Stocks, Defined: What Is Stock, Anyway?
Carey Chesney8-minute read
February 18, 2022
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Most Americans have a vague understanding of what stocks are, usually based on sensationalized movies or a hard-to-read statement from their retirement fund every few months. You’ve probably heard of the stock market, Wall Street and a few peripheral phrases like “bull market” or “buy low and sell high.” This may leave you wondering, “what is a stock, anyway?” Sometimes referred to as shares or equity, stocks are essentially parts of ownership in a company. These pieces of ownership can be bought and sold on a stock market, with their value constantly changing based on supply and demand. Beyond that basic definition, increasing your knowledge of what stocks are and how they work can be a useful endeavor, often leading to future financial success. Here we’ll take a deeper dive to increase your understanding of stocks, beyond just images of business suits and jumbled neon letters on a moving ticker display.
How Do Stocks Work?
When corporations sell ownership in their companies to raise money, they’re issuing stocks. This means when you buy stock in a company you actually own a part of that business. Pretty cool, right? While it can be exciting to think of yourself as a partial owner in a company, it may leave you wondering, “What does that really get me?” There are some key benefits that are instantly yours the moment you buy stock. Beyond your stock certificate – the physical piece of paper verifying your ownership in the company – you now have a claim to part of the company’s assets as well as its earnings. You’re also entitled to an annual report on how the company is doing, an important piece of information that can help you decide if you want to buy more stock in the business or sell the shares you’ve acquired. If you find yourself owning enough stock in a company, it may offer you a position on its board of directors – the governing body of the company that guides its plans for the future. Even if you don’t hold that much, your piece of stock, however small, affords you a voice in the decisions the company faces each year at the annual shareholders meeting.
Once your stock in the corporation is put on the public market, you can buy and sell it at your own discretion, all the while keeping an eye on the stock’s changing value. “How does the stock’s value change?” you may ask. This basically comes down to supply and demand. If more people want to buy the stock, it’s worth more. If fewer people want to buy it, the value goes down. This may seem like a far too simple explanation for something that most people view as a complicated and ever-changing institution of the American financial system. Well, it is. First off, much of the value of stock has to do with speculation. This means that people buy based on what they think the stock will be valued at in the future, rather than taking into account only its current value. In addition, the value of a company is more complicated than the value of its stock. Remember, stock demand is only a reflection of what investors think the company is worth, or what it will be worth in the future. The actual value is determined by its market capitalization, which is the stock’s price multiplied by the number of shares. For example, a company with 10 million shares selling at $100 a share would have a market cap of $1 billion. So how does market cap go up and increase stock value? The simple answer is the company’s earnings.
The profits a company makes – also known as earnings – are really the most important measure of its value. Makes sense, right? When more money is coming in and being distributed to investors, the market capitalization goes up and more people want to buy the stock. If profits dry up, the market cap declines and investors are no longer interested in buying the stock. Public companies are required to report their earnings every quarter of each year, and, as you may have guessed, good investors pay attention to what they report. Earnings reports are a critical piece of information to pay attention to when deciding which stocks to invest in and which ones to leave alone, as they are the single biggest indicator of how a stock will perform. Furthermore, how the earnings of a company compare to what people are expecting to see affect the market greatly as well. If the company reports earnings that are surprisingly good, the stock goes up. If they report earnings that don’t meet expectations, the stock drops.
- Joint Stock Company Definition: A joint stock company is owned by shareholders who each have company stock in proportion to the number of their shares. Some may own more of a company's share than others, but all shareholders are able to transfer their shares to others as they see fit. The most important distinction between being a shareholder in a joint stock company as opposed to a public company comes down to liability. Shareholders in a joint stock company are liable for the company's debts only to the value of the money they have invested, a limitation of loss that is not placed on shareholders in public companies. This limited liability is very attractive to investors. If they decide to become a shareholder, their money cannot be attached to the debts of the company. If the company they invest in is mismanaged and goes belly up, the shareholder doesn’t go belly up with it.
