What are Common Stocks?
Common stock, also known as ordinary shares or common shares, is a security that reflects the investor’s ownership of a company. Holding this stock offers investors the power to elect the company’s board of directors and have voting rights. These voting rights allow you to be a part of the company’s internal decision-making and vote to plan for various corporate policies.
Common stocks have the potential to realise better returns in the long term at a high rate. Also, common shareholders are compensated with dividend income, which is paid after distributing the accrued profits to preference shareholders. Furthermore, in the event of liquidation, the common shareholders have the rights to company assets only after the company repays the preference shareholders, bondholders, creditors and other debtors in full.
These shares are issued in the market through Initial Public Offering (IPO). In the company’s balance sheet, the common socks are reported under the equity section. It can be expressed as –
Number of outstanding shares = Total number of issued shares – Total treasury stocks.
What are the Features of Common Stocks?
The following are the features of common stocks –
- Ownership – Common stocks reflect the investor’s ownership of a company to the proportion of shares held. For instance, if you hold 2000 common shares in a company, you are the company’s owner in the same proportion of its percentage value.
- Rights – These stocks offer certain rights/power to their shareholders. They are entitled to voting rights such as electing the board of directors and voting for internal policy matters. Also, shareholders are entitled to receive dividends, receive assets in the event of liquidation and pre-emptive rights.
- Transaction – These stocks can be bought and sold like any other stocks listed on the stock exchange. You will require a demat and trading account to buy and sell equity shares.
- Stock Exchange – Like any other shares, these stocks are listed on the National Stock Exchange (NSE) and Bombay Stock Exchange (BSE).
- Repayment – Common stockholders are paid at the time of company liquidation but after paying the preference shareholders, bondholders and other debt holders.
Why do Companies Issue Common Stocks?
The primary reason why companies issue common stocks is to raise capital. The following are the ways the company uses the raised capital –
- Business Expansion – Companies want to increase their goodwill and profits by expanding their business further. Therefore, companies issue common stocks to raise funds, allowing them to capture the market share and use this money to achieve their expansion plans.
- Acquisition – This is one of the best ways for a company to expand by acquiring a competitor or a promising company within the same sector. However, acquisitions can be expensive and companies require additional funds to purchase. Thus, they issue common shares.
- Paying Outstanding Debts – Most companies borrow money to fund their initial stages of business operations. After stabilising their business activities, companies use revenues to clear off the outstanding debt. Sometimes, companies may issue common stocks to raise money and clear their debts in one go.
- Creating Cash Reserve – As individuals save for an emergency, companies also make a cash reserve for emergency requirements. Usually, companies create this reserve from their profits. But sometimes, they can issue these stocks and use the funds to make a cash reserve for future requirements.
One of the significant aspects of issuing these stocks is that it dilutes the power of old and existing shareholders. Therefore, companies weigh the pros and cons before making a final decision for issuance.
Why Should Investors Invest in Common Stocks?
Common stocks have significant risks associated with them which investors should be aware of. Especially in the short term, these stocks are prone to high volatility due to dynamic market conditions. In the long term, stocks have performed well and given significant returns to investors. However, there is no guarantee of returns and upside.
Over the years, the stock market has had many highs and lows. Therefore, as an investor, you must be cautious while investing in these stocks. Investors with high-risk tolerance can consider investing in common stocks. Nonetheless, investment in stocks comes with high growth potential, and investors can make the most of it by parking long-term funds. Also, performing a proper fundamental and technical analysis while selecting these stocks for investment is essential. Making investments blindly in any company stock may sometimes get negative, making you lose money. Therefore, you must do your own due diligence before investing in common stocks.
Advantages of Investing in Common Stocks
The following are the advantages of investing in common stocks –
- Returns – In comparison to bonds, deposit certificates, etc., common stocks have the potential to perform better. Also, there is no upper limit where investors can benefit from their investment in these stocks. Moreover, these stocks are less expensive and more feasible alternatives to debt instruments. This is because companies do not have to pay interest to investors and choose to reward them in case of excess profits.
- Voting Rights – Being a common stockholder gives you the right to vote and be a part of the company’s decision-making process. For instance, investors can vote to elect the company’s director or may decide on the company’s strategic policies. Moreover, investors with substantial common stocks can make the most of such power.
- Limited Legal Liability – Beyond the events that occur within the company, the obligations of common shareholders still exist, and they need to be concerned with all legal liabilities. If the company grows and generates good profits, shareholders are entitled to receive dividends. However, if the company is making losses or decides to liquidate, it cannot be held liable.
- Liquidity – These stocks are very liquid, and investors can efficiently buy and sell anytime. Investors can buy more shares and increase the shareholding in a company. Similarly, they can immediately sell all the shares if the investment is not profitable enough. Therefore, it offers flexibility to do with their investments without any hassle.
Disadvantages of Investing in Common Stocks
The following are the disadvantages of investing in common stocks –
- Market Risk – The major disadvantage of these stocks is a market risk where companies can underperform over a period. Due to market volatility, stock prices tend to fluctuate. This leads to a change in company valuation, which makes the performance evaluation process quite challenging. Moreover, in case of bankruptcy, the shareholders are more exposed to losing their investments.
- Lack of Control – The common shareholder’s profitability largely depends on the business strategies and associated policies. This makes the investors have no control over it. Also, investors do not have the right to participate in all decision-making sessions or scrutinise the company’s account books or business plans. This limits their power in the company.
- Uncertainty of Profits – The market conditions affect the business revenue generation, and income is not fixed. There is no guarantee when it comes to generating profits for the company. Therefore, investors looking for common stocks with growth potential can be a drawback when the company is not able to generate consistent profits.
Common stocks can be an effective way of investing in equity markets and realise good returns on investment. However, there are other investment avenues where you can invest based on your investment horizon and risk levels. For instance, mutual funds can provide good diversification. Mutual funds invest in multiple stocks, and professionals manage them. Therefore, this can eliminate the risk of exposure to one stock. However, this also does not guarantee returns.