Common stock equity represents ownership rights to a corporation. Investors must become familiar with the purpose of the corporation, the structure of the entity and the privileges that are associated with holding shares of stock within the business. Of course, all common stock equity investments carry particular risk profiles that are distinct to this asset class.
Investor Words glossary defines the corporation as "the most common form of business organization, and one which is chartered by a state and given many legal rights as an entity separate from its owners." Corporations are set up to grant limited liability status to ownership and allow the business to easily raise capital by taking on debt or by issuing common stock equity to owners.
Stock and Corporate Structure
Corporations finance themselves by selling shares in the business to investors that put up capital in exchange for ownership. Common stock carries voting rights and subordinated claims to property and future earnings after the claims of creditors and preferred stock holders have been satisfied. Consequently, the value of the common stock equity will fluctuate according to profits, market conditions and the strategic planning of management.
Large corporations employ a dual structure to merge the respective goals of management and owners. The board of directors is elected by equity owners and is led by the chairman. The board then hires management to create value for shareholders.
The Balance Sheet
The balance sheet is best described as a snapshot of the corporation's financial position at a particular moment. All financial entities are "balanced" by an equation in which assets are equal to liabilities plus equity. The assets of the corporation are carried to create income and may be described as cash, investments, or property, plant, and equipment. Liabilities represent the claims of creditors, while equity identifies ownership.
Logically, common stock equity is synonymous with dividing the equity of the corporation among shareholders. The equity section of the corporate balance sheet is basically made up of common stock, common stock held in treasury, and reinvested earnings. Management will seek to grow the business and investor returns by reinvesting profits into the company to enhance equity, and/or by paying out income to common equity holders in the form of dividends.
Corporations are also able to increase individual share value by purchasing outstanding common stock of the business and holding shares as treasury stock. Doing so reduces the amount of outstanding stock and competing ownership claims to the available capital.
Although common stock holders own the company, common stock equity rights are superseded by the rights of creditors and preferred shareholders. In the event of bankruptcy, creditors (bondholders) are given priority to receive loan payments. Next, preferred stockholders negotiate rights whereby dividends are paid on their investments before those of common equity holders during the normal course of business and during liquidation.
Theoretically, all businesses maintain the potential to earn infinite amounts of profits, or go bust beneath staggering amounts of debt. Because of the limited liability status of the corporation, owners may benefit from the upside potential of the company, but their outside interests are shielded from bankruptcy litigation. This means that common stock equity holders stand to lose, at worst, the value of their investment.
The allure of limitless corporate profits and shareholder value compensates common stock equity investors for taking upon this risk.