Common Stock And Preferred Stock
The two main types of stock are common stock and preferred stock. These are similar in how they work and how they are bought and sold, but with a few important differences. There are two key distinctions regarding how they’re paid out and how much of a voice they give you in a company. Common stocks give you voting rights as a shareholder in a company. Preferred stock, in contrast, usually doesn’t give you voting rights. In terms of the company’s income, preferred stock shareholders take precedence. This means they are paid dividends before shareholders with common stock. Ultimately there are advantages and disadvantages to both common stock and preferred stock. Let’s take a deeper look at the key differentiators so you can make an informed decision when selecting between the two.
- Voting Rights: Voting rights, as you may have guessed, give you a voice in a number of decisions the company has to make. Most of this occurs at the company’s annual shareholders meeting, which is often required by law to be held each year. Voting rights can give you a say on many aspects of the company, including who gets to sit on the board of directors, as well as the establishment of corporate policies and objectives. If you choose, you can transfer your voting rights to another person without giving up your shares in the company, a practice called proxy voting. And as a bonus, in some instances, a shareholder can receive cash for their vote. Voting rights represent a key example of how holding stock in a company truly makes you a part owner of the business.
- Fixed Dividends: Dividends – the money a company pays to shareholders out of its profits – are not paid to everyone at the same time. Preferred shareholders get paid before common shareholders. Sometimes these dividends are fixed, meaning that the amount you get paid each year remains the same. This amount remains constant year over year, regardless of what happens in the company – even if it goes bankrupt or is liquidated. Like regular dividends, preferred stockholders are paid before common stockholders regarding fixed dividends as well.
As you can see, there are benefits to being either kind of shareholder, depending on what you want your relationship with the company – and your money – to be. While you lose voting rights as a preferred stockholder, you get paid first when the money comes in and the amount is guaranteed. As a common stockholder, you get a vote but need to wait a bit longer for your cash, all the while not knowing exactly how much it will be.
How To Invest In Stocks
Now that you have a pretty good understanding of how stocks work, you are likely wondering how to get started investing. First, carefully select a broker. Online options are abundant, but you can also set up in-person appointments if you’re more comfortable with a face-to-face experience. Most importantly, select a broker who shares your investing philosophy and is geared toward your level of experience. Some cater to beginners, while others focus on the seasoned investor. Some lean toward higher risks and rewards when selecting stocks, while others take a very conservative approach. Also, prices and services vary greatly depending on what you’re looking to do and whom you’d like to do it with. Think about what type of investor you want to be – not to mention how much you want to spend – and find a broker who aligns accordingly.
Once you have selected a broker, it’s time to figure out what companies you’d like to buy stock in. Remember, you are part owner in this company, so think about what you value in terms of philosophy and operating principles for a business. Combine this with thoughtful consideration of which companies you think will increase their – and your – profits over time. How do you get all this critical info? It’s easier than you might think. Reviewing a company’s earnings reports, annual reports and stock history, as well as researching their competitors, is a good place to start. Also, beginning with companies you already know a little bit about is a good strategy. If there’s a company with products and business philosophies you love, chances are their earnings are solid and they may offer a desirable stock.
Found the company you want to invest in? Now it’s time to decide the number of shares you want to buy. Start slow and make conservative choices about how much to buy – you’re not quite the wolf of Wall Street yet. Wait until you’re comfortable with your stock selection process and the amounts in play before you start to ante up more of your hard-earned cash. Most of all, have a plan and stick to it. Keep in mind your plan may have a lot to do with your age. Younger people are often interested in stocks that offer more reward, but this usually is associated with more risk. As you near retirement, you may be well-served to take a more conservative approach so you don’t lose that nest egg you’ve worked so hard to accumulate.
Is It A Good Idea To Get Into The Stock Market?
If you’re interested in building assets that can help with your current finances or move you toward early retirement, jumping into the stock exchange might be for you. However, keep in mind that saving and investing are never without risk, as markets can decline and companies can become unprofitable. Even so, taking a thoughtful and calculated approach as you dip your toe into the stock market waters can be lucrative for now and the future. As with anything related to your personal finances, research and focus are critical. Do your homework and pay attention to how your stocks are performing to ensure you’re getting the most bang for your buck.
The Bottom Line
So now you understