more common stock, the price falls, and when it buys back stock, the price rises. 

If a company shows a lot of promise and is expected to make money in the future, common stock represents a great investment opportunity. Therefore, the value of the stock rises. Of course, when revenue projections are gloomy, the value of the stock falls. 

The price-to-earnings ratio is a metric that investors use to determine whether a stock is expensive or not. If the price is high relative to earnings, the stock is expensive. If the P/E ratio is low, the stock is on sale.

In today’s market, a P/E ratio that ranges between 20 and 25 is considered acceptable. However, the average figure can change over time, depending on investor sentiment and monetary policy factors. 

Investors can buy common stock directly through registered brokerages. Brokers go to the market on their clients’ behalf to purchase the requested stocks, charging a small fee.

They add the stock to the customers’ account, quoting its real-time market value for reference. 

Alternatives to Common Stock

Buying individual common stocks directly from companies listed on public exchanges is not the only option available to investors. Here are a few alternatives: 

  • Mutual funds: This is a professionally managed investment. Fund managers purchase a diversified portfolio of stocks and bonds on behalf of investors. They actively manage their clients’ holdings, buying and selling according to new information they receive, and charging around 2% of the account value per year for the service. 
  • Exchange-traded funds or ETFs: ETFs are traded on stock exchanges in the same way as regular standalone shares. However, they represent a basket of stocks, allowing investors to diversify without going through the hassle of bidding on dozens of individual shares. ETFs are managed by third-party licensed companies that maintain stock mixes according to the pre-defined strategy of the fund. Since these are largely passive, annual fees tend to be lower and hover around 0.15% to 0.50% per annum.
  • Bonds: You can also buy bonds on public exchanges via a regular brokerage account. Bonds are promises to pay the bearer a specific sum of money on a particular date (called the “maturity”). Like stocks, bond prices go up and down depending on demand in the market. The higher the price paid for the bond, the lower the expected return. Usually, bond prices rise when investors begin seeing stocks as too risky.

Common Stock vs. Preferred Stock

There are several significant differences between common stocks and preferred stocks. The main point of divergence is that holders of preferred stocks have no voting rights, while owners of common stocks do.

This means that common stockholders have a say in the future direction of the company, such as who it hires, which products it develops, and which markets it tries to enter, while preferred stockholders don’t. 

However, preferred stock owners have priority when it comes to receiving a share of company profits.

Dividend yields of preferred stocks are calculated as the dollar amount of the dividend over the stock price from a specific point in time when the stock starts trading. This differs from common stock, where the dividend (if one is paid) is declared by the board of directors but not guaranteed. 

During the liquidation of a company, preferred stockholders have a greater claim over any remaining company assets or earnings.

Administrators begin by paying off creditors and bondholders, followed by preferred stockholders, then common stockholders. 

Taxes on Stocks

In the US, shares don’t incur any taxes until you start making profits, which is when you pay capital gains. 

Profits from sales of stocks and shares occur when you sell them at a price that is higher than what you originally paid. For instance, you might buy a share for $1,000 and then sell it for $1,300 a year later, making a gain of $300. 

The IRS defines two classes of gains from sales of common stock: short-term and long-term. Short-term gains are profits that occur from selling a stock after holding it for less than a year, while long-term gains are for more than a year. 

Short-term capital gains are taxed at the same rate as regular income. For instance, if your regular income is $50,000 per year and you make a $10,000 capital gain, you would pay an income tax on $60,000. 

Long-term capital gains depend on your filing status and income bracket and are taxed at either 0%, 15%, or 20%. People who make less than $80,000 from labor pay zero taxes on long-term capital gains. 

Conclusion

So, what is a common stock good for? If you want voting rights on corporate issues and dividend payouts, this is an excellent investment. Common stockholders have a say over the direction of the firm.

However, unlike preferred stockholders, they do not have priority for either dividends or assets if the company goes into liquidation. 

You’ll need to pay taxes on short-term profits gained from the sale of common stock. However, capital gains rates for profits earned after more than a year are taxed at a more favorable rate.

FAQ

Why do companies issue common stock?

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Companies issue common stocks to raise capital to help them grow or achieve specific business goals. Firms, for instance, might sell equity stakes to finance R&D projects or expand into foreign markets. 

Is common stock an equity?

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Because common stock represents an ownership stake in a firm, it is a form of equity. It may also give the bearer the right to a percentage of the company’s profits.

Is common stock a dividend?

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Common stock can either be accumulating (where company profits are paid directly back into the firm to help raise the share price) or dividend-paying, where shareholders receive a percentage of the profits proportional to their share in the ownership.

Who can issue common stocks?

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Any publicly-registered corporation is allowed to issue stocks. Holders get voting rights that give them a say over the direction of the firm.

About author

For years, the clients I worked for were banks. That gave me an insider’s view of how banks and other institutions create financial products and services. Then I entered the world of journalism. Fortunly is the result of our fantastic team’s hard work. I use the knowledge I acquired as a bank copywriter to create valuable content that will help you make the best possible financial decisions.

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