What Is Common Stock? Types and Comparison With Preferred Stock

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Common stock is the basic ownership security of a corporation. Each share is a fractional claim on the company’s earnings and net assets. It usually carries the right to vote on major corporate matters and to receive any dividends the board of directors declares. That claim is residual: common shareholders are entitled only to what remains after creditors, bondholders and preferred shareholders have been paid. Common stock therefore carries the most risk in a company’s capital structure. It also has no ceiling on the value it can capture if the business grows.

What Common Stock Means

Owning common shares makes you a part-owner of a business, but not in a physical sense. You do not own a slice of the company’s buildings, inventory or computers. Those belong to the corporation, which is a separate legal entity. What you own is a proportional claim on whatever value the corporation has left once its obligations are met, plus the governance rights the company’s charter attaches to your shares.

Your stake is measured by your share of the total. If a company has 10 million common shares outstanding and you hold 10,000, you own 0.1% of its common equity. That entitles you to 0.1% of any common dividend, 0.1% of the common vote (under a one-share, one-vote structure) and 0.1% of whatever is left for common holders if the company is wound up.

The terms “common stock,” “common shares,” “ordinary shares” and “common equity” describe the same thing in most contexts. “Ordinary shares” is the usual term in the UK and many other markets outside the U.S.

How Common Stock Works

Rights of Common Shareholders

Common stock bundles several rights. The company’s charter, its bylaws and the corporate law of the state or country where it is incorporated define the details.

• Voting. Shareholders elect the board of directors and vote on major corporate actions such as mergers and acquisitions, changes to the charter, stock splits and equity compensation plans. Most ordinary common shares carry one vote per share. Votes are cast at the annual meeting or at special meetings. Shareholders who don’t attend can vote by proxy, authorizing a third party to vote their shares as instructed.
• Dividends. If the board declares a dividend on common stock, each share receives the same amount. Nothing obliges the board to declare one. Many companies pay none and reinvest their earnings instead.
• Residual claim. Common shareholders own whatever value is left after all prior claims. In a healthy, growing company that residual can become very large. In a failing one it can be zero.
• Transferability. Shares of public companies can be sold to other investors on an exchange or over the counter. Common stock is the most actively traded class for most companies.

Issuing Common Stock

When a company issues common stock, it sells new ownership stakes in exchange for capital. A private company becomes public through an initial public offering (IPO). It works with an underwriting investment bank to set the structure and price of the offering. After the IPO, the shares trade on the secondary market, where investors buy from and sell to each other rather than from the company. Public companies can issue additional shares later through follow-on offerings. They can also use stock to pay for acquisitions or compensate employees.

Three share counts matter here:

• Authorized shares: the maximum number the charter allows the company to issue.
• Issued shares: the shares the company has actually sold or granted.
• Outstanding shares: issued shares currently held by investors. This excludes any the company has bought back and holds as treasury stock.

Issuing new shares raises equity capital without creating debt. Because the ownership pie is divided into more slices, each existing share then represents a smaller percentage of the company. This is dilution. Suppose a company with 10 million shares issues 2 million more. A holder of 100,000 shares drops from 1.0% to about 0.83% ownership. Whether existing holders are worse off depends on what the company receives for the new shares and what it does with the money.

Larger U.S. companies list their shares on exchanges such as the New York Stock Exchange or Nasdaq. Companies that cannot meet a major exchange’s listing requirements trade over the counter.

Common Stock in Accounting

On the issuing company’s balance sheet, common stock appears in the shareholders’ equity section, not among assets or liabilities. The accounting equation shows why:

Assets = Liabilities + Shareholders’ Equity

Assets are what the company owns or is owed: cash, property, equipment and receivables. Liabilities are what it owes: payables, loans and bonds. Equity is the residual, the owners’ claim on assets after liabilities. Common stock is one component of that residual. It is called equity because it represents ownership rather than an obligation to repay. For a deeper look at how the residual is calculated, see what equity means and how to calculate it.

Contributed capital from common stock is usually split into two accounts:

• Common stock (at par): the number of shares issued multiplied by the par value, a nominal legal value often set at a fraction of a cent or a dollar.
• Additional paid-in capital (APIC): the amount investors paid above par.

