Common Stock Basics

When you buy a share of common stock, you become a part-owner of a company. This ownership stake—however small—gives you a claim on the company's assets and earnings, and a voice in how the company is run. Understanding common stock is fundamental to the SIE exam because equity securities form the backbone of most investment portfolios.

What Is Common Stock?

Common stock represents ownership shares in a corporation. When a company needs to raise capital, it can issue shares of stock to investors. Each share represents a fractional ownership interest in the company.

For example, if a company has 1 million shares outstanding and you own 1,000 shares, you own 0.1% of the company.

Key Characteristics of Common Stock

Rights of Common Stockholders

As a common stockholder, you have several important rights:

Voting Rights

Common stockholders can vote on major corporate matters, including:

• Election of the board of directors - The most important voting right
• Approval of mergers and acquisitions - Major structural changes
• Authorization of new stock issuances - Potential dilution decisions
• Changes to the corporate charter - Fundamental document modifications

Most companies use statutory voting, where shareholders get one vote per share for each director position. Some companies allow cumulative voting, which lets shareholders concentrate all their votes on one or more candidates.

Preemptive Rights

Preemptive rights allow existing shareholders to maintain their proportional ownership when new shares are issued. If a company announces a new stock offering, shareholders with preemptive rights can purchase new shares before the public offering.

Example: You own 10% of a company. If the company issues 100,000 new shares, preemptive rights let you buy 10,000 of those shares to maintain your 10% ownership.

Right to Receive Dividends

Common stockholders have the right to receive dividends when declared by the board of directors. Key points about dividends:

• Dividends are not guaranteed
• The board decides the amount and timing
• Companies can cut, skip, or eliminate dividends at any time
• Most U.S. stocks pay dividends quarterly

Residual Claim on Assets

In the event of bankruptcy or liquidation, common stockholders have a residual claim on assets. This means they are paid last, after:

1. Secured creditors (bondholders with collateral)
2. Unsecured creditors
3. Preferred stockholders
4. Common stockholders

In practice, common stockholders often receive nothing in a bankruptcy.

How Common Stock Is Valued

Investors use several methods to value common stock:

Market Value vs. Book Value

Par value is largely meaningless for common stock today—it is simply an accounting concept. Do not confuse it with market value.

Earnings Per Share (EPS)

Earnings per share (EPS) measures profitability on a per-share basis:

EPS = Net Income ÷ Shares Outstanding

EPS is a key metric for comparing companies of different sizes.

Price-to-Earnings Ratio (P/E)

The P/E ratio compares a stock's price to its earnings:

P/E Ratio = Market Price per Share ÷ EPS

• High P/E (20+): Investors expect strong future growth
• Low P/E (<15): May indicate undervaluation or limited growth expectations

Types of Common Stock

Companies may issue different classes of common stock with varying rights:

Real-World Example: Alphabet (Google's parent company) has three classes: Class A (1 vote), Class B (10 votes, held by founders), and Class C (no votes).

Risks of Common Stock

Common stock carries significant risks that every investor should understand:

• Market risk - Stock prices can decline due to overall market conditions
• Business risk - Company-specific problems can reduce stock value
• Liquidity risk - Some stocks may be difficult to sell quickly
• Dividend risk - Dividends can be reduced or eliminated
• Last claim in bankruptcy - May lose entire investment if company fails

Key Takeaways

• Common stock represents ownership in a corporation
• Stockholders have voting rights, preemptive rights, and dividend rights
• Common stockholders are last in line during bankruptcy
• Stock value is measured by market value, book value, and earnings metrics
• Different share classes can have different voting rights