Common Stock—Fundamental Ownership of the Corporation
Common stock is the basic form of ownership of a corporation. In the classic scenario, a company’s management issues stock to investors in return for their cash and then uses the cash to start and operate the business. A share of stock represents a unit of ownership of a company, but the size of that unit depends on the number of shares of stock issued. A small company owned by a handful of people might only have a few hundred shares outstanding, that is, owned by its stockholders. Microsoft, by contrast, has over five billion shares outstanding. So percentage of ownership is not just about how many shares you own; it’s about how many shares everybody owns. Thus we arrive at a key observation of stock ownership: the more shares there are, the less your shares are worth. This is called dilution.
Common stock is the basic ownership unit, as noted before. The common stockholder is the residual owner of the company’s assets. That means the common stockholder gets all the remaining value when all the debts are settled, which may be a great deal or may be nothing. It is this risk/reward relationship that has enabled public stock ownership to become the best investment for growth in the long term—and also one of the riskiest investments in the short term.
Equity ownership in a corporation entitles the stockholders to dividends and/or capital appreciation and the right to vote. In the event of liquidation, common stockholders have rights to corporate assets only after bondholders, holders of other debt, and preferred stockholders. Good for the Company, Bad for shareholders. Issuing stock to raise cash helps the company, but it can hurt the shareholders. Consider the example of Wonder Widget, our rapidly growing company. It is publicly owned now, under the understated symbol WOWI. The company is profitable, earning $1 million in net income last year. You own 1,000 shares, out of 500,000 outstanding. The company’s earnings per share (EPS) were $2.00 ($1,000,000/500,000). The market thinks WOWI’s shares are worth 20 times earnings (price/earnings ratio), meaning the company is valued at $20 million. Your shares would bring $40,000 (1,000 x $2 x 20) if you sold them today. But the company is still growing, so the next year it sells some more stock, in a “secondary” stock offering: it sells 100,000 shares at $20 to raise $2 million in cash. WOWI is better off now, but how about you? You still have your 1,000 shares and the company earns $1,050,000 that year, a 5% increase over the prior year. But since there are now 600,000 shares outstanding, EPS is down to $1.75 ($1,050,000/600,000). The market still thinks the company is worth 20 times earnings, so valuation is up to $21 million (20 x $1,050,000).Your shares, however, are now worth only $35,000 (1,000 x $1.75 x 20).The company has more cash and is making more money. You did nothing different—and lost $5,000 in market value. That is dilution.
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The owners of corporation are its stockholders (shareholders). Stockholders are the residual claimants against the assets and income of the corporation, they can only claim what is left after the creditors of the corporation are paid their claims. There are two general classes of stockholders: common stockholders and preferred stockholders. Preferred stockholders are preferred in the sense that they stand ahead of the common stockholders, typically no dividends can be paid to the common stockholders until all dividends due to the preferred stockholders have been paid. Preferred stock often carries a fixed annual dividend rate (for example, $8 per share) after that dividend rate is paid, the profits remaining are then the property of the common stockholders. But preferred stockholders are more like owners of the firm than they are like creditors of the firm. In particular, if the corporation decides not to pay dividends to the preferred stockholders, this does not constitute a breach of contract in the same way that not paying interest due on debt does. Instead, “passing” a dividend due to the preferred stockholders ordinarily only means that common stockholders must not be paid a dividend until all dividends due to the preferred stockholders have been paid.
External sources of funds are basically new common or preferred stock issues (new equity issues), bond issues (long term debt), bank loans and increases in accounts payable to other businesses (short term debt), and miscellaneous sources. All of these involves the corporation’s participation in the capital markets, tapping funds of individuals, banks, pension funds, insurance companies, and so forth.
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