This lesson will explore the concept of ownership in a company through stock. Also in this lesson, different types of stocks will be explained and examples will be given.
Definition of Stocks
There are two types of stock. The first is common stock, which is typically what is meant when referring to ‘stock’.
Common stock is an investment security which represents ownership in a company. You may hear a friend or relative state they own stock (commonly referred to as shares) of a particular company. They are referring to common stock. If your friend or relative owns a few shares of that company, they are therefore an owner of the company.
Preferred stock is an investment security which, depending on the issuing company, can represent ownership in a corporation along with being a debt instrument of the company. Companies typically issue common stock to raise proceeds to expand, pay down or pay off debt. When a company ‘goes public,’ those proceeds are often used also to expand or reduce debt.
Types of Stocks
Common and preferred are two very different types of stock. As we will see, companies issue the two stocks for different reasons. The risk and potential reward to the investor can also be very different.
Common stock represents ownership in a company. By owning part of the company, you share in both the good times and the not-so-good times of the company. A benefit of being an owner includes the receipt of any dividends paid by the company. Also, if the company experiences growth of sales and profits, hypothetically, the dividend and stock price will increase, increasing your investment performance.
In addition, most common stock is classified as ‘voting stock,’ which allows stockholders to vote for (or against) the board of directors and various shareholder proposals. It is important to note that common stock dividends are never guaranteed, and neither is share price appreciation.
Common stock certificates have historically been issued, like the one for Gerber you’re looking at on screen now, but due to progressive technology, most shares are now electronically issued.
Preferred stock typically is a debt instrument of a company. When purchasing preferred stock, think as though you are loaning the company money. When loaning money to a friend, you expect to be paid back with interest. Preferred stock works in a very similar fashion. It may be issued at $25 per share and may trade on the stock market.
However, instead of sharing in the profits through hopefully increasing dividends and share price growth, preferred stock owners (similar to bondholders) receive fixed dividend payments. Some preferred stock may be convertible to common stock, but this depends on the way the preferred stock was issued.
Preferred stock dividends typically must be paid prior to a corporation issuing dividends to common stock holders. As a result, for this risk premium, common stockholders typically experience greater returns than preferred stock holders. It is important to note that past performance of common stocks and preferred stocks is not a guarantee of future performance.
Examples of Stocks in Play
Let’s use Grandma’s Holiday Pies, a fictitious company, as an example. Grandma’s Holiday Pies is a publically traded company (which means anyone eligible to invest can purchase shares). If Grandma’s has a total of 100 shares, and you buy 1 share, you now own 1% of the company. If Grandma’s becomes popular nationwide, hypothetically, the stock price will increase. If Grandma’s pies are deemed unhealthy, less people might buy the pies, resulting in a stock price decline.
If Grandma’s wanted to expand operations, they may go to the preferred stock market to borrow money. Rather than owning part of the company, you become a creditor of Grandma’s. A preferred stock holder is paid dividends on the preferred stock. If Grandma’s issues preferred stock with a par value of $25 at a 5% interest rate, Grandma’s will send you a check for $1.25 every year (although the dividend is typically paid in quarterly installments). The risk with preferred stock is that the company won’t be around to pay you the dividend.
However, you should know that preferred stock claims are higher on the capital structure than common stock; in case the company declares bankruptcy, preferred stockholders will recover losses prior to common stock holders.
Stock is not limited to that of publicly traded companies. Local corporations may have shares of stock, too. These may or may not be open for public investment. Local corporations such as bowling alleys typically allow investors to purchase shares; however, a medical corporation, such as a doctor’s office, may just have one shareholder – the doctor.
As a recap, there are two types of stocks; common and preferred stock. Common stock is an investment security, which represents ownership in a company. When you purchase common stock shares, you own a percentage of that company depending on the number of shares you purchased and the number of shares that are available. As a result of ownership, common stock is typically riskier than the other type of stock, preferred stock, but the long-term performance may also be better due to the extra risk you are taking as an investor.
Preferred stock is an investment security which, depending on the issuing company, can represent ownership in a corporation along with being a debt instrument of the company. The benefit of owning preferred stock over common stock is that the dividend of preferred stock is typically fixed and must be paid prior to common stock holders receiving dividends.