What is common stock (short definition)
– Common stock is a basic ownership share in a corporation. Holders of common stock own a residual claim on the company’s assets and profits after all creditors and higher-priority claims (like bondholders and preferred shareholders) are paid.
Key terms (quick definitions)
– Dividend: a cash or stock payment a company may distribute to shareholders from earnings.
– Preferred stock: a different class of equity that usually has fixed dividends and higher claim priority than common stock.
– Par (face) value: an accounting value assigned to a share for legal or dividend-calculation purposes; it is not the market price.
– Cumulative preferred: preferred shares for which missed dividends accumulate and must be paid before common dividends.
– Initial public offering (IPO): the first sale of a company’s stock to the public, which enables listing on exchanges or secondary markets.
– Stockholder’s equity: the section of the balance sheet that records owners’ claims (including common stock, paid-in capital, retained earnings).
How common stock works (plain explanation)
– Ownership and claims: Owning common shares makes you an owner of the company in proportion to your holdings, but the corporation itself owns the physical assets. Your ownership gives you a residual right to profits and assets after higher-priority claims are settled.
– Voting: Common shares typically carry voting rights that allow shareholders to elect the board of directors and vote on major corporate decisions. Voting power usually scales with the number of shares owned, unless the company issues multiple share classes with different voting rights.
– Dividends: Boards decide whether to pay dividends to common shareholders. Dividends to common owners are not guaranteed and can be reduced or eliminated. Preferred shareholders usually have fixed, pre-specified dividends that are paid before common dividends.
– Trading and liquidity: Common shares are commonly traded on public exchanges (NYSE, Nasdaq, etc.). Smaller or unlisted company shares may trade over-the-counter (OTC), which is often less liquid.
– Bankruptcy and liquidation: If a company is liquidated, common shareholders are paid last—after creditors, bondholders, and preferred shareholders—so common stock carries higher downside risk in insolvency events.
– Long-term return potential: Because common shareholders share in earnings growth, common stock has historically offered stronger long-term growth than fixed-income or preferred shares, though with greater volatility.
Common stock vs. preferred stock (comparison)
– Voting rights: Common = usually yes; Preferred = usually no.
– Dividend certainty: Common = discretionary; Preferred = fixed (often stated as a percentage of par value).
– Priority at liquidation: Preferred > Common.
– Price behavior: Common tends to have higher price volatility and potentially higher capital-growth potential; preferred tends to be steadier with income focus but less upside.
Pros and cons — quick checklist
Pros of common stock
– Potential for capital appreciation over time.
– Voting rights that influence corporate governance.
– Access to company growth and retained-earnings appreciation.
Cons of common stock
– Dividends are not guaranteed and can be cut.
– Last in line in bankruptcy—higher downside risk.
– Greater price volatility than debt or preferred shares.
Why companies issue preferred stock (short)
– Preferred shares let companies raise capital with an equity-like instrument while offering investors income-like stability (fixed dividends). Issuing preferred stock can preserve common shareholders’ voting control because preferred shares often lack voting rights.
Other types of stock
– Multiple classes of common shares (e.g., Class A, Class B) can carry different voting and dividend rights.
– Preferred shares come in many flavors (convertible, cumulative, non-cumulative, participating).
– Unlisted or OTC stocks trade outside major exchanges and can be less liquid.
How to vote as a common shareholder (practical steps)
1. Confirm shareholder status and record date (the company sets a date that determines who can vote).
2. Review the proxy materials mailed or posted online before the shareholder meeting.
3. Choose how to vote:
– Vote electronically or by mail using the proxy card.
– Vote in person at the annual meeting.
– If you own shares through a broker (street name), instruct your broker how to vote or request a legal proxy if you wish to attend.
