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Understanding Common Stocks

Updated on July 2, 2010

Stock Certificate

an example of a company's common stock certificate
an example of a company's common stock certificate

Common Stocks

Individuals and different companies buy a firm's common stockhoping it will increase in value, provide dividend income - or both. How is the value of a common stock determined? Stock values are expressed in three ways - par, market, and book value.

  1. The face value of a share of stock at the time it is first issued is the par value. In order to receive their corporate charters, all companies must declare par values for their stocks. Each company has to preserve the par value money in it's retained earnings, and it can't be distributed as dividends.
  2. A stock's real value is it's market value (the current price of a share in the stock market). Market value reflects the buyers' willingness to invest in a company.

Owner's Equity (the total of a company's common stock par value, retained earnings, and additional paid-in capital). The book value of a common stock represents owners' equity divided by the number of shares. Book value is used as a comparison indicator because for successful companies, the market value is usually greater than the book value. When market price falls to near book value, some investors buy the stock on the idea that it is under-priced and will increase in the future.

the Blue Chip
the Blue Chip

Investment Traits Of Common Stocks

Common stocks are one of the riskiest of all securities. Being uncertain about the stock market itself, can quickly change someone's given stock's value. Also,when companies are unprofitable for years, most of the time they can not pay dividends. Therefore, shareholder income - and maybe share price - drops. However, at the same time, common stocks offer high growth potential. Naturally, the prospects for growth in various industries change from time to time. However, the blue-chip stocks of well-established, financially established firms such as Ralston Purina (www.ralston.com) and ExxonMobil (www.exxon.mobil.com) have historically provided investors with steady income with consistent dividend payouts.

The "Old" Economy Versus the "New": What's a "Blue Chip" Now? Because the nature of the stock market is always changing, the future performance of any stock is often unpredictable. With the proliferation of internet and start-up dot-coms, experts realize that a lot of the old rules for judging the market prospects of stocks is changing. Conventional methods do not seem to apply to the surprising surges in "new economy" stock prices. Old performance yardsticks - a company's history of dividend payouts, steady growth of earnings per share, and a low-price earnings ratio (current stock price divided by annual earnings per share) - do not seem to measure the value of new economy stocks. In some instances, market prices are soaring for start-ups that have not earned a profit yet.

Although some of the newcomers - America Online, Amazon, eBay, Yahoo! - are considered by many on Wall Street as Internet blue chips, their financial performance is different than traditional blue-chip stocks. Let's compare Yahoo! and Wal-Mart. If you had invested $10,000 in Wal-Mart stock in July 1997, the market value of this blue chip would have increased to more than $35,000 in just five years. The same investment in Yahoo! would have also grown to about $35,000. At peak value during the five-year period however, the Yahoo! investment surged to almost $600,000 versus Wal-Mart nearly $40,000.

Could this huge difference be predicted from indicators traditionally used by market experts? Hardly. The initial public offering (IPO) of Yahoo! stock in 1996 was priced at $13 per share. It quickly jumped to $43, then settled down to close the day at $33 even though the company had not yet made a profit. Subsequently, because Yahoo! was the leading Internet portal brand name, investors were betting that it would become a profitable business in the future - a bet that many traditionalists would view as extremely risky.

Consider the fact that Wal-Mart's book value is more than double that of Yahoo! Even more glaring is the fact that entering 2002, Yahoo! has had zero or negative earnings per share for the past six years, Wal-Marts net earnings have grown steadily during the past 10 years. The comparison is similar for dividends: Wal-Mart has a steady history of payouts to stockholders. Yahoo! has never paid a cash dividend. Overall, the traditional performance yardsticks favor Wal-Mart heavily. Investors are betting the future on Yahoo!. As recently as July 2000, the original $10,000 investment accumulated in three years to a market value of more than 10 times that of the same investment in Wal-Mart.



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      indian stock market tips 

      7 years ago

      This post is really nice and informative. The explanation given is really comprehensive and informative. I am feeling happy to comment on this post. I think this is useful information for users-How does the ordinary investor fit into the equation comprising of global factors coupled with manipulation in the stock markets.

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