Equity accounts carry a normal credit balance, so issuing common stock is recorded as a credit to these accounts. The matching debit goes to cash or whatever asset the company received. Issuing stock increases the common stock account and total shareholders’ equity. A buyback reduces equity through a treasury stock account, which is a contra-equity account with a debit balance.

Common stock does not appear on the income statement. Issuing shares is a financing transaction, not revenue, so it does not raise profit. Dividends paid to common shareholders are not an expense either, so they do not lower net income. They are a distribution of earnings and reduce retained earnings, another equity account.

For the investor, the picture flips. Shares you hold are an asset on your own balance sheet, even though they are equity on the company’s.

Worked Example: Recording a Share Issue

Hypothetical: a company sells 1,000,000 new common shares at $15 each. The par value is $0.01 per share.

• Cash received: 1,000,000 × $15 = $15,000,000
• Common stock (par): 1,000,000 × $0.01 = $10,000
• Additional paid-in capital: $15,000,000 − $10,000 = $14,990,000

The entry debits cash $15,000,000, credits common stock $10,000 and credits APIC $14,990,000. Total assets and total equity both rise by $15 million. Liabilities and net income are unchanged.

Interpreting Common Stock

The accounting value of common stock and its market value are different numbers. The par value and APIC record what the company originally received. They do not track what the shares are worth today. Investors use a few measures to connect the two.

• Market capitalization = share price × shares outstanding. This is the market’s current valuation of the company’s common equity.
• Book value per common share = (total shareholders’ equity − preferred equity) ÷ common shares outstanding. This is the accounting value attributable to each common share.
• Earnings per share = (net income − preferred dividends) ÷ weighted average common shares outstanding. Preferred dividends are subtracted because common shareholders only have a claim on what is left after them. See how EPS is calculated.

From these, investors build valuation ratios such as price-to-book and the price-to-earnings ratio, which compare what the market pays for a share with the earnings or net assets behind it. Changes in share count matter too. If a company keeps issuing stock, each share’s claim on earnings shrinks unless earnings grow faster than the share count.

Types of Common Stock

Share Classes

Some companies issue more than one class of common stock. The classes usually differ in voting rights rather than economic rights. In a dual-class structure, founders or insiders often hold a class with several votes per share, while the publicly traded class has one vote or none. Alphabet, Google’s parent company, is a well-known example: its Class A shares (GOOGL) carry one vote each, while its Class C shares (GOOG) carry no vote. Such structures let insiders keep control while raising outside capital. They also weaken the influence ordinary shareholders have through voting.

Investment Categories

Investors also group common stocks by characteristics that have nothing to do with legal rights:

• Growth stocks belong to companies expected to increase earnings quickly. They often pay little or no dividend and reinvest profits.
• Value stocks trade at lower prices relative to fundamentals such as earnings or book value. They are more likely to pay dividends.
• Market capitalization tiers (large-cap, mid-cap, small-cap) sort companies by size. Large-cap stocks tend to be established companies that trade frequently. Small-cap stocks are more often younger, growth-oriented firms with more volatile prices.

Broad indexes such as the S&P 500 track baskets of large-company common stocks. A stock screener lets investors filter common stocks by size, valuation, dividend status and other criteria.

Common Stock vs. Preferred Stock

Both are equity, and both give the holder a stake in the company. The difference is how they rank and what they trade away to get there. Every public company has common stock. Issuing preferred stock is optional.

How Preferred Dividends Work

A preferred dividend is defined in advance as a rate applied to the share’s par value. Hypothetical: a preferred share with a $50 par value and a 6% dividend rate pays $3 a year. A common shareholder has no such figure. The dividend can be raised, cut or suspended.

If a company cannot pay everyone, preferred holders are paid first. With cumulative preferred stock, any skipped preferred dividends build up as dividends in arrears. The company must pay these in full before common shareholders receive anything. Non-cumulative preferred stock carries no such catch-up right.

Callable and Convertible Features

Preferred terms vary by issue:

• Callable preferred stock can be redeemed by the issuer at a preset price after a set date. Holders then lose the future dividends.
• Convertible preferred stock can be exchanged for a set number of common shares under the issue’s terms. This lets the holder take part in a rise in the common stock price.

