Question

Why is the return associated with common stock referred to as a residual claim? Contrast this kind of claim with a fixed claim

Answer 1

Equity is an ownership interest in something. When a homeowner makes payments on his mortgage, he is said to “build equity” in the house. With each payment, his ownership interest increases as that of the mortgagee decreases. Equity is capital.

If an asset is owned by multiple parties, each owner’s equity is called a share in that asset. A stock is a security representing a share in a corporation. The words “stocks,” “equities” and “shares” are often used synonymously, although the last denotes a more general concept.

When a corporation is first formed, investors contribute capital. Collectively, they own the corporation, and they receive stock representing their ownership interest. The investors are called stockholders or shareholders. The stock of the corporation is divided into equal shares, so an investor’s ownership is proportional to the number of shares he holds. Usually, the capital investors first contribute to a corporation is in the form of cash. It could also be in the form of goods or services. For example, employees in a startup corporation sometimes receive stock as part of their compensation—their contribution is in the form of “sweat equity.”

In any sort of joint ownership situation, the rights of individual owners must be balanced against a need to safeguard the interests of other owners. For example, it may be in the best interest of all shareholders that individual shareholders are prohibited from trespassing on company property or having access to company trade secrets. Accordingly, shareholders have limited rights that include:

• voting rights: Shareholders elect members of the board of directors. They also may vote on certain issues affecting the corporation. Voting is generally conducted on a one-share-one-vote basis. Shareholders may appoint proxies to exercise voting rights on their behalf.
• dividends: When a corporation earns profits, these may be reinvested in the corporation or paid out to shareholders as dividends. Usually, dividends are paid quarterly as an amount of cash per share.
• transferability of shares: Shareholders may sell or otherwise legally transfer their shares to a third party of their choosing. Many stocks are actively bought and sold in stock markets.
• residual claim: If a corporation is liquidated, the corporation’s assets are applied to satisfy outstanding claims against the corporation—indebtedness, employee salaries, taxes, contractual obligations, etc. Shareholders have a residual claim on the assets. Any assets left over after all other claims have been met belong to them. Generally, those residual assets are liquidated, and the proceeds are distributed to shareholders as a fixed payment per outstanding share.

Another fundamental aspect of stock is the fact that owners enjoy limited liability. The corporation’s liabilities are not their liabilities, so creditors of the corporation can not pursue shareholders to satisfy their claims against the corporation. For this reason, shareholders can lose no more than the capital they paid to acquire their stock. Shares can never have a negative market value.