(This post is a part of the series Basics of Finance and Investing.)

Unlike a debt type security such as a money market or a bond, a stock is an equity or ownership type security, which entitles its buyer one share in the ownership of the issuing corporation. Because the risk of investing in a stock is significant (you may lose your entire invested asset if the corporation faces bankruptcy), stocks are examples of a variable income type security.

There are two classes of stocks: common stock and preferred stock.

Common Stock

If you buy a common stock, your ownership stake in the company comes in two flavors: you have a claim on the company’s earning, and you also get to cast one vote per stock on the company’s management decision in its yearly meetings. (Stockholders often vote by proxy, instead of attending these meetings.)

The company may either directly pay your share of income as cash dividend, or may reinvest it for business growth to earn you a capital gain (increasing the value of your stock). You have a residual claim on the company’s assets and finances in the event of a bankruptcy, because you are the last in line after others, including tax authorities, employees, bondholders and such creditors, are paid off.

Most common stocks are traded in stock exchanges such as NYSE. The most important feature of a publicly traded stock is its P/E ratio (price-to-earning ratio), which is the current stock price divided by last year’s earning per share. This value tells the investor how much to pay for each dollar the company earns. A low P/E makes a stock “undervalued” (a good buy unless the firm is facing problems), and a high P/E makes it “overvalued” (a good sell).

Preferred Stock

A preferred stock is a stock that retains some features of a bond, because the issuing company pays the investor a fixed amount each year (like a bond that never matures). Also, like a bondholder, owners of a preferred stock does not have a voting right in company management.

But, for tax purposes this payment is treated as a dividend and not an interest, which makes a preferred stock an equity type security. Also, unlike a bond, the company is not obliged to make a regular payment to the investors. In case of a bankruptcy, the preferred stock owners have a right to claim the company’s assets after the bondholders and before the holders of common stocks.

See related posts:

1. What is a "bond"?