What is a Stock and How Does It Work?

Have you ever wanted to own your own business? Maybe a computer software manufacturer such as Microsoft, a grocery store such as Safeway, or a fast-food chain such as McDonald’s? Now, what if you could own your own business without showing up for work — ever? 

Well, you can own any one of these businesses — or, at least, a piece of them — without ever setting foot in the front door. How? By buying their stock. Stock is a proportional share of ownership in a company, in the form of a piece of paper (a stock certificate) that grants you your ownership rights. 

Shares of stock are bought and sold in specialized marketplaces known as stock exchanges. The biggest and best-known include the New York Stock Exchange and the NASDAQ in the United States, and the London, Hong Kong, Bombay, and Tokyo stock exchanges elsewhere in the world. 

In this article, we take a closer look at what stock is, the different kinds of stock, and some basic stock-investing strategies.

What is a Stock?

A stock is a financial instrument issued by a publicly-traded company. The tiniest fraction of a company’s ownership is represented by these shares of stocks. Owning one share of a company’s stock makes you part-owner of the firm.

When you own shares of stock, you are entitled to vote for the board of directors of the underlying company, along with other critical issues that are being considered by management. Dividends are paid to shareholders when a company decides to distribute its earnings.

Your liability in a company is limited to the value of your shares if you own stock. In other words, if a company loses a lawsuit and has to pay a huge fine or judgment, you cannot be held responsible for it.

Furthermore, you cannot be pursued by the company’s creditors if the company goes bankrupt. 

Common vs. Preferred Stock

Stock shares are divided into two different types. The first is common stock and the second is preferred stock. There are far more common stock shares than preferred stock shares.

Most of the time, ordinary people own these shares. Besides having full voting rights, they are also eligible to receive dividends from the company. There are fewer voting rights with preferred stock, but dividends are paid in a preferred manner.

Common stock: The most basic form of stock, which conveys fractional ownership in the company that issued it, including a share of its assets and profits. Common stock usually gives shareholders the right to vote on important matters to the corporation, such as membership on the board of directors, with one vote for each individual share of stock owned.

Preferred stock: Stock that gives its owners priority in the payment of dividends or in the event of liquidation (sale and dismantling) of the company.

Stocks vs. Bonds

Companies issue stocks to raise capital, whether paid-up or as shares, to expand their businesses or take on new projects. When someone buys shares, there are important differences between buying them directly from a company when it issues them (in the primary market) and buying them from another shareholder (in the secondary market). A corporation issues shares in exchange for money.

There are a number of ways in which bonds differ from stocks. The bondholders of the corporation are creditors and are entitled to both interest and principal repayments. In the case of bankruptcy, creditors have legal priority over other stakeholders, and if the company must sell assets in order to pay them back, they will be compensated first. By contrast, shareholders often receive nothing, or pennies on the dollar, if a company goes bankrupt. This means that stocks are a riskier investment than bonds.

Learn more about how bonds work.

Stockholders and Equity Ownership

When you buy a share of stock in a company, you’re actually buying part ownership in it — that is, a portion of its assets and its profit. One share of stock doesn’t represent a very large portion of ownership for the typical large corporation, which may have hundreds of millions of shares outstanding. At the time of this writing, for example, General Motors has issued more than 566 million shares of stock. 

The more shares of stock you accumulate in a company, the more of the company you own. Someone who owns stock in a company is known as a shareholder. The idea of stock is not a new one; stock ownership has actually been around for centuries. 

Generally, you can make money in stocks in two different ways: through appreciation, the increase of a stock’s price over time, and dividends, a portion of a company’s profit, paid out to eligible shareholders on a per-share basis.

For most ordinary shareholders, being unable to manage the company isn’t such a big deal. Shareholders are entitled to a portion of the company’s profits, which is, as we will see, the foundation of the stock’s value. Owning more shares means you get a greater share of profits. Dividends, however, are rare in many stocks, which reinvest profits instead. However, retained earnings still contribute to the value of a stock.

How To Buy and Sell Stocks?

For shares of stock to have value, a mechanism must exist for readily buying and selling them. When a company issues its stock to the public, buyers and sellers all around the world can buy and sell that stock. Stockbrokers conduct the actual buying and selling transactions for their clients and take a small commission with each transaction.

However, it would be grossly inefficient if individuals had to directly seek out other individuals who just happened to have the stock they wanted to buy — and for sellers to have to do the same thing. 

Stock exchanges, designed to provide a place where consumers can easily buy and sell a stock, efficiently conduct millions of stock transactions each day. Two major categories of stock exchanges exist in the United States:

  • Listed exchanges: In a listed exchange, such as the New York Stock Exchange (NYSE) (founded in 1792 as the result of a meeting of 24 large merchants), brokerage firms provide specialists responsible for all buy and sell transactions for a particular stock. The NYSE is perhaps the most famous stock market in the world.
  • Over-the-counter market: In this kind of stock exchange, brokerages act as “market makers” for specific stocks, buying and inventorying their shares for consumers who may want to buy them. In the United States, the three largest over-the-counter markets are the Nasdaq, the Nasdaq Small Cap, and the OTC Bulletin Board.

Generally, when you want to buy or sell a share of stock, you do so through a broker (full service, discount, or online), who conducts the transaction on your behalf via one of these exchanges.