4. If you can’t attend, use the proxy to have your votes cast by management or another designated party.
How to invest in common stock (step-by-step checklist)
1. Open a brokerage account that suits your needs (fees, research tools, order types).
2. Research the company: financials, dividend policy, governance, and market position.
3. Check liquidity and trading venue (exchange-listed vs. OTC).
4. Decide position size and risk controls (position limits, stop orders).
5. Place the order (market, limit, or conditional).
6. Monitor holdings and corporate actions (dividends, splits, proxy votes).
7. Consider tax treatment for dividends and capital gains in your jurisdiction.
Small numeric example — dividend priority and distribution
Assume a company has $200,000 available to distribute in a year. It has:
– 100,000 preferred shares with $10 par and a 5% preferred dividend.
– 1,000,000 common shares outstanding.
Step 1 — Calculate total preferred dividend:
Preferred dividend per share = $10 × 5% = $0.50
Total preferred dividend = $0.50 × 100,000 = $50,000
Step 2 — Residual amount available to common shareholders:
Available to common = $200,000 − $50,000 = $150,000
Step 3 — Dividend per common share:
Dividend per common share = $150,000 ÷ 1,000,000 = $0.15
If the company could only pay $120,000 total, preferred shareholders (with cumulative terms) would still be owed $50,000 first; common shareholders would receive the remaining $70,000 or $0.07 per share. If preferred dividends are non-cumulative and the company skips them, cumulative rights determine whether missed payments must be made later.
Explain like I’m five (simple analogy)
– Think of a company as a pizza. Common shareholders
get whatever slices are left after the preferred shareholders take their fixed pieces. If there isn’t much pizza that day, common shareholders might get very small slices or none at all. If the preferred shareholders are “cumulative” and you skipped a week, they keep a tab and get paid first next time; if they’re “non‑cumulative,” skipped slices are gone forever.
Voting rights and control
– Common stockholders usually have voting rights: typically one vote per share on matters like electing the board of directors or approving major corporate actions.
– Some companies issue multiple classes of stock (e.g., Class A, Class B) with different voting power. Check the company’s charter for class differences.
– If you don’t want to vote in person, you can vote by proxy—authorizing someone else (often management) to vote your shares.
Dividends (what they are and how to measure them)
– Dividend: a cash payment (or stock) the company may distribute to shareholders from profits; not guaranteed.
– Dividend yield = Annual cash dividend per share ÷ Current share price. Example: annual dividend $0.60, price $30 → yield = 0.60 ÷ 30 = 0.02 = 2.0%.
– Companies decide dividend amounts and timing at their board’s discretion; some follow consistent payout policies, others pay none.
Capital gains and total return
– Capital gain = Selling price − Purchase price. Percentage gain = (Selling price − Purchase price) ÷ Purchase price.
– Total return = Capital gains percentage + dividend yield (over the holding period). Example: buy at $30, sell at $36 (20% gain) and you received 2% in dividends during the holding period → total return ≈ 22%.
Priority in liquidation (simple rule)
– If a company is liquidated, creditors (including bondholders) are paid first, preferred shareholders next, and common shareholders last. Often there’s nothing left for common owners in a bankruptcy.
Dilution and share count
– Dilution happens when a company issues additional shares, reducing existing shareholders’ percentage ownership and voting power.
– Worked example: You own 1,000 shares out of 100,000 outstanding = 1.0% ownership. If the company issues 50,000 new shares, total becomes 150,000 and your ownership falls to 0.67% (1,000 ÷ 150,000).
Basic valuation ratios (quick formulas and example)
– Price-to-earnings (P/E) ratio = Market price per share ÷ Earnings per share (EPS). Example: Price $50, EPS $2 → P/E = 50 ÷ 2 = 25.
– Dividend yield formula (above): Annual dividend ÷ Current price.
– Price-to-book (P/B) = Price per share ÷ Book value per share.
– Use these ratios with industry context—what’s high in one sector may be low in another.