Why Companies Issue Preferred Stock

Preferred stock raises equity capital without diluting voting control, because it usually carries no vote. It appeals to investors who want steadier income than common stock offers, which widens the pool of buyers. For some issuers it can also cost less than borrowing. Preferred dividends are not mandatory the way bond interest is. They are generally not tax-deductible for the corporation, unlike interest. Even so, they may cost less than the rate a company would need to offer bond investors.

Choosing preferred over common stock does not remove company risk. If the issuer runs into serious trouble, both classes are likely to lose value. The preferred holder’s priority only matters if something is left to distribute.

Example: Where Common Stock Sits in a Liquidation

Hypothetical: a company is wound up and its assets are sold for $100 million. It owes $80 million to creditors and bondholders. It has preferred stock with a total liquidation preference of $15 million. There are 10 million common shares outstanding.

1. Creditors and bondholders: $80 million paid in full, leaving $20 million.
2. Preferred shareholders: $15 million paid in full, leaving $5 million.
3. Common shareholders: $5 million ÷ 10 million shares = $0.50 per share.

Now assume the assets sell for $90 million instead. After creditors take $80 million, preferred holders receive the remaining $10 million, short of their $15 million preference. Common shareholders receive nothing. A drop of $10 million in asset value, about 10%, wipes out the common equity entirely. That sensitivity is why common stock is the riskiest claim on a company. When things go well, the same sensitivity runs in the shareholder’s favor, because all the excess value belongs to common holders.

Advantages and Limitations of Common Stock

Advantages

• Unlimited upside. All value created beyond fixed claims belongs to common shareholders. Over long periods, stocks have historically outperformed bonds and preferred shares, with more short-term volatility.
• Voting rights. Shareholders have a say in who runs the company and in major decisions.
• Liquidity. Common shares of listed companies generally trade more actively than the same company’s preferred shares or bonds.
• Dividend growth. Unlike a fixed preferred dividend, a common dividend can rise as earnings grow.

Limitations

• Last in line. Common holders rank behind creditors and preferred holders, both for dividends and in liquidation.
• No guaranteed income. The board can cut or eliminate the dividend.
• Volatility. Prices move with company results, sentiment and broader market conditions.
• Dilution. New share issues reduce existing holders’ percentage of ownership.
• Weaker votes in some structures. In dual-class companies, public common shares may carry little or no practical influence.
• Limited liability, total loss possible. A shareholder generally cannot lose more than the amount invested in the shares. But that full amount can be lost.

Investing in Common Stock

Investors buy common stock through a brokerage account. They either pick individual companies or buy funds that hold many stocks. Stocks carry more risk than certificates of deposit, bonds or preferred stock, and that risk comes with higher potential returns. They tend to suit investors with longer time horizons who can tolerate interim declines. Investors focused on steady income and lower price swings may lean toward preferred stock or bonds, accepting lower growth potential in exchange.

Evaluating a common stock means looking past the share price to what each share claims. That includes the company’s earnings and growth, its debt load (which ranks ahead of shareholders), any preferred stock outstanding, the trend in share count, dividend policy and voting structure. For preferred stock, focus on the dividend relative to the share price (the yield), whether the dividend is cumulative, and any call or conversion features.

A Brief History

The first shares widely recognized as common stock were issued in 1602 by the Dutch East India Company, and they traded in Amsterdam. Selling transferable ownership stakes to the public let the company finance costly, risky voyages that no single backer could fund. Over the following four centuries, stock exchanges spread worldwide, including major markets in London, Tokyo and New York. The basic bargain remains the same: shareholders supply capital in exchange for a residual claim on the profits.

FAQs

The Bottom Line

Common stock suits investors with long time horizons who can ride out price declines in exchange for unlimited participation in a company's growth. Because holders rank last and dividends are never guaranteed, evaluating a share means checking the company's earnings, debt load, preferred stock, share count trend, dividend policy and voting structure. Investors who prefer steady income and smaller price swings may lean toward preferred stock or bonds instead.