It is paramount to understand how companies and economies work if you want to be a good investor. This begins by understanding the common terms you will encounter as you perform the financial due diligence of a company. The term Capital Stock is one of these terms that you will see again and again. Let’s break down the term Capital Stock and understand what it means.
What does Capital Stock Mean?
The term Capital Stock may mean one of the two different things depending on the context. In either case, the underlying idea is to indicate the “capital” that exists that powers the production of goods and services. This can be understood as the total input value that is invested in a company or an economy to produce the output. While we are mainly concerned about the capital stock as it refers to a company, we will fist look at the capital stock as it refers to an economy or a country so we can intuitively understand how these two concepts are in fact linked together.
What is the Capital Stock of an Economy?
Capital stock of an economy refers to the plant, equipment and other assets that help with production. You will recall that the economy is made up of two actors – producers and consumers. Here, we are mainly concerned with producers. This include private and public corporations, non-profits and governmental organizations. You can imagine the capital stock of all the firms in the economy add up to the capital stock of the economy. Conceptually this may be indicative, however the capital stock of the economy will be larger than the sum of the capital stock of all corporations as companies reinvest earnings over time in additional assets.
What is Capital Stock of a Company?
Capital stock of a company is the total amount of stock that the company is authorized to issue. This can be further divided into preferred stock and common stock. This is not the same as outstanding stock. The company may issue less number of shares than they are authorized, therefore the outstanding stock is less than the capital stock. Additionally, over time the company may repurchase shares issued earlier. The repurchased shares are called treasury stock.
The Relationship between Capital Stock and the Par Value of Shares
The total authorized shares is mandated by the charter of the company. These shares are authorized at a par value that the company arbitrarily defines when they issue the shares. Please note that the par value of the shares is not the same as the market value of the shares. The capital stock of the company can then be expressed as
Capital Stock = Authorized Shares x Par Value of Share
Remember to include both common stock and preferred shares when you calculate the capital stock.
Any capital raised by issuing capital stock is listed as Paid in Capital and Additional Paid in Capital on the balance sheet under the Stockholders Equity section. Authorized shares may be issued form time to time. The value of the shares issued at par becomes part of the Paid in Capital, and the excess value received by issuing these shares are noted in the Additional Paid in Capital under the Stockholders Equity section.
Suppose a company has authorized 100,000 shares at par value of $1 per share.
Therefore, the capital stock of the company is 100,000 x $1 = $100,000.
Now further suppose that the company issued 1000 shares and they were sold in the market for $10 each. Since the par value of the share is $1, an additional $9 was received for each share that was issued.
Now, Outstanding Shares = 1000,
Paid in Capital = $1 x 1000 = $1000, and,
Additional Paid in Capital = $9 x 1000 = $9000.
Once the shares are authorized and the par value of the stock is fixed, the capital stock of the company is defined. No further financial action will change this value, as long as the charter of the company is not amended to increase or decrease the authorized shares. New shares issued increase the outstanding shares count, while any stock repurchase goes into the treasury stock. Stock splits affect the par value of each share but the total number of shares also change in an inversely proportional manner, therefore the capital stock value is not affected.
What’s the Difference between Capital Stock and Common Stock?
As mentioned earlier, the capital stock of a company refers to the authorized capital base for the company in the charter. This value is determined from the number of shares authorized and the par value of each share. Capital stock is made up of common stock and preferred stock. Capital stock of a company will normally not change over time and is not dependent on the trading of the common or preferred shares in the market.
Common stock is just one component of the capital stock. The value of the common stock depends on the current market value of the shares and the number of shares outstanding. This will change over time due to corporate actions (new issues, repurchases, etc) and the change in the market price of the shares.
Why the Capital Stock of the Economy is Greater than Sum of Capital Stock of All Corporations in the Economy?
The companies purchase additional assets from their retained earnings as the reinvest profits to scale up. These additional assets are counted in the capital stock of the economy but are not included in the capital stock of the company. Therefore, the capital stock of the economy will grow more than the sum of the value of the capital stock of all existing corporations in the economy.