Simple checklist before you buy a common stock
1. Define your goal and time horizon (growth, income, speculation).
2. Check the company’s financial health: revenue trend, profit margins, debt levels.
3. Look at earnings per share (EPS) and growth trends.
4. Compare valuation ratios (P/E, P/B, dividend yield) to peers.
5. Review dividend history and policy if income matters.
6. Consider liquidity: average daily volume and exchange listing.
7. Read recent 10‑K/10‑Q (annual and quarterly reports) for risks and management commentary.
8. Decide position size and set buy/sell rules (use limit orders if appropriate).
9. Diversify—avoid putting too large a share of your portfolio into one stock.
A compact worked example
– You buy 100 shares at $30 = $3,000 invested. Annual dividend = $0.60 per share → annual cash = 100 × 0.60 = $60 (2.0% yield).
– Company EPS = $1.00 → P/E = 30 ÷ 1.00 = 30.
– One year later you sell at $36: capital gain = ($36 − $30) × 100 = $600 → 20% capital gain. Total return ≈ 20% + 2% dividend = 22% (ignoring taxes and transaction costs).
Key risks to remember
– Market risk: share prices can fall for market-wide reasons.
– Company risk: poor earnings, management issues, or competitive threats.
– Liquidity
– Liquidity: shares of some companies trade thinly, so it can be hard to buy or sell large blocks without moving the price. Low liquidity also widens the bid–ask spread, increasing trading costs and slippage.
– Dilution: when a company issues additional shares (for capital, acquisitions, or employee compensation), your percentage ownership and earnings per share (EPS) can decline.
– Dividend risk: dividends are not guaranteed. A company can reduce or eliminate dividends if earnings fall or management reprioritizes cash use.
– Volatility: common stocks can show large price swings over short periods. Higher volatility increases both potential gains and potential losses.
– Subordination in claims: in bankruptcy or liquidation, common shareholders have lower priority than bondholders and preferred shareholders; recovery can be zero.
– Regulatory and event risk: lawsuits, regulatory actions, management changes, or major operational failures can sharply damage a stock’s value.
How to mitigate common-stock risks — practical checklist
1. Diversify across industries and holdings. Target no more than a pre-set percentage of your portfolio in any single stock (example rule: 3–5%).
2. Position sizing: calculate position size from portfolio risk tolerance. Example: portfolio = $50,000; max per-stock exposure = 5% → $2,500. At $30/share you would buy 83 shares (2,490).
3. Check liquidity: prefer average daily volume that comfortably supports your intended trade size; avoid microcaps if you need quick exits.
4. Use limit orders for less-liquid names to control execution price; use market orders for highly liquid, large-cap stocks only when immediate execution matters.
5. Consider stop-loss or mental exit rules to limit downside. Example: buy at $30, set a 20% stop-loss → automatic sell at $24.
6. Rebalance periodically to lock in gains and restore target allocations.
7. Review fundamentals: sales, earnings trends, cash flow, debt levels, and management quality.
8. Keep an emergency cash buffer to avoid forced sales in downturns.
9. Consider staging buys over time (dollar-cost averaging) to reduce timing risk.
How to buy common stock — step-by-step
1. Choose a broker whose fees and platform match your needs (discount brokers for self-directed trading; full-service brokers for advice).
2. Open and fund your brokerage account; decide account type (taxable, IRA, etc.).
3. Research the company and ticker symbol using financial statements and analyst coverage.
4. Decide order type:
– Market order: executes immediately at current price (use for liquid stocks).
– Limit order: sets a maximum purchase price (or minimum sale price).
– Stop order / stop-limit: triggers an order when a price level is reached.
5. Calculate position size using your risk rules (see checklist).
6. Place the trade and confirm execution details (price, quantity, commission).
7. Record the trade for tax and portfolio-tracking purposes; monitor performance and news.
8. If you receive dividends, decide whether to enroll in a DRIP (dividend reinvestment plan) or take cash.
Key metrics to monitor (definitions)
– Market capitalization (market cap): shares outstanding × share price; rough size measure.
– Earnings per share (EPS): net income divided by outstanding shares.
– Price-to-earnings ratio (P/E): price divided by EPS; a valuation gauge.
– Dividend yield: annual dividend per share ÷ share price.
– Payout ratio: dividends ÷ earnings; indicates sustainability of dividends.
