What Is a Stock? (+How to Tell Common Stock From Preferred Stock)

April 4, 2019

Kindergarten teachers around the world impart the same lesson on their students: sharing is caring.

Kindergarteners don’t have much to share besides fruit snacks and crayons, but when they grow up, they might start their own business, and they’ll need to know how to share that too.

Luckily there is already a global economy in place, and a stock market available for them to do so.

What is a stock?

Stocks are partial shares in a company. Those who purchase stock own part of the company. The stockholders, or shareholders, have equity in the company, and through their stock purchases, the company gains equity capital. Depending on the stock’s provisions, the company pays out stockholders in (typically quarterly) payments called dividends. Stocks can also be bought and sold on the stock market and are considered assets with high liquidity.

The provisions of individual stocks vary, but they can be categorized distinctively into two groups: common stock and preferred stock.

Common stock

Common stock is, you guessed it, the most common type of stock. When most people use the term “stocks” they are referring to this kind of stock. Common stockholders have voting rights, meaning that according to how many shares of a particular company they own, they have a certain amount of say in mergers and board elections. The more shares they own, the more influence they have on these decisions.

Voting rights give common stockholders some agency over the direction of the company as part owners. This right is a bit of a trade off because if they were to invest in the same company in other ways, say, with corporate bonds or preferred stock (which we’ll cover below), they would be paid out first in the event of the company’s liquidation. There’s a chance that common stock could lose all of its value in a bankruptcy scenario. 

On the flip side, if the company is doing well, two things happen to common stock. First, the company’s dividend payments will go up. Second, the value of the stock itself goes up, and it can be sold for a profit. Overall, common stock is a high risk/high reward investment, depending on the company that issues it.

Preferred stock

Most stocks sold in the stock market are common stocks. Although it is much rarer, preferred stock can be bought and sold in the same way. Potential buyers must be wary of what they are purchasing because there are differences between common and preferred stock that make them very different investments.

As opposed to the voting rights and appreciation potential that come with common stock, preferred stockholders have other benefits. Preferred stock has a fixed dividend policy, meaning the company makes the same dividend payments each quarter. If the company is doing well, there’s a chance that dividend payments on common stock will rise above those of preferred stock. On the other hand, if the company is doing poorly, common stock payments will fall while preferred stock payments remain the same.

In this way, preferred stocks are much more similar to bonds, however in the case that the company goes under, bondholders and other debt investors are paid back before preferred stockholders. They are also perpetual, whereas bonds no longer earn payments from the company after their maturity dates. Preferred stocks can be sold just like common stock, but preferred stocks’ value does not fluctuate as much. While there is some volatility depending on the company’s financial status, they are thought of as a generally low risk/low reward investments.

common stock vs. preferred stock

Why do companies sell stocks?

After its initial public offering, or IPO, a company can decide whether it wants to finance growth using debt capital (corporate bonds, bank loans, etc.), equity capital (common or preferred stock), or a combination of both. Companies that sell only stock (rather than using debt financing strategies) are selling partial ownership of their company in order to generate capital. In this way, a company can grow without debt.

From Sesame Street to Wall Street

The idea of sharing is elementary, but the idea of shares is much less so. Learning about stocks can feel like learning how to count again, but with practice and experience, you can learn how to buy them, or if you aspire to own your own company or work as a stock broker, sell them yourself.

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What Is a Stock? (+How to Tell Common Stock From Preferred Stock) Stocks are a great way for investors to earn capital gains and for companies to generate equity capital, but they can be confusing. Learn the risks of common stock and preferred stock and weigh the benefits of each in this article. https://learn.g2crowd.com/hubfs/what-is-a-stock.jpg
Maddie Rehayem Maddie is a former content specialist at G2. She also has a passion for music and cats. (she/her/hers) https://learn.g2crowd.com/hubfs/linkedinprofile.jpeg https://www.linkedin.com/in/maddie-rehayem/

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