Investment Glossary – Common Stock
“Yeah, I’m thinking about playing the market.”
“Hey, I got a great stock tip for you.”
When things are good in the market, everyone’s an expert. And if you ask people what they own when they buy a stock, some of them might even be able to tell you, “Oh yeah, I’m an owner of the company.” But what does that actually mean, and how does what you own affect the price of what you own? These are really important questions to answer since they’re incredibly instructive as to why some stocks go up in value and why others go down.
People talking about stock ownership are typically talking about owning common stock. The use of the word “common” doesn’t mean that everyone does (or should) own it, but it does give us some clues as we try to discover exactly what common stock ownership means. Simply put, common stock is a claim to the future cash flows of a company. The size of that claim varies based on how many shares you own and how many shares are outstanding. So if you own 100 shares of stock and there are 10,000 shares outstanding for Company X, you own 1% of the future cash flows of Company X. Most investors will never get anywhere near this high of an ownership percentage, so don’t sweat it if you don’t quite get there. And then there’s that word “common.” Unfortunately, this signals that, in the event that there is trouble at the company and they can’t pay all their bills, you are dead last in line to get paid. Every other creditor, employee, and other higher classes of stock owners will come first. This is why stocks can go to $0. When things go bad, there’s nothing left for you.
Common stock does typically give investors a number of rights within that company. You can typically vote on company matters, though if you are a teeny, tiny owner, your vote doesn’t usually have much of an impact. Some companies allow shareholders to attend annual meetings. But the real perk of owning a stock, and the reason why people do, is because as dangerous as stocks can be on the way down when things go wrong, they can also go up in value if things go right for the company. And while there are a whole bunch of reasons why stocks go up and down in value, you’re probably considering whether to buy a company’s stock because you believe it will be worth more in the future. Either the company is going to generate more cash flow in the future, which would make it more valuable, or people think it will generate more cash flow in the future and will drive its value up even if there is no current change in its operations. Just about any movement in a stock boils down to these factors, or the lack of these factors in the event a stock moves negatively.
Understanding what you own is critical to determining if a holding is right or wrong for you. Coming back to this idea when you examine risks in the economy is a really, really important piece of building a reliable investment process. Is inflation on an upswing? Great, how does that affect your stock? People aren’t making as much money? How does that factor affect the company I own? These are questions you need to ask as you build a portfolio and try to determine how much of your savings should be in stocks. Knowing and understanding what you own is a basic prerequisite to being a successful investor.