– Free cash flow: cash generated after capital expenditures; supports dividends and debt repayment.
– Beta: statistical measure of volatility vs. the overall market (beta >1 implies greater volatility).
Worked numeric example — position sizing and stop-loss
– Portfolio value: $50,000. Risk per position (max exposure) = 4% → $2,000.
– Target stock price = $25 → buy 80 shares → cost = $2,000.
– You decide a 15% absolute stop-loss to protect capital → stop price = $25 × (1 − 0.15) = $21.25. If hit, loss ≈ 15
…% of the position value = 0.15 × $2,000 = $300. Per-share loss = $25 − $21.25 = $3.75; 80 shares × $3.75 = $300. That matches the risk budget ($2,000 position × 15% = $300).
Key formulas from this example
– Position cost = shares × entry price.
– Absolute per-share risk = entry price − stop price.
– Position risk (dollars) = shares × per-share risk.
– Shares to buy given risk budget = risk_budget ÷ per-share_risk.
Worked alternates
– Want to risk $500 with a 10% stop on a $25 entry:
– Stop price = $25 × (1 − 0.10) = $22.50.
– Per-share risk = $2.50.
– Shares = $500 ÷ $2.50 = 200 shares.
– Position cost = 200 × $25 = $5,000 (exceeds the 4% position cap in the earlier portfolio example, so you would reduce shares or raise stop distance to stay within the $2,000 exposure).
– Include trading friction: subtract expected commissions, fees, and slippage from the risk budget. For small retail trades, assume $1–$5 or percentage-based commissions depending on broker.
Practical trade-entry checklist
– Calculate max portfolio risk per position (absolute $ and % of portfolio).
– Decide entry price and stop price (stop-loss = predetermined exit on loss).
– Compute per-share risk and resulting share quantity using the formula above.
– Check position cost against capital allocation limits and liquidity (average daily volume).
– Verify there are no imminent corporate events (earnings, ex-dividend date) that could cause volatility.
– Choose order type: limit order to control execution price; stop-limit for tighter control of slippage. Know how your broker implements stop orders.
– Record the trade plan (entry, stop, target, rationale, time horizon) before executing.
Common-stock mechanics (concise definitions)
– Voting rights: shareholders typically vote on board members and major corporate actions. Some companies issue multiple classes of stock with different voting powers.
– Dilution: issuance of new shares reduces existing ownership percentage; can lower earnings per share (EPS).
– Share buybacks: company repurchases its own stock, which reduces shares outstanding and can increase EPS and ownership percentage for remaining holders.
– Dividends: cash paid to shareholders; characterized by yield (annual dividend ÷ price) and payout ratio (dividends ÷ earnings). Qualified dividends may receive favorable tax rates if holding-period requirements are met.
– Corporate actions to watch: stock splits, reverse splits, mergers, rights offerings and tender offers — all affect share count or value.
Portfolio-risk reminders
– Diversify across sectors and uncorrelated assets to reduce idiosyncratic risk (company-specific risk).
– Monitor beta (sensitivity to market moves) at portfolio level; a high-beta portfolio amplifies market swings.
– Rebalance periodically to maintain target allocations.
Tax and recordkeeping notes
– Keep records of buy/sell dates, prices, dividends received and any reinvestments for accurate tax reporting.
– Dividends and capital gains tax treatment varies by jurisdiction; check local rules or consult a tax professional.
Sources (for further reading)
– Investopedia — Common Stock: https://www.investopedia.com/terms/c/commonstock.asp
– U.S. Securities and Exchange Commission — Investor.gov (Beginners’ guide and market mechanics): https://www.investor.gov
– Internal Revenue Service — Topic: Dividends and Capital Gains: https://www.irs.gov/taxtopics/tc409
– New York Stock Exchange — What Is a Stock?: https://www.nyse.com/what-is-a-stock
Educational disclaimer
This is educational information, not personalized investment advice. It does not recommend specific securities, position sizes, or actions. Consult a licensed financial professional for advice tailored to your circumstances.