Because the risks of common stocks have a way of getting forgotten amid the dazzle of Wall Street’s aggressive marketing, I think it’s useful to take a minute to revisit the basics. If it sounds like baby talk, forgive me. I meet a lot of intelligent grown-ups who cry like babies when they bring in their stock portfolios.
Common stock is simply corporate ownership broken down into units that can be bought and sold. When companies become publicly traded, which happens by way of a highly lucrative investment banking process called underwriting, the shares, which are traded on organized stock exchanges (like the New York Stock Exchange) or electronic stock exchanges (such as NASDAQ), acquire a market value. That market value is based not just on what the shares are worth as a portion of the company‘s equity, but on what investors in general think they should be worth, anticipating corporate and economic developments still in the future. The more assured future profits seem to be, the more investors are willing to pay for the shares. In a nutshell, that’s what the stock market is basically about, except for one all-important thing, which is the risk that stock investors assume.
The fact that common stock represents ownership, whether it’s ownership of General Motors or ownership of a lemonade stand, means that shareholders assume all the risk of business failure. Except for what they may have received from the business in the form of dividends, which are cash distributions made from profits, the owners (including common stockholders) in the event of liquidation rank last in terms of their claim on assets. Only after every bill is paid, all lenders and bondholders are made whole, and preferred stockholders take their share are common shareholders legally allowed in to rake the rubble.
In a going concern, common stockholders likewise stand at the end of the line when profits are paid out. Lenders, including bondholders, get paid their contractual interest before preferred dividends are paid, and whatever is left is either paid out as dividends on common stock or retained in the business as ownership equity.