Learn more about how to trade stocks.

Key Stock Terms

The basic idea of stock — a share in the ownership of a company — is a simple one, but this simple idea gets more complicated when you start to dig into the different kinds of stock and the many different ways to manipulate it for financial gain. As you explore the wonderful world of stock, you’re bound to read or hear all sorts of terms bandied about. Take a look at some of the most common:

Price-to-earnings (P/E) ratio: The current market price of a particular share of stock divided by its earnings (profit) per share over the previous 12 months. Investors often use this ratio to determine and compare the relative value of different company stocks. In the United States, the average P/E ratio for stocks from 1900 to 2005 is 14.

Yield: The annual rate of return of a stock, generally expressed as a percentage.

Dividend: A payment that a corporation makes to its shareholders out of its profits for a given period of time.

Split: When a company increases the number of shares of stock outstanding without changing the proportionate of individual shareholders. For example, in a two-for-one split, 100 shares of stock with a current price of $10 per share and a total value of $1,000 become 200 shares of stock at a price per share of $5 — still worth $1,000. A reverse split works in the opposite direction, by decreasing the number of shares of stock and increasing the price per share.

Initial public offering (IPO): The initial offering of a company’s stock to the public, such as when Google offered its stock for sale to the public for the first time on August 19, 2004, raising more than $1.5 billion for the company in the process.

Market capitalization: The value of a company on the stock market — market cap, for short. This figure is determined by multiplying the total number of shares of company stock issued by the share price. For example, a company with 1 million shares of stock outstanding, with a share price of $10, has a total market capitalization of $10 million.

Option: The right to purchase or sell a specific number of shares for an agreed-upon price during a specified time period. The right to purchase the stock is known as a call option. The right to sell the stock is known as a put option.

Future: An agreement that obligates someone to sell a fixed quantity of stock at a specific price on a particular future date — for example, 100 shares of Microsoft stock at a price of $35 on September 30, 2012. Note that if the actual market price of Microsoft stock is lower than $35 on the date of the future transaction, the buyer loses money on the deal. If the actual market price is higher than $35, the buyer makes money on the deal.

Blue-chip: A particularly high-quality stock, usually issued by a large company with a long history of stable earnings and profitability. Although the idea of which companies constitute blue-chip stocks changes over time, currently, companies such as Apple, Nike, Wal-Mart, Procter & Gamble, and Coca-Cola would make most investing observers’ list of such stocks.

Dow Jones Industrial Average (DJIA): The most commonly used indicator of overall American stock market health and vitality. The average is derived from a price-weighted average of 30 blue-chip stocks chosen by the editors of the Wall Street Journal.

Bull market : A prolonged increase in the overall market value of stocks, usually 20 percent or more.

Bear market: A prolonged decline in the overall market value of stocks, usually 20 percent or more.

This list includes just the basic definitions of key stock terms — you’ll uncover many more specialized ones if you dig deeper.

How To Pick a Stock-Investment Strategy?

Over time, stock investors have developed a variety of novel strategies for deciding when to buy and sell stock. Some are highly analytical, taking into account all sorts of numbers, facts, and figures, and some aren’t so much. Read over some of these most popular and long-lasting stock investment strategies:

Technical analysis: Investors use stock market data, such as charts of price and volume, to predict future market trends (particularly short-term trends) of selected stocks.

Fundamental analysis: Investors use company financial and operations data, such as sales, earnings, debt, management, and competition, to predict future market trends of selected stocks.

Buy and hold: This strategy advocates buying and holding stocks for very long periods of time (10 to 20 years or more), regardless of short-term market fluctuations, on the assumption that the stock price will continue to increase over the long term along with the overall growth in the economy.

Growth investing: Within a particular industry — say, automotive — some companies perform better than others, and some industries do better than others, too. In this strategy, you pick out the companies that are performing better than their peers and invest in them, hoping that they will continue to outperform the market into the future.

Value investing: The opposite of growth investing, value investing involves seeking out company stock that is undervalued compared to its peers, with the hope that the stock is poised to increase in value after company management addresses whatever fundamental issues are holding down the value of the stock.

Dollar-cost averaging: This strategy involves buying a specific dollar amount of stock each investment period — say, $1,000 each month — regardless of the stock price. When stock prices are up, you purchase fewer shares; when stock prices are down, you purchase more shares.

Market timing: Investors use price, volume, and economic data to try to predict the overall future direction of the stock market. Day traders do this when they buy stock, but their time frame usually is only a day, whereas most market timers have a much longer time horizon.

Buy what you know: This strategy involves investing in companies that you have personal experience with. For example, maybe you notice that as overall economic conditions worsen, your local Wal-Mart store is substantially busier and it’s harder to get a parking spot. This personal experience may indicate to you that Wal-Mart’s business prospects will continue to improve in the future, leading you to buy 100 shares of Wal-Mart stock.

Dogs of the Dow: In this strategy, at the end of each year, you look at the list of the 30 stocks that make up the Dow Jones Industrial Average and buy shares of the 10 that have the highest yields. You hold on to these stocks for the entire year and then repeat the process at the end of the year, selling the stocks that fall off the top-ten list and buying the ones that are added.

Plenty of other stock-investing strategies exist — see which ones work best for you. If you’re not happy with one approach, try another until you find one you like.

Leave a Comment

error: