What is a Stock?
- A stock represents part ownership in a company
- It carries two fundamental rights: the right to dividends, and the right to vote
- Shares can be traded on public exchanges or privately.
- Why buy stock: capital appreciation, dividends (if applicable) and shareholder rights
- Types of shares: common shares and preferred shares
- Large potential for capital appreciation but high risk present too
What is a stock?
A stock is a financial security that represents part ownership of a company. ALT: A stock represents part ownership of a company, and is also known as a financial security.
This gives the holder of the stock the right to own a certain amount of a company’s assets and profits, based on the number of “shares” they own. The owner of a share is called a shareholder and his/her ownership depends on the number of shares they own versus the total number of company shares (aka shares outstanding).
For example: Giuseppe owns 1,000 shares of Amazon stock. Amazon has a total of 50,000 shares outstanding. That means Giuseppe owns and has a 2.0% (1,000/50,000 * 100) claim to the company’s assets and earnings.
All publicly traded company shares are transacted on exchanges like NYSE and Nasdaq, but private companies can only sell shares privately to individual investors. Companies issue shares in order to raise funds to operate and maintain the business. There are two types of shares: common and preferred shares.
The transactions must follow regulations set forth by the SEC in order to protect investors buying private shares (which can be risky). Historically, stocks have outperformed all other asset classes over the long run.
Why do people buy stocks?
There are 3 reasons why an investor buys stocks:
- Capital appreciation: growth of investment amount as the price of a stock rises
- Dividends: some companies directly pay their shareholders a portion of its earnings
- Rights: by holding a company’s stock, some shareholders can vote and have an influence on company decisions
Why does a company issue stock?
The main reason a company issues stock to the public is to raise money to fund operations. This includes activities like paying off debt, supporting research & development projects to grow the business or simply maintaining business operations.
Money raised from selling shares on the public market is called equity. A company’s market value of equity (total amount of equity) is equal to the number of shares outstanding * current stock price. Major companies are funded through equity and debt (explained later).
What kind of stocks can you invest in?
The two main types of stocks are, common stock and preferred stock.
Common stock: most common form of equity ownership which gives the owner the right to vote at shareholder meetings and receive dividends if they are offered.
Preferred stock: alternative form of equity ownership where the owner does not have voting rights, but has preference over common stockholders in order of receiving dividend payments and repayment if the company goes bankrupt.
Advantages and disadvantages of trading stocks:
Stocks provide investors with an opportunity for large capital appreciation. As mentioned above, stocks have outperformed all other asset classes over the long term. However, in the shorter term, stock prices move down as well.
If a company goes bankrupt and all its assets are liquidated, common shareholders (the most common form of stockholders) are last in line to receive any repayment. The hierarchy of repayment in such a situation starts with bond holders, preferred shareholders and then common shareholders are left with residual value. Hence, common shareholders are at the highest risk of losing most/all of their investment.
If a company is not bankrupt and faced with negative information (like missing earnings expectations, strict government regulation, bad press), this will result in the price of the stock going down. As a result, common shareholders will be in a loss, if the market price crosses their average cost.
This risk can be managed through investing in different stocks, so that the correlation of your assets is lower. Essentially, if one stock price goes down due to bad information, the other stocks in your portfolio will not be affected (if the news is on a micro scale). This will be explained further in the “Diversification” article.