The Investment Series: Stock Basics

Stock Basics  (Go to the Investment Series for other Basics)

This is the second article in a series on investment basics. If you are new to investing, it is recommended that the articles be read in order. Prior articles introduce terminology that is used in later articles.

 

What is a Stock?

Stock represents ownership of a company. Stock is bought and sold as shares. Each share is one unit of ownership. If there are a total of 1 million shares of stock issued by a company, and you own one share, then you would own 1/1000000 (one-one millionth) of that company. As a part owner of the company, you receive information about the company financial performance and you have voting rights in determining who runs the company. As a result, an objective of management is to make money for the stockholders. Stockholders typically vote on company officers and on certain significant changes such as mergers between companies. When a company issues stock, it is said to be incorporated and is then a corporation. Stock may be held privately or distributed to the public.

Why Do Companies Issue Stock to the Public?

When a company issues stock to the public, the company is selling ownership shares to the public. The company receives the proceeds from the sale, and that raises money for the company. That money is in turn used to grow the company. Unlike bonds, common stock is not a debt obligation of the company.

How does stock make money for the investors (i.e. the stockholders)

Stock can make an investor money in two fundamental ways:

  1. The company may issue dividends to the stockholders, and
  2. The price of shares of the stock may increase.

To better understand these two concepts, we need to first look at some company basics.

Dividends and Company Basics

In general, companies are created to make money. Companies obtain money (revenue) from the sale of products or services. This incoming money is gross revenue. Companies also have expenses to produce, distribute, and sell these products or services. If the gross revenue is greater than all of the expenses, the company has made a profit. This profit represents the earnings of the company. The company determines how much of the earnings is to be retained by the company and how much is to be distributed to the shareholders. Retained earnings can be used to improve (grow) the company. The earnings distributed to the shareholders are dividends. If all earnings go to the shareholders, there is no money left to grow the business. Conversely, if all earnings are retained by the company, investors will only be interested in owning the stock if there is reason to believe that the stock will increase in price.

Why  a Tulip?
You'll find out!

Some Terminology

  • Growth Stock
    A stock selected for expected price appreciation.
     

  • Income Stock
    Stocks that have shown a steady income (dividend). These are not expected to appreciate much in price and tend to be more stable in price than growth stocks.

  • Value Stocks
    Stock judged to be selling for less than its real value based on the company's present or projected financial performance.

  • Blue Chip Stocks
    Stocks of nationally recognized companies with a history of consistent good financial performance.

  • Preferred Stock
    Unlike common stock, preferred stock does not usually include voting rights and pays a specified dividend. Since the stock pays a specific dividend, the stock price does not rise and fall along with the company profits. If the company gets in trouble, preferred stockholders get paid their dividend before common stockholders.

 

This brings us to the second fundamental way investors make money by owning stock: increased stock price.
Stock Price

Stock price is what an investor will pay to buy shares of stock in a company. If an investor has bought shares at $10 each and now sells them for $100 each , that investor has clearly made money. Although a wide variety of factors can influence the price of a stock, these can be reduced to two:

  1. The financial performance of a company
  2. The perception of investors as to the potential future cost of buying shares

A company with good financial performance will be growing in size, growing in assets, and earning increasingly more money. As the company grows, so will the value of an individual share of that company.

However, current financial performance is not always a good indicator of future value. For example ,a single dramatic event such as an explosion might completely wipe out the value of shares of a small but growing concern.

IPO's

IPO- Initial Public offering- is the initial offering of a stock to the public. With stock, the law of supply and demand applies. IPO's are often limited in the number of shares being offered. This limited supply, coupled with demand, can cause dramatic short term swings in the stock price. In 1999, when the stock market was HOT, many IPO's made quick money for those able to buy shares at the initial offering price. In 2000, with the market much cooler, IPO's have lost much of this allure.

 


On the other hand, poor financial performance is also not always a good indicator of future value. Consider an imaginary company called Joe's Biotech 2000 that has lost money for each of the last three years. Joe announces a surprise discovery that cures migraine headaches. The future potential of Joe's company has just shot up and so will the stock price, even though Joe has yet to make a penny.

Company value and market (public) perception are two interwoven factors affecting stock price. The example given above makes sense, but remember- there is no rule that says the price of any given stock has to make sense!

Tulip Madness

Stock prices follow the law of supply and demand. If demand goes up and the supply doesn't match the demand, the price will increase. Over history, investors have on numerous occasions created demands for an item that have outrageously inflated its price. We have seen it in the stock market, and it was seen in Holland in the early 1600's. Tulip bulbs became popular, speculative buying increased demand, and an insane price spiral resulted. In his book, " A Random Walk Down Wall Street", Burton Malkiel states " A single bulb of the Viceroy species commanded all of the following items in exchange: seventeen bushels of wheat, thirty-four bushels of rye, four fat oxen, eight fat swine, twelve fat sheep, two hogsheads of wine, four tons of beer, two tons of butter, 1000 pounds of cheese, a complete bed, a suit of clothes, and a silver drinking cup thrown in for good measure." All for a single tulip bulb! The spiraling pricing could not go on indefinitely. At some point folks would realize that it was after all just a tulip bulb. The prices crashed and threw Holland into a long economic depression.

In Conclusion

In summary, stocks represent ownership of a company. Investors can make money by receiving dividends or by realizing gains in stock price. Conversely, an investor can lose money if the stock price goes down. Companies do go out of business, and stocks can become worthless.  

Check the next article in our investment series: "Mutual Funds". Did you think "No Load" funds were free of added costs?

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