Common Stock – Definition

Cite this article as:"Common Stock – Definition," in The Business Professor, updated March 11, 2019, last accessed August 7, 2020, https://thebusinessprofessor.com/lesson/common-stock-definition/.

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Common Stock Definition

Common stock refers to a security that represents ownership in a company. All too often, holders of common stock have the ability to exercise control through electing an experienced board of directors as well as voting on corporate policy.  Holders of common stock are usually on the bottom of the ladder of priority when it comes to ownership structure. In the case of liquidation, common stakeholders have the right to a corporation’s assets. The preferred stakeholders will then be fully paid.

A Little More on What is Common Stock

With common stock, if a corporation is declared bankrupt, the shareholders won’t receive their money until when the creditors, as well as preferred shareholders, have garnered their shares respectively. This implies that common stocks are pretty riskier compared to somewhat preferred shares. The upside to these common shares is that they often outperform bonds as well as preferred shares. As such, many companies will issue the three available types of securities. Common shares refer to those shares in a corporation that doesn’t provide guaranteed dividends to its investors. The sum of dividend distributions is at the discretion of the management of the company. While investors of common stock may either earn or not earn money based on dividends, they still expect to a rise in the share price as the company expands its operations to increase profits. Stocks will offer higher returns compared to bonds and other investments.

Difference between Common and Preferred Stocks

There are two main types of stocks in the stock industry- common stock and preferred stock. Although they are both referred to as stock, the two operate differently from each other. They also have different potentials for garnering profits. Every stock has a different risk profile that may only be suitable for certain types of investors. Here are the main differences:

  •         Common shares have major political rights. On the other hand, preferred shares don’t have the right to vote particularly in meetings.
  •         Preferred shares have an additional right that offers preference to receive the dividends generated by a company while common shares don’t have these extra rights.
  •         Preferred shares have a slightly lower level of liquidity compared to common shares.
  •         A company can instantly redeem the preferred shares at any given time. This implies that they can buy the shares at the same price.
  •         Common shares often have a limited liability while preferred shares have greater responsibility.

Advantages of Common Stocks

  •         The administration of capital through various stock shares doesn’t compel restrictions on the company. Therefore, the corporation will be allowed to have greater flexibility mainly when it comes to having long-term financing without any problems.
  •         It’s pretty advantageous for a company to gain finance through common shares. This implies that the issuance of common capital, unlike preferential capital, doesn’t impose major restrictions on debt issuances. This allows a company to uphold flexibility in order to acquire long-term financing.

Disadvantages of Common Stocks

  •         Usually, the total cost of financing is higher than the existing alternatives. One must be careful when it comes to the issuance since the process may entail significant loss which may have a substantial negative impact on the company.
  •         The issuance of more common shares imposes high risks on the loss of the control of the company by the existing owners.

Creditors, as well as the preferred stakeholders, have priority rights over the common shareholders. However, the latter have always assumed the greatest risk in the company. They are also the ones who own a higher needed return on the money they have invested in. The conventional shareholder on the other hand can’t lose more than the financial contribution to society. Besides, the assets they own aren’t at risk if the said company is experiencing financial difficulties.

