Common stocks are one of the most prevalent forms of equity ownership in a company. When you own common stock in a company, you essentially own a share of that company's assets and earnings. These stocks represent ownership rights in a corporation and are typically bought and sold on public stock exchanges like the National Stock Exchange (NSE) or Bombay Stock Exchange (BSE).
What are common stocks?
Common stocks are equity securities that represent your ownership in the said company. Common stocks are issued through an initial public offering. Owning common stocks of a company entitles you to a share of its profits. As a common stock owner, you are entitled to certain voting rights, including the power to elect the company’s board of directors, vote on company policies, and influence the direction of the company.
By virtue of your ownership rights in the company, you receive dividend income from time to time. This dividend income is distributed from the company’s profits after paying the preferred stockholders. If the company liquidates its assets due to bankruptcy, preferred shareholders, creditors, and bondholders are prioritised. Common shareholders receive their share from the remaining company assets only after others have received their payments.
Why are common stocks issued?
Common stocks are issued with the objective of raising capital to meet different financial needs. Usually, companies issue common stocks instead of selling debt bonds or issuing preference stocks. Companies can use the capital raised for different purposes, including debt repayment, expansion, acquisitions, and the creation of a cash reserve.
However, each time a company issues common stocks, the holding power of its existing shareholders gets diluted. That’s why the issuance of new common stocks is always a topic of contention within the company’s management.
Types of common stocks
Common stocks can be classified into the following categories:
1. Growth stocks:
- Characteristics: Growth stocks belong to companies experiencing rapid expansion, often reinvesting earnings for growth. Examples include Bank of Baroda and Bajaj Auto.
- Investment focus: Investors seek capital appreciation as they anticipate the stock's value will increase over time.
2. Value stocks:
- Characteristics: Value stocks are undervalued by the market, with lower P/E ratios. Examples include L & T Technology and Abbott India.
- Investment focus: Investors look for stocks trading below their intrinsic value, anticipating a rise as market perception changes.
3. Large-cap stocks:
- Characteristics: Large-cap stocks belong to well-established companies with a market cap over Rs. 20,000 crore. Examples include Tata Consultancy Services (TCS) and Cipla Limited.
- Investment focus: Investors prefer stability, dividends, and lower risk with these stocks.
4. Mid-cap stocks:
- Characteristics: Mid-cap stocks have a market cap between Rs. 5,000 crore and Rs. 20,000 crore. Examples include Castrol India and Just Dial.
- Investment focus: Investors seek a balance of growth potential and stability.
5. Small-cap stocks:
- Characteristics: Small-cap stocks have a market cap below Rs. 5,000 crore, often showing high growth potential. Examples include Remus Pharma and Bajaj Steel Industries.
- Investment focus: Investors aim for substantial growth, accepting higher risk for potential returns.
These categories offer diverse opportunities for investors in the Indian stock market. Tailoring your investments to your financial goals and risk tolerance is crucial.
Please note: The examples provided are as of October 9, 2023 and are subject to change based on the company earnings, stock market fluctuations, or any other external events/ factors that may impact the stock prices and market capitalization of these companies.
These stock categories offer diverse opportunities for investors in the Indian stock market. Tailoring your investments to your financial goals and risk tolerance is crucial.
Additional read: Types of stock trading
Why are common stocks issued?
Companies issue common stocks for various reasons, including:
- Raising capital: The primary reason for issuing common stocks is to raise capital for business expansion, research and development, debt reduction, or other corporate purposes.
- Ownership transfer: Common stocks allow businesses to transfer ownership without transferring physical assets. This is particularly important in the case of succession planning or selling a portion of the company.
- Liquidity: Publicly traded common stocks provide liquidity to existing shareholders, allowing them to easily buy or sell their holdings.
Features of common stocks
Understanding the features of common stocks is crucial for investors. Here are some key characteristics:
- Ownership: Common stockholders have ownership rights in the company, granting them a share of profits, assets, and a say in corporate decisions through voting rights.
- Dividends: While common stockholders have the potential to receive dividends, they are not guaranteed. The payment of dividends depends on the company's profitability and its decision to distribute earnings.
- Voting rights: Depending on the class of common stock, shareholders may have the right to vote on corporate matters such as the election of directors and major business decisions.
- Residual claims: In the event of bankruptcy or liquidation, common stockholders have a residual claim on the company's assets, but they stand behind preferred stockholders and bondholders in the hierarchy.
Benefits of common stocks
Investing in common stocks offers several benefits:
1. Potential for high returns
Historically, common stocks have provided higher returns compared to many other asset classes over the long term. Owning common stocks can generate higher returns than traditional investment vehicles like FDs and RDs. Moreover, there is no upper cap on the returns from common stock ownership. If the company performs well, share prices can appreciate without any upper limits.
