Stock represents ownership in a company’s assets and earnings. There are two primary types of stock--common and preferred. Depending on the type that is owned, different rights are given to the stockholder. While stock represents ownership in a company, the ultimate value of the stock is derived from the sum of all current and future cash flows that will be paid to the owner.
Share of Stock
Percentage ownership of a company is determined by the number of shares you own. For example, if there are 100 shares of stock outstanding and you own 51 of them, then you own 51 percent of the company.
Common stock is the most widely held and most actively traded form of stock. Owners of common stock are entitled to elect the board of directors. Based on their selections, the shareholders can provide some input into the direction of the company. Because of the small percentage of ownership the typical shareholder has, they are unlikely to be able to exert a large amount of influence.
Preferred stock is a less common form of stock ownership. Owners are generally paid higher dividends than common stock owners and there are often provisions that state that preferred stock dividends must be paid before any common stock dividends can be paid. This is particularly important when a company’s performance deteriorates.
In exchange for the higher dividends and being ahead of the common stockholders for dividend payments, preferred stockholders do not get voting rights nor do they usually get to share in the growth of the company, because preferred stock is typically priced on the size and risk involved in the dividend payment.
Risk and Reward
Owning stock is the riskiest way to invest in a company. Unlike a bondholder, who is guaranteed certain payments of interest throughout the life of the bond and the repayment of principal when the bond matures--barring bankruptcy or default--a stockholder has no guarantee that the capital he invested will be worth anything when he wants to sell it. To compensate him for the risk he is taking with his capital, the stockholder is able to share in the growth and earnings of the company with no cap on his return.
Order of Repayment
While stock ownership can convey the greatest potential for gains, it requires the assumption of greater risk. In the event of a bankruptcy, common stockholders will be paid last. Preferred stockholders will be paid behind creditors but ahead of common stockholders. Owners of stock will receive whatever remains after all debts have been paid.
Because the value of a stock is generally based on a company’s ability to generate cash, in the event of a bankruptcy, a company’s ability is effectively zero, which makes the stock worth about the same.