You are here

Common Stock

Printer-friendly versionPDF version

Common stock represents a basic ownership claim in a corporation. Think of this as the investors who have put up investment capital to get things going, just like if you decided to invest in the creation of a business in the town or city that you live. Whoever starts the company can sell partial ownership of it in order to capitalize, or raise money for company growth.

The most important thing about common stock is that it represents a residual claim against the corporation's cash flows or assets. In other words, if the company goes bankrupt, shareholders have a legal right to repayment in bankruptcy court. However, common stockholders are last in line. All prior debts must be paid to the employees (wages), the government (taxes or judgments), short term creditors (banks), bondholders (long term lenders), and preferred shareholders (owners). The common stockholders get whatever is left, the residual value of the firm. Therefore, the value of common stock is directly related to the company's profits.

Legally, common stockholders enjoy limited liability, meaning that their losses are limited to the original amount of their investment when they bought their common stock. For example, the Bhopal Disaster of 1984 is considered to be the worst industrial disaster in history. It was caused by the accidental release of 40 tons of methyl isocyanate (MIC) from Union Carbide India Limited, a pesticide plant located in the heart of the city of Bhopal, India. The accident, in the early hours of December 3, 1984, produced heavier-than-air toxic MIC gas which rolled along the ground through the surrounding streets killing thousands outright. The gas also injured anywhere from 150,000 to 600,000 people, of whom at least 15,000 later died. Heads rolled at the corporate level in the aftermath, but none of the common or preferred shareholders stood to lose more than the initial investment they made when they purchased the company stock.

Common Stock Dividends

A dividend is a portion of a company's profits that is paid to its stockholders. Common stock dividends are not guaranteed, and are often irregular or even non-existent. Dividends are always paid from the company's after-tax cash flows. Because dividend income is taxable for most investors, dividends are double taxed – once when the company pays the corporate income tax on its profits, and once more when the investors pay their personal income taxes. To avoid double taxation, some investors hold stocks in growth companies that reinvest their accumulated earnings instead of paying large cash dividends.

Companies will sometimes reinvest their accumulated earnings back into the business instead of paying out dividends. This allows the company to accumulate capital and grow faster than it otherwise might. As a firm's earnings grow, people expect its stock price to rise. If this happens, the stockholders can sell their stock and pay capital gains taxes on their profits. The Tax Reduction Act of 1997 set a lower tax rate on capital gains than on dividends. Taxes on capital gains are paid only upon the realization of the gain, meaning when it is sold. Investors can reduce their tax bills by delaying the sale of securities to postpone realization of capital gains.
Voting Rights of Common Stockholders

Even though stockholders hold ownership of the corporation, they do not exercise control over the firm's day-to-day activities of doing business. They do, however, exercise control over the firm's operations indirectly by electing the board of directors. It is the task of the board of directors to monitor the management's activities on behalf of the shareholders. As a practical matter, most shareholders cannot actually vote in person, but instead by proxy where they vote by absentee ballot or endorse a representative.