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Common Stocks (or common shares) - A complete guide for investors and beginners
Common stocks, or common shares, represent an ownership stake in a given company. When you buy common stock, you’re actually buying a small part of a company. As a part owner, you may be entitled to certain benefits such as a share of company profits, and a say in certain company decisions. Common stocks are the most common type of stock traded on the stock market.
This article will help investors understand what common stocks are, how they work, and how to add them to your investment portfolio.
What are common stocks and how they work?
Definition and characteristics of common stocks
Common stocks represent ownership shares in a company. When you buy common stocks, you’re actually buying a small part of the company that issued it. As an owner, you could be entitled to certain benefits, like voting rights and shares of the company’s profits. And if the company does well, and the value of the stock goes up, you’ll be able to sell your stock for a profit.
Importance of common stocks as a type of investment
Some companies share their profits with common stockholders through dividend payments, which could be monthly, quarterly, semi-annual, or annual, with the vast majority of dividend payments being quarterly. Dividends are payments made to shareholders out of the company’s profits, paid based on the number of shares you own, but be aware that companies are not required to pay dividends to common stockholders. Some companies may decide to reinvest profits back into the company instead. In addition, common stockholders will only receive dividend payments after dividends are paid to preferred stockholders. If a company does pay dividends, it might make sense to enroll in the Dividend Reinvestment Plan (DRIP) so that the dividend amount received can automatically be reinvested by buying more shares of the company. You can learn more about DRIP in this article.
Depending on the type of common stock you own, you may also get a vote in certain company decisions. Common stockholders often get to vote in the election of a company’s board of directors. You may also get to vote on changes to company policies and major decisions like mergers and acquisitions.
Differences between common stocks and preferred stocks
Preferred stocks are another type of ownership share. As the name suggests, preferred stockholders receive certain benefits that common stockholders don’t.
Preferred stockholders are paid dividends before common shareholders. It’s always possible that once profits are paid to preferred stockholders, there won’t be any profits left to divide among common stockholders. In addition, if the company goes bankrupt, or needs to sell off any assets, preferred shareholders will always get paid out before common stockholder. However, preferred stockholders don’t typically have any voting rights.
Most preferred shareholders get fixed rate dividend payments, but they can have floating rate too, meaning the payments paid on preferred shares are tied to floating rate, which is usually spread over a benchmark rate.
As the value of common stocks is tied to business performance, they tend to offer higher returns in the long run compared to preferred stocks, if the company performs well. At the same time, common stocks are also considered riskier because of their tendency to fluctuate in value. Preferred stocks are less volatile, may get fixed or floating rate dividend payments and higher priority for other payments over common stocks, and as a result, they are considered lower risk investments than common stocks.
Benefits of investing in common stocks
There are several benefits of investing in common stocks.
Potential for higher returns: Common stocks tend to pay higher returns than other types of investments. While returns are never guaranteed, there’s no cap on how much your investment can grow or the amount of dividends you could earn over time.
Voting rights: You’ll get one vote for every share you own, giving you the right to vote on important decisions, such as changes to corporate policies and electing the company’s board of directors.
Liquidity: Common stocks can be bought and sold easily, making them highly liquid. This gives you lots of flexibility to modify your investment strategy whenever needed.
Limited legal liability: Common stockholders are considered passive investors. As a result, you can’t be held responsible for any actions taken by the company.
Risks of investing in common stocks
As with any investment, investing in common stocks comes with certain risks.
Market fluctuations: There’s no guarantee the company you choose to invest in will do well. If the company underperforms, it may not have any profits to divide among common stockholders. If things really go wrong, and the company has to start selling off assets or goes bankrupt, you could even lose your initial investment.
Volatility and uncertainty: Even if the company you invest in does well, you’re still not guaranteed to receive dividends. Companies may decide to reinvest their profits back into the company instead of paying out dividends to stockholders. Even if the company chooses to pay out dividends, preferred shareholders and bondholders will always be paid first. There’s always a chance that no additional profits are left to divide among common stockholders.
Factors to consider when investing in common stocks
Consider these factors when deciding which common stocks to invest in.
Financial health and performance of the company
A number of factors affect the value of a company’s stock, including:
- Current earnings and profits
- Forecasted earnings and profits
- Dividends paid to shareholders
- New products being released, or existing products being recalled
- Potential mergers or takeovers
- Changes in management and staffing levels
- Scandals or bad press
Valuation metrics and ratios
Certain ratios can be used to assess a company’s performance and compare the value of common stocks:
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Price-to-earnings ratio (P/E ratio): A quick way to determine whether a stock may be over or undervalued. The P/E ratio is calculated by dividing the current price of a share by its earnings per share (EPS).
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Price-to-book ratio (P/B ratio): A company’s P/B ratio is calculated by dividing the price of the stock by its book value per share (BVPS). A low P/B ratio may be a sign that a stock is undervalued.
