You may wonder, "What is a stock?" - Let us clarify. A stock represents the equity in a business – it is essentially the value assigned to a portion of a particular business. Therefore, stockholders own a percentage of the company’s equity or a fraction of the company.
The process of buying and selling a stock is called trading. When purchasing and holding the stock for an extended period, it’s called investing.
The terms stocks, shares, and equity are often used interchangeably, but shares are units of stock. Therefore, stock refers to the entire allocation of shares in the company and also to individual allocations.
Private and public companies have stock, but retail investors can usually only buy shares in publicly listed companies. Sometimes, businesses allocate stock to their employees, which makes them shareholders and part-owners in the company.
Definition of a Stock
In layman's terms, stock is an asset that represents the value assigned to a portion of a business. Owning stock in a company means you own part of a company's equity.
More formally, a stock is essentially a security symbolizing part ownership in a company. By acquiring a stock, you gain a share of that company, essentially becoming a co-owner, albeit on a smaller scale. This investment strategy hinges on the anticipation of a company's growth. As the company's value escalates, so does the worth of its stock, providing investors with the opportunity for profit through subsequent sales.
Holding stock in a company also grants you the status of a shareholder. This title reflects your participation in the company's financial successes, as you partake in its profit distribution. In summary, investing in stocks is a way to share in a company's future gains, aligning your financial prospects with its growth trajectory.
An Example of a Stock
Company A has 100,000 shares of stock. Alice buys 200 shares, and Bob buys 50 shares. Alice and Bob both own company stock, but Alice owns more stock in Company A than Bob.
Each stock is a type of financial security, which falls into the same category as a bond or option, but each has its unique characteristics. A stock represents the monetary value of the holder’s company ownership.
So, if Company A’s shares cost $10 each, Alice’s stock is worth $2,000, and Bob’s is worth $500.
How Stocks Work
When a company is formed, its ownership structure is clearly defined. The company’s value is split into shares, and each owner is allocated a portion. The entire stock allocation could go to one single owner or be divided between various titleholders.
For instance, a giant corporation such as Disney (NYSE: DIS) is owned by a wide selection of investors, each of which is allocated stock relative to their investment. These shareholders include company employees, investment advisors, hedge funds, insurance companies, sovereign wealth funds, pension funds, and individual investors (including high-net-worth individuals and retail investors).
When a company issues (sells) stock, it does so to raise money. This could be for many reasons, but most commonly to grow the company or invest in improving it. The company may use the money from selling its stock to pay for premises, machinery, staff, acquisitions, or more.
Investors buy stock in the hope it will appreciate in value. When a company’s value increases, so does its share price. This is called capital appreciation, and it’s one of the ways an investor can make money.
Another way is from dividends. Some company stocks come with a dividend yield which is like an interest payment. Not all stocks offer this, but some investors like to buy stocks with dividends attached, as it’s another way to realize a profit.
For many investors, stocks represent the backbone of their portfolios, although alternative investments are sometimes present too.
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How Do Stocks Earn a Return?
Stock investments involve higher risks but offer potentially greater rewards compared to other investment types. Investors primarily earn from stocks in two ways. First, if the stock's price rises during the period they own it, selling it at a higher price than the purchase price leads to a profit. Second, some stocks yield dividends, which are periodic payments made to shareholders, often on a quarterly basis, although not all stocks offer dividends.
Historically, the stock market has delivered an average annual return of about 10%. However, this figure represents an average across the market rather than a guarantee for individual stocks, and actual yearly returns can vary significantly.
For those interested in investing in stocks, the process involves opening an account with an online broker, akin to opening a bank account.
Where Can Investors Buy a Stock?
When a company first issues stock, this is called the primary market. Investors usually buy and sell stock on stock exchanges; these are referred to as secondary markets. There are many stock exchanges around the world supporting the trading of company stocks. Companies can also sell stocks via a private sale, but this is less common.
The trading of stocks via a stock exchange, such as The New York Stock Exchange (NYSE), is heavily regulated. This is to protect investors from fraud and provide credibility to the company.
While stock exchanges are government regulated, different levels of credibility are attached to the indices in which stocks are listed. For instance, stocks in the S&P 500 tend to carry more integrity than those listed on over-the-counter (OTC) markets.
Investors buy stocks from stockbrokers. Nowadays, there are many brokers to choose from online. In recent years it has become easier and cheaper to buy company stock and some brokers even allow fractional share buying.
What Does Stock Ownership Entail?
Shareholders own company stock but do not own the underlying assets of the business.
The corporation is a legal entity in its own right and is treated like a person. This means the business takes ownership of all its assets. Therefore, its property, land, and furniture are owned by the company and not by the shareholders.
Types of Stock
There are two main classifications of stock: common stock and preferred stock.
Common Stock
Most stock issued is common stock. That’s why it’s called common. Historically, common stocks have proved a lucrative investment, bringing owners capital appreciation and high yields.
Common stock usually comes with voting rights. So, owners receive one vote per share of stock owned. This gives them a voice in electing board members to oversee the running of the business.
Common stockholders sometimes receive dividend payments, but these vary depending on whether management deems it appropriate to pay dividends.
The owners of common stocks are last in line to be paid when things go wrong. For instance, if a company goes bankrupt or liquidates its assets, the common stock shareholders have the lowest repayment priority after creditors, bondholders, and preferred shareholders.
Preferred Stock
Owners of preferred stock don’t usually have voting rights, but they are given priority when it comes to dividend payments. In fact, they typically receive a guaranteed dividend payment for life. And they are ahead of common stockholders to be paid in the event of liquidation.
Different Stock Classes
Although Common and Preferred stocks are the most popular classification, companies can also organize stock in bespoke classes.
One reason for this is to ensure voting power is maintained by a specific group of shareholders, such as the founding family. In this instance, the class of stock would receive a higher number of votes per share than the usual one vote found in common stock.
When a company customizes its stock like this, it usually results in different stock classes listed separately on a stock exchange. Warren Buffett’s Berkshire Hathaway is the most famous example of this. Berkshire has Class A shares with the ticker symbol BRK.A and Class B shares with the ticker symbol BRK.B. Both list on the NYSE.
Each class of Berkshire shares references the same company, but the share price differs wildly, as do the voting rights.
Advantages of Owning a Stock
Making Money
The primary goal of owning a stock is to make money. If the company does well, the share price should appreciate, and the stock owners will profit.
Company Ownership
Some investors want to own a piece of the company and play a part in steering its journey.
Voting Rights
Owning company stock gives the holder voting rights and gives them a say in how the company is run.
Disadvantages of Owning a Stock
Financial Risk
When investors buy a stock, they risk losing their money if the company goes out of business. Alternatively, the share price may decline considerably from when the buyer purchased it, losing value.
Share Dilution
A business can issue new company shares whenever it wants to raise funds. This dilutes the existing share count, potentially reducing the share price value. This process sometimes makes an attractive investment if the company is making a promising acquisition. But it often annoys existing shareholders causing the share price to fall.
Where’s the ‘Value’ in Owning a Stock?
Own your favorite company: buying stock makes you a part-owner in the business. Owning shares in your favorite companies is a great way to start investing.
Low barrier to entry: you can start investing in a company with a small amount of money. Fee-free brokers have eliminated the barrier to investing so beginners can get started with as little as a dollar.
Easy access: buying stocks is increasingly easy so that beginners can get started with little fuss.
It can be lucrative: investing in the stock market has historically outperformed most other investments over a long period.
Share buy-backs: the opposite of a new stock issue is a share buy-back. This is when the company buys back a chunk of its shares, decreasing the pool of available stock. This benefits existing shareholders and often leads to a share price rise.