The stock (also capital stock) of a corporation is constituted of the equity stock of its owners. A single share of the stock represents fractional ownership of the corporation in proportion to the total number of shares. In liquidation, the stock represents the residual assets of the company that would be due to stockholders after discharge of all senior claims such as secured and unsecured debt. Stockholders’ equity cannot be withdrawn from the company in a way that is intended to be detrimental to the company’s creditors.
Holding a company’s stock means that you are one of the many owners (shareholders) of a company, and, as such, you have a claim (albeit usually very small) to everything the company owns. Yes, this means that technically you own a tiny sliver of every piece of furniture, every trademark, and every contract of the company. As an owner, you are entitled to your share of the company’s earnings as well as any voting rights attached to the stock.
When a company is first founded, the only shareholders are the co-founders and early investors. For example, if a startup has two founders and one investor, each may own one-third of the company’s shares. As the company grows and needs more capital to expand, it may issue more of its shares to other investors, so that the original founders may end up with a substantially lower percentage of shares than they started with. During this stage, the company and its shares are considered private. In most cases, private shares are not easily exchanged, and the number of shareholders is typically small.
As the company continues to grow, however, there often comes a point where early investors become eager to sell their shares and monetize the profits of their early investments. At the same time, the company itself may need more investment than the small number of private investors can offer. At this point, the company considers an initial public offering, or IPO, transforming it from a private to a public company.
Different Types of Stocks
Aside from the private/public distinction, there are two types of stock that companies can issue: common stock and preferred shares.
Common stock is, well, common. When people talk about stocks in general they are most likely referring to this type. In fact, the majority of stock issued is in this form. We basically went over features of common stock in the last section. Common shares represent ownership in a company and a claim (dividends) on a portion of profits. Investors get one vote per share to elect the board members, who oversee the major decisions made by management.
Over the long term, common stock, by means of capital growth, yields higher returns than almost every other investment. This higher return comes at a cost since common stocks entail the most risk. If a company goes bankrupt and liquidates, the common shareholders will not receive money until the creditors, bondholders, and preferred shareholders are paid.
Preferred stock represents some degree of ownership in a company but usually doesn’t come with the voting rights (this may vary depending on the company, but in many cases preferred shareholders do not have any voting rights). With preferred shares, investors are usually guaranteed a fixed dividend in perpetuity. This is different from common stock which has variable dividends that are declared by the board of directors and never guaranteed. In fact, many companies do not pay out dividends to common stock at all.
Another advantage is that in the event of liquidation, preferred shareholders are paid off before the common shareholder (but still after debt holders and other creditors). Preferred stock may also be “callable,” meaning that the company has the option to re-purchase the shares from preferred shareholders at any time for any reason (usually for a premium). An intuitive way to think of these kinds of shares is to see them as being somewhat in between bonds and common shares.
Difference between Preferred & Common Stocks
The key difference between common and preferred stocks is in the promised dividend payments. Preferred stocks promise investors that a fixed amount will be paid as dividends every year. A common stock does not come with this promise. For this reason, the price of a preferred stock is not as volatile as that of a common stock. Another key difference between a common stock and a preferred stock is that the latter enjoy greater priority when the company is distributing surplus money.
Common and preferred are the two main forms of stock; however, it’s also possible for companies to customize different classes of stock to fit the needs of their investors. The most common reason for creating share classes is for the company to keep voting power concentrated with a certain group. Therefore, different classes of shares are given different voting rights. For example, one class of shares would be held by a select group who are given perhaps ten votes per share while a second class would be issued to the majority of investors who are given just one vote per share. When there is more than one class of stock, the classes are traditionally designated as Class A and Class B, etc..
However, if the company is getting liquidated – its assets are being sold off to pay off investors, then the claims of preferred shareholders rank below that of the company’s creditors, and bond- or debenture-holders. Another distinction is that preferred shareholders may not have voting rights unlike holders of common stocks.
How Stocks Trade
Most stocks are traded on exchanges, which are places where buyers and sellers meet and decide on a price. Some exchanges are physical locations where transactions are carried out on a trading floor. You’ve probably seen pictures of a trading floor, in which traders are wildly throwing their arms up, waving, yelling, and signalling to each other. The other type of exchange is virtual; composed of a network of computers where trades are made electronically.
The purpose of a stock market is to facilitate the exchange of securities between buyers and sellers, thus reducing the risks of investing. Just imagine how difficult it would be to sell shares if you had to call around the neighbourhood trying to find a buyer. Really, a stock market is nothing more than a super-sophisticated farmers market linking buyers and sellers.
Before we go on, we should distinguish between the “primary” market and the “secondary” market. The primary market is where securities are created (by means of an IPO) while, in the secondary market, investors trade previously-issued securities without the involvement of the issuing-companies. The secondary market is what people are referring to when they talk about “the stock market.” It is important to understand that the trading of a company’s stock does not directly involve that company.