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Price/earnings to growth ratio (PEG - ratio): One of the only valuation metrics that considers a company’s earnings growth rate when determining its value. You can calculate the PEG ratio by dividing a company’s P/E ratio by its expected annual EPS growth rate.
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Dividend yield: Is calculated by dividing how much a company pays shareholders per share by the stock’s price. Dividend yields are expressed as a percentage of a stock’s current price. If a stock costs $50 per share, and pays an annual dividend of $2 per share, the annual dividend yield is 4%.
Industry trends
Industry trends can affect a company’s stock price positively or negatively.
If demand for a certain product goes up, the stock price of all companies making that product could go up as well. Conversely, if demand for that product goes down, that can negatively affect all companies in the industry as well.
Changes in individual companies within an industry can affect other companies too. For example, if one company in an industry stops producing a given product, its stock price may go down, while the price of a competitor’s stock may rise.
Economic factors
Economic changes can have a significant effect on stock prices. If the economy is expected to grow, investors may be more likely to buy common stocks in the hopes that their value will increase.
If the economy is expected to shrink, investors may be more likely to sell stocks out of fear that their value will drop.
Specific economic factors affecting the price of common stocks include:
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Interest rates: Interest rates are controlled by the Bank of Canada. The Bank of Canada may lower interest rates to stimulate the economy and raise interest rates to slow inflation. The higher interest rates are, the more expensive it is for a company to borrow money and pay off debt. That can reduce growth and profits and cause stock prices to level out or fall.
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Inflation/deflation: Inflation occurs when consumer prices go up. If inflation gets too high, the Bank of Canada may raise interest rates to encourage saving and discourage spending. Deflation occurs when prices begin to drop. If prices drop to fast, the Bank of Canada may lower interest rates to encourage increased borrowing and spending.
Economic policies and political shocks
Changes in governments can lead to changes in economic policies.
Policy changes that are seen as being good for business or a specific industry may help increase the value of a company’s stock. Policy changes that are considered bad for a given business or industry may reduce the value of a company’s stock and its associated price.
How to buy a common stock
Where do I start:
Step 1 – select an online broker
One of the easiest ways to buy common stocks is through an online broker. Look for an online broker that offers a range of tools and an easy-to-use trading platform.
Step 2 – choose an account
Common stocks can be purchased and held within a number of accounts, including a Registered Retirement Savings Plan (RRSP), Tax-Free Savings Account (TFSA), cash or margin account.
Step 3 – research the company(s) you want to invest in
Research your options before deciding which common stocks to buy. It’s important to always make informed investment choices. Explore the educational tools and resources on the trading platform to enhance your trading knowledge
Step 4 – place the trade
Once you’ve done your research and decided on which stocks to buy, just place your order. It’s really that simple.
For more details on each of these steps, check out this article on how to buy stocks.
FAQs related to common stocks
How do I research and choose which common stocks to invest in?
If you are considering investing in common stocks, you should carefully review some key factors:
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Learn more about the companies you’re thinking of investing in.
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Review their financial statements and any other information you can find.
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Compare stocks from a number of different companies within the same industry to understand which companies may be performing well.
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Some brokerage tools, such as, TD Direct Investing’s, help make it easy to research companies within different sectors. You can also sign up for master classes, webinars and leverage other educational resources to build your investing knowledge.
How do I know when to buy or sell common stocks?
It can be hard to know exactly when to buy, and when to sell a particular stock. Based on your research, the goal is to buy when you consider prices are low and sell when prices are high. The more research you do, the more likely it is you’ll be able to identify the right time to do both.
What are dividends and how do they work with common stocks?
Payments paid by companies to their shareholders are called dividends. Dividends are paid based on the number of shares you own. Companies pay dividends when they have excess profits beyond what is being reinvested back into the company.
How do taxes affect my investments in common stocks?
That will largely depend on the type of account you use. You won’t pay tax on any earnings held within a RRSP until you withdraw it. All withdrawals, including investment gains held within a TFSA are entirely tax-free. If you use a non-registered account, you’ll have to pay capital gains tax on any income earned.
Can I lose all my money investing in common stocks?
Investing in common stocks is never risk free. If the company that issued the stock goes bankrupt, you could lose your investment. Companies that go bankrupt will only make payments to common stockholders after creditors and preferred stockholders have been paid.
How long should I hold onto my common stock investments?
That will depend on your particular savings goals. Regardless of what your goals are, it’s important to monitor your investments and adjust your investment portfolio as necessary.
Why is common stock a form of equity?
When you buy a stock, you’re buying a piece of a company. That ownership gives you equity in the value of the company.
Conclusion
Common stocks, or common shares, are the most common type of stock traded on the stock market. They can provide investors with a range of potential benefits, including income through dividends and the ability to vote in important company decisions. If the company performs well, you may be able to sell the stock later at a profit.
Common stocks can be an important part of a comprehensive investment portfolio. TD Direct Investing makes it easy to add common stocks to your investment strategy. Open a TD Direct Investing account today and start using common stocks to help reach your investment and savings goals.
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