Additionally, since companies do not have to pay interest on capital (unlike debt financing), they may be more willing to pay a higher dividend share from the company’s surplus profits to its investors.
2. Ownership in profitable companies
Owning common stocks allows investors to share in the success and growth of profitable businesses. Investing in well-performing businesses with strong fundamentals and good growth potential can help you grow your wealth over time. The dividend share from profitable ventures can help boost your corpus value, while capital appreciation in terms of increasing share prices can enhance your portfolio’s value.
3. Liquidity
Publicly traded common stocks can be bought or sold easily on stock exchanges, providing liquidity for investors. If the company is minting good profits, you can easily choose to buy more shares and increase your shareholding in the said company. Alternatively, if it is performing poorly, you can sell your shares and redeem your investment to invest in other stock options.
4. Voting rights
Some common stocks come with voting rights, giving shareholders a say in company decisions. Each share of common stock carries one voting right. Therefore, your voting right as a common stockholder is proportional to the number of shares you own. In other words, the votes of investors with a substantial investment in the common stocks of a company carry more power than the others. This voting right can be exercised to decide on various company policies, business decisions, appointment of C-suite executives, and other such seminal decisions.
5. Limited legal responsibilities
As a common stockholder, your legal liabilities are limited beyond financial investment. In other words, you are not liable to cover the company’s debts as an equity owner in the company. You partake in the gains and profits of the corporation without being involved in its debt obligations. This allows you to enjoy the growth potential of the company without getting tangled in complicated legal liabilities.
Limitations of common stocks
While common stocks offer many advantages, they also come with certain limitations and risks:
1. Volatility
Common stocks are prone to price volatility, and their value can fluctuate significantly in the short term. Additionally, the valuation of common stocks also undergoes changes, making it difficult to evaluate their performance. Common stockholders also risk losing their entire investment if the stock value declines significantly or the company goes bankrupt.
2. No guaranteed returns
Ownership in common stocks does not offer guaranteed returns. Unlike bonds, which pay investors a fixed interest, dividend payments are not assured. Price fluctuations and market forces impact revenue generation, making returns uncertain. Additionally, companies can also decide to reinvest profits for expansion, making returns uncertain.
3. Limited influence
The scope of making profits from a common stock investment depends on the company’s policies and strategies. As such, the stockholder has little to no control over this. While investors do have voting rights, in reality, this translates to very limited influence on corporate decisions since most investors do not have a majority stake in the company. Moreover, common stockholders also do not have access to the company’s books of accounts.
Who should invest in common stocks?
Common stocks can be suitable for various types of investors, but they may be particularly appealing to those who:
- Have a long-term investment horizon.
- Are willing to tolerate market volatility.
- Seek higher potential returns compared to conservative investments.
- Are looking to build wealth over time through capital appreciation.
- Have a diversified investment strategy that includes a mix of asset classes.
It's important for investors to assess their risk tolerance and investment goals before committing to common stocks.
Common stocks and balance sheet
On a company's balance sheet, common stock is typically listed under the shareholders' equity section. It represents the total value of issued to investors and is calculated by multiplying the number of outstanding shares by the stock's market price.
Common stock is an essential component of a company's capital structure, providing a source of equity financing.
Common stocks vs preferred stocks
Now, let's compare common stocks to preferred stocks:
Common stocks:
- Represent ownership in the company.
- Typically offer voting rights (depending on class).
- Dividends are not guaranteed and can vary.
- Lower priority in terms of dividends and assets in case of bankruptcy.
- Potential for higher returns but also higher volatility.
Preferred stocks:
- Represent a hybrid between stocks and bonds.
- Often have fixed dividend payments.
- Typically do not offer voting rights.
- Higher priority in terms of dividends and assets in case of bankruptcy.
- Generally less volatile than common stocks.
The choice between common and preferred stocks depends on an investor's preferences and financial objectives. Common stocks are more suitable for those seeking growth and willing to accept higher risk, while preferred stocks may appeal to income-oriented investors seeking steady dividends.
Conclusion
Common stocks play a significant role in the world of investing, offering the potential for high returns and ownership in successful companies. However, they also come with risks and uncertainties. Understanding the various types, features, benefits, and limitations of common stocks is crucial for investors to make informed decisions about their investment portfolios. Additionally, comparing common stocks to preferred stocks allows investors to tailor their investments to their financial goals and risk tolerance.
If you're looking to start investing in common stocks, the first step ahead would be finding a reliable stockbroking firm that would facilitate the investment process. Consider opening a Demat and trading account with Bajaj Financial Securities Limited for a seamless and secure investment experience.
