What it means
A corporation is owned by its shareholders, and common stock is the ordinary, default form of that ownership. Every corporation has it; many have nothing else.
The holder of a share of common stock owns a proportionate slice of the company: one share in a company with a million shares is one millionth of the votes, one millionth of any dividend, and one millionth of whatever remains after the company's obligations are met. The rights are threefold.
Voting: common shareholders elect the directors, approve major transactions (mergers, sales of the business, changes to the charter) and vote on matters the law or the charter reserves to them, usually one vote per share, though some companies issue classes with different voting rights so that founders retain control with a minority of the economic interest. Dividends: common shareholders receive dividends only when the board declares them, and only after any preferred dividends (including arrears on cumulative preferred) have been paid; there is no entitlement, and growth companies commonly pay none, retaining earnings instead.
Residual claim: on liquidation, common shareholders receive whatever is left after creditors and preferred shareholders, which may be everything or nothing; in a going concern, they own the growth in the business's value, which is why common stock is the instrument through which wealth is created and lost. The balance sheet records common stock at par value (a nominal figure, often cents) times shares issued, with the excess of the issue price over par as additional paid-in capital or share premium; together with retained earnings and other reserves, these make up shareholders' equity, the common shareholders' book stake.
Shares issued and later repurchased are treasury stock, deducted from equity; shares authorised but not issued are disclosed but have no value. Book value per share is equity attributable to common shareholders divided by shares outstanding; market value per share is whatever the market pays, which for a successful company far exceeds book value and for a failing one may be below it.
Common stock is issued at formation, in fundraising rounds, in public offerings, as consideration for acquisitions, and under employee share and option schemes. Each issue dilutes existing holders' proportionate ownership unless they subscribe; pre-emption rights, where they exist, give existing holders first refusal.
Buybacks and cancellations concentrate ownership in the remaining shares. Stock splits and bonus issues change the number of shares without changing the total value.
For investors, common stock offers the highest expected return of the company's securities and the highest risk; the return comes as dividends and capital gains, and the risk is that the residual claim proves worth nothing. For companies, common stock is permanent capital that need never be repaid, that carries no fixed cost, and that supports borrowing; its price is dilution of ownership and, for listed companies, the obligations of public disclosure and shareholder accountability.
In practice
Real-world examples.
Example
A founder holds 40% of a start-up's common stock and sees it diluted to 12% through three funding rounds, while its value rises from nothing to $30 million.
Example
A listed company's common shareholders vote down a takeover bid at $45 a share, judging the residual value higher.
Example
A bank's common shareholders are wiped out in a rescue while its bondholders are repaid in full, the residual claim having proved worth nothing.
Think of it
“Common stock is regular ownership shares-you own part of the company with voting rights.
Formula
Calculation
Common Stock (balance sheet) = Shares issued x Par value
Additional Paid-In Capital = (Issue price minus Par value) x Shares issued
Shares Outstanding = Shares issued minus Treasury shares
Earnings per Share = (Net income minus Preferred dividends) / Weighted average common shares outstanding
Book Value per Common Share = (Total equity minus Preferred equity) / Common shares outstanding
Market Capitalisation = Share price x Common shares outstanding
Worked example. A company has 5,000,000 common shares of $0.01 par issued at an average of $4.00, 200,000 of which have been repurchased and held in treasury at a cost of $1,600,000; 500,000 preferred shares of $10 par with a 6% cumulative dividend; retained earnings of $22,000,000. Net income this year is $4,500,000. The share price is $12.50.
Equity section:
- Preferred stock: $5,000,000
- Common stock (5,000,000 x $0.01): $50,000
- Additional paid-in capital (5,000,000 x $3.99): $19,950,000
- Retained earnings: $22,000,000
- Treasury stock: minus $1,600,000
- Total shareholders' equity: $45,400,000
Common shares outstanding = 5,000,000 minus 200,000 = 4,800,000.
Preferred dividend = 6% x $5,000,000 = $300,000.
Earnings per common share = ($4,500,000 minus $300,000) / 4,800,000 = $0.875.
Book value per common share = ($45,400,000 minus $5,000,000) / 4,800,000 = $8.42.
Market capitalisation = $12.50 x 4,800,000 = $60,000,000; price to book = 1.48.
Dividend: the board declares $0.30 per common share: $1,440,000, payable after the $300,000 preferred dividend; payout ratio 34% of earnings available to common.
New issue: the company raises $10,000,000 by issuing 800,000 new common shares at $12.50. Common stock rises by $8,000 (800,000 x $0.01); additional paid-in capital by $9,992,000; shares outstanding to 5,600,000. An existing holder of 480,000 shares (10%) who does not subscribe now holds 8.6%. Earnings per share, if net income is unchanged, falls to $0.75: the issue is dilutive unless the $10,000,000 earns at least $0.875 x 800,000 = $700,000 of additional net income (a 7% return) to maintain it.
Liquidation illustration: if the company were wound up with net assets realised at $30,000,000 after creditors, preferred holders would receive $5,000,000 (plus any arrears) first, and common holders would share $25,000,000, or $4.46 per share, below book value and well below the market price. If net assets realised were $4,000,000, preferred holders would receive it all and common holders nothing. The residual claim is the whole of the upside and the whole of the downside.Case study
Seen in the real world.
A technology company went public with two classes of common stock: Class A shares sold to the public with one vote each, and Class B shares held by the founders with ten votes each. The founders held 15% of the economic interest and 64% of the votes. Public investors accepted the structure for the growth.
Five years later, the company's growth had slowed, its chief executive (a founder) had made two poor acquisitions, and institutional shareholders holding 70% of the economic interest wanted a change of leadership; they could not effect it, because the Class B votes controlled the board. The share price fell to a discount against peers that analysts attributed partly to the governance.
The company eventually adopted a sunset provision converting Class B shares to Class A after a further five years or on the founders' departure, and the discount narrowed. The episode illustrated what common stock is: the residual claim is the same for both classes, but the control that normally accompanies it had been separated, and the market priced the separation.
Watch out
Common mistakes.
- Reading the common stock line on the balance sheet as the shareholders' investment. Par value is nominal; the investment is par plus additional paid-in capital, and the value is the market price.
- Assuming common shareholders are entitled to dividends. They are paid at the board's discretion, after preferred dividends, and many companies pay none.
- Ignoring dilution. Every new issue reduces existing holders' proportion unless they subscribe, and earnings per share falls unless the new capital earns its keep.
Questions
People also ask.
What is the difference between common stock and preferred stock?
Preferred stock has a fixed dividend paid before any common dividend and priority on liquidation, usually without votes. Common stock has votes, discretionary dividends and the residual claim: more risk, all the upside.
What are dual-class shares?
Two classes of common stock with different voting rights, typically giving founders control with a minority economic interest. They are controversial and often carry a market discount.
Why does common stock have par value?
Historically as a minimum issue price and capital floor for creditors. Many jurisdictions now allow no-par shares; where par exists it is usually a trivial amount.
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