What Is Capital Stock? (With Formula, Benefits and FAQs)
By Indeed Editorial Team
Updated August 30, 2022
Published February 4, 2020
The Indeed Editorial Team comprises a diverse and talented team of writers, researchers and subject matter experts equipped with Indeed's data and insights to deliver useful tips to help guide your career journey.
As companies grow, they might require capital, or money, to purchase new buildings or cover other expenses. If a company needs a lot of money for a project, its leadership team might take out a loan from a bank or issue capital stock, allowing private investors to purchase a piece of the company in return for capital. If you're interested in business investment, learning about capital stock can help you understand the relationship between a company and its investors.
In this article, we explain what capital stock is, describe its different types, show the advantages and challenges of this financial strategy and answer common questions about buying and selling shares in a company.
What is capital stock?
When people give a company money as an investment in their success in return for a percentage ownership in the company, they gain capital stock as proof of their investment. They buy stock in units called shares. Investors buy capital stock because they believe that the business might increase its market share and revenue, which means the investors get dividends from their investments. A dividend is an amount paid to investors at the end of a financial reporting period. As the company grows, the capital stock's market value and dividends increase.
Related: What Is Capital?
Why do companies issue capital stock?
Companies issue capital stock to raise money for various purposes, including:
Adding a new product line
Building a new facility
Purchasing new manufacturing equipment
Expanding its workforce
Paying off loans
Acquiring another business
Related: Your Guide to Careers in Finance
Types of capital stock
There are two main types of capital stock:
Common stock: Common stock gives shareholders more votes over a company's business decisions. These shares also have higher appreciation potential, but they're less guaranteed, which means shareholders can lose money if the company's market value decreases.
Preferred stock: Preferred stock acts like a bond, with reliable dividends. This type of stock gives shareholders less voting power and has less earning potential, but it also carries less risk, as preferred shareholders usually get their dividends before common shareholders.
Related: How To Record Capital Assets
How much is capital stock worth?
Since capital stock represents a portion of a company's total market value, its worth fluctuates as the market changes. The company's accounting team might assign an arbitrary value to each share of capital stock, like $0.01. This value, called par value, allows the accounting team to report the stock, but doesn't represent the amount a shareholder might pay to purchase shares. The amount of capital stock issued to individual investors determines each investor's percentage of ownership. For example, if there are 20,000 shares of capital stock and an investor owns 10,000 stocks, he owns 50 percent of the company.
How to calculate the value of capital stock
A company's accounting team might calculate the stated value of all capital shares issued for financial reporting purposes. To calculate the value of capital stock, use the following formula:
Value of capital stock = (Par value per share) x (Number of shares issued)
Advantages of issuing capital stock
Capital stock is a common feature of business growth plans because this practice has many benefits, including:
The ability to finance growth without going into debt: Selling capital stock can be a valuable alternative to taking out a loan because capital stock doesn't register as a liability on public financing documents. This makes the company more appealing to further investors.
Large amounts of interest-free capital: The amount of capital raised by selling stock may be more than the funding received had the company taken out a loan from a bank, and the company doesn't pay interest on the stock, just dividends.
Shareholder insights: Issuing stock allows the company to benefit from investors' expertise, especially with common stock, where shareholders have a voice in company policies.
Related: What Is a Shareholder?
Challenges of issuing capital stock
While issuing capital stock can help a company expand, it can also present some challenges, including:
Loss of part of the company's equity: By selling capital stock to investors, the company is giving up some of its ownership.
Dilution of share value: While selling more stock can increase capital, issuing more stock dilutes the value of the current shares, unless the company increases its market value.
Finite resource: After selling an extensive amount of capital stock, a company can run out of ownership to offer investors. In this case, the company's leadership team might have to consider a loan from a bank to get more capital.
Responsibility to pay dividends: While stocks don't have interest the way loans do, the business pays dividends to shareholders at the end of each financial period, starting with preferred shareholders.
Frequently asked questions
What is market value?
While par value is the monetary value a company assigns to each share, market value is the real-world value of the price of a stock on the open market. Once investors sell their shares to third-party buyers, a company's stock gains market value. A stock's par value stays the same, but the market value might change because of a variety of factors, like public confidence in the brand and supply chain status.
Read more: Why Market Value Is Important
Can a company buy back shares from investors?
Companies can buy back shares of capital stock from shareholders. A company's leadership team might offer to buy back stocks to gain a majority ownership of the company and reduce investor power over business decisions. When this happens, the shares become treasury stock. Some types of companies, like incorporated businesses, are not legally allowed to own shares of their own stock. These companies might report a decrease in capital stock if they buy back shares from investors.
What is share trading?
Share trading is the process of buying and selling shares between shareholders. A shareholder might buy more shares to get more dividends or gain more influence over business decisions. This trading has no impact on the company's financial documentation unless the company buys them back, in which case the shares become treasury stock.
What are outstanding shares?
Outstanding shares are the shares that investors currently own versus treasury shares that the company owns. As a company sells more stock and buys back shares from investors, the number of outstanding shares a company has can vary over time. Publicly traded companies report the number of outstanding shares, so potential investors can understand the company's financial situation before investing.
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