So, what exactly is common stock, anyway? A surprising number of people – investors included – don’t fully understand the answer to that question.
“Though it may be socially acceptable to talk about things we know nothing about and to nod our heads in agreement with things we don’t understand, this isn’t acceptable when it comes to your investments,” said Mark B. Robinson, presenter for the Investor Education in Your Community program. “If you own common stocks – but don’t know what they are and how they work, you’re like the majority of investors. Be in the minority. Ask questions. Know what you own.”
The following is a primer of facts every investor should know before investing in stocks or stock mutual funds.
At its core, a share of common stock represents partial ownership of a company. If a company issues 500 shares, then an investor who buys one share has purchased a 1/500th ownership stake. And investor who owns 250 shares owns half. As a rule, companies that trade their shares on the stock market issue millions of shares and have many thousands of shareholders.
Companies issue common stock in order to raise money for a variety of purposes – such as expansion. Companies also can borrow money and pay the loans back, with interest to lenders. But, because owners of common stock are partial owners of the company, they are able to:
- Participate in the company’s growth and profitability.
- Possibly sell their shares at a profit, of the company does well.
- Receive dividend payments – if the company chooses to pay them.
Shareholders also are entitled to certain rights which are specified in the corporation’s charter or bylaws such as the rights. Shareholders can:
- Attend shareholder annual meetings and vote on issues. The number of votes you have is determined by the number of shares you own. For example, ownership of 100 shares usually will provide 100 votes.
- Transfer shares – that is, sell them, gift them or bequeath them to heirs.
- Inspect certain books and records of the company including the stockholders’ list and the minutes of stockholders’ meetings.
It also is important to know that common stock does not pay a specific annual dividend. The company’s board of directors decides what dividends, if any, the company will pay to its common shareholders.
Buyers of common stock also accept certain risks, including the risk that their shares could decrease – or even become worthless – if the company fares poorly. There is no guarantee, however, that any publicly-traded company will grow and be profitable. You can lose money.
“Buying several stocks in different sectors of the economy can reduce the specific risk associated with having all your money concentrated in one or two stocks or in one sector of the economy, like technology or energy.”
Some of the Lingo
Here are some common stock-related terms:
- Initial public offering: When a company decides to issue common stock for the first time, this is often referred to as going public through what is called an initial public offering, or IPO. Among the more famous recent IPOs took place August 19, 2004, when Google raised $1.2 billion by going public.
- Dividends: An amount paid on a per-share basis, e.g., if a $1 dividend is declared, stockholders will receive $1 for every share owned. Dividends usually are paid quarterly.
- Proxy: Proxies give authority to someone else to vote their shares on their behalf. Most shareholders vote by proxy rather than in person.
- Par value: Common stock is usually issued with a par value that is nominal – for example, one penny or $1. This price is used for the company’s financial statement. Par value has no relationship with market value.
- Market value: The price at which the stock can be sold.
- Price-to-earnings or P/E ratio: Market value per share divided by earnings per share. If a company that is trading at $50 has had earnings per share of $4 over 12 months, then the P/E ratio would be 12.5.
- Stock certificates: Documents that provide proof of ownership for shareholders.
Classifying Common Stocks
One way is by their market capitalization or “market cap.” Market cap is calculated by multiplying the number of common shares outstanding by the market share price. For example: a company with 100 million shares outstanding and a market value of $50 per share has a market cap of $5 billion.
You’ve probably heard the terms “large cap” and “small cap.” What’s the difference between them? Definitions vary. But, as a rule:
- Large-cap stocks have market caps between $10 billion and $200 billion.
- Mid-cap stocks between $2 billion and $10 billion.
- Small cap stocks between $300 million and $2 billion.
Another way of classifying stocks is by industry or other characteristics. Here are some common classifications:
- Growth stocks: These are companies with accelerating sales and earnings and are growing faster than the economy in general. Growth stocks typically pay small, or no dividends.
- Value stocks: A value stock that tends to trade at a lower price relative to its fundamentals, i.e., dividends, earnings, sales, etc. and is thus considered undervalued. Common characteristics of value stock such stocks include a high dividend yield and a low price-to-earnings or P/E ratio.
- Defensive stocks: Stock of companies in industries that provide necessary products and services and tend to remain profitable during economic slowdowns. Examples include food, drugs and electric power and gas.
- Cyclical stocks: Stocks whose prices are vulnerable to trends in the general economy. Examples include companies in basic industries such as steel, autos and building materials, heavy machinery and equipment.
Stocks can also be categorized – or grouped together – into something called an “Index.”
An index is essentially an imaginary portfolio representing a broad market or sector of a larger market. It is used as a statistical measure of market conditions and for benchmarking investment returns. The most widely-used Index is the S&P 500 Stock Index. We’ll provide more about indexes next month.
The Investor Education in Your Community program paid for placement of this article. Its views do not necessarily reflect those of WWJ Newsradio 950 or CBS Radio.