References for Common Stock

Academic Research for Common Stock

  • Price performance of common stock new issues, Ibbotson, R. G. (1975). Journal of financial economics, 2(3), 235-272. This paper analyzes the before and aftermarket performance by measuring risk-adjusted returns on newly issued common stocks that underwent public offering in the 1960s. As such, the results have confirmed that the average initial performance in the market is 11.4 percent, which is positive according to the results. On the other hand, the distribution of these returns is slightly distorted such that the number of random subscribers per issuance has a single chance to either gain or lose.
  • Common stock repurchases and market signalling: An empirical study, Vermaelen, T. (1981). Journal of financial economics, 9(2), 139-183This article analyses the pricing character of various securities of companies that purchase their shares. The results are pretty consistent especially in a market in which investors price their securities such that there is some expectation of arbitrage profits. The same results also indicated that there is some consistency with the hypothesis that many firms provide a premium for their shares if only to send a positive message and target a segment of insider holdings such as signals. This is usually done to price their securities.
  • Trading is hazardous to your wealth: The common stock investment performance of individual investors, Barber, B. M., & Odean, T. (2000). The journal of Finance, 55(2), 773-806. This research paper indicates the common stock performance of individual investors. The results suggest that individual stockholders directly pay a considerable performance penalty for active trading. Therefore, out of 66,465 households that have various accounts between 1991 and 1996, the ones that traded the most earned a significant return of 11.4 percent. Others garnered a market return of 17.9 percent. It was also noted that the average investors earned approximately 16.4 percent annual returns.
  • The stochastic behavior of common stock variances: Value, leverage and interest rate effects, Christie, A. A. (1982). Journal of financial Economics, 10(4), 407-432. This paper analyzes the relation between the variances of various equity returns as well as several explanatory variables. It was concluded that equity variances have a positive association with financial leverage. This is contrary to the usual predictions of the various literature options and interest rates. To some extent, the negative impact of variance in regards to equity value is that some segment of the market is primarily attributed to the financial leverage.
  • Debt/equity ratio and expected common stock returns: Empirical evidence, Bhandari, L. C. (1988). The journal of finance, 43(2), 507-528. This paper discusses the debt-equity ratio as well as the expected common stock returns. As such, it was concluded that the expected common returns are related to the ratio of a stock’s debt to equity, thereby controlling or the beta company size including and excluding January. Even though the relationship isn’t sensitive to variations in the proxy market and the estimation technique, evidence highlights that the premium isn’t likely to be a risk premium.
  • The effect of bond rating changes on common stock prices, Holthausen, R. W., & Leftwich, R. W. (1986). Journal of Financial Economics, 17(1), 57-89. This paper has credible evidence suggesting that downgrades by Moody’s as well as Standard & Poor’s are directly connected with negative stock returns in the first two days of the press release by a rating agency. Moreover, negative performance can be detected after the elimination of observations that contain various concurrent news releases. As such, there is little evidence regarding abnormal performance based on announcement additions to the Credit Watch List.
  • The effect of interest rate changes on the common stock returns of financial institutions, Flannery, M. J., & James, C. M. (1984). The Journal of Finance, 39(4), 1141-1153. This article analyzes the existing relation between the sensitivity of the interest rate of common stock returns as well as the maturity composition of the company’s nominal contracts. By using a sample of the traded commercial banks alongside stock savings and loan associations, it was concluded that common stock returns could be correlated with various interest changes. The size of the maturity difference directly impacts the movement of different stock returns as well as interest rate changes.
  • The week‐end effect in common stock returns: The international evidence, Jaffe, J., & Westerfield, R. (1985). The journal of finance, 40(2), 433-454. This paper highlights the daily returns of stock markets that belong to four foreign countries. The research team analyzed the weekend effect and its impact on the stock market. It was discovered that there’s an element known as “weekend effect” in those countries. Besides, the lowest mean returns for Australian and Japanese stock markets happen on Tuesday. The rest of the research paper highlights questions and answers to four major questions. Are there seasonal patterns in the existing foreign stock markets? Do Japan and Australia have stock markets that exhibit seasonal phases because of the time zones?
  • Anatomy of initial public offerings of common stock, Tinic, S. M. (1988). The Journal of Finance, 43(4), 789-822. This paper discusses the initial public offerings of common stocks and their impact in the industry. As such, the author develops and tests the hypothesis that underpricing is a form of insurance that acts against legal liability as well as the associated damages to the stellar reputation of the investment bankers. The results of the study were based on the collected samples of the IPOs that were projected to the market after the outset of the 1993 Securities Act.
  • Long-term dependence in common stock returns, Greene, M. T., & Fielitz, B. D. (1977). Journal of Financial Economics, 4(3), 339-349.   In this paper, researchers test for the long-term dependence in the United States stock returns by analyzing composite as well as sectoral stocks indices and company’s returns series in order to evaluate various aggregation effects. As such, fractal dynamics aren’t detected in various stock indices but are readily available in some company’s returns series. The efficient market and martingale security model price movement demands that the outset of new information should be arbitraged away. If persistent statistical dependence is availed in the market, the price changes don’t follow a martingale. Therefore, they should have an infinite variance.
  • Common stock offerings across the business cycle: Theory and evidence, Choe, H., Masulis, R. W., & Nanda, V. K. (1993). This article discusses the fact that historically, many firms issue various common stocks as well as the proportion of external financing that’s hugely accounted for by the equity market. Research shows that this theory is consistent with various firms that sell seasoned equity especially when they face lower as well as adverse selection costs. Evidence shows that consistent historical patterns allow firms to increase their equity more in expansion periods.
  • The impact of the degrees of operating and financial leverage on systematic risk of common stock, Mandelker, G. N., & Rhee, S. G. (1984). Journal of financial and quantitative analysis, 19(1), 45-57. This paper shows research based on capital asset pricing model that indicates that the equilibrium on a risk security is the total sum of the risk-free rates of return as well as a risk premium that’s often measured by the assets of the market price of risk. In this pricing model, the index of systematic risk is the security-specific parameter that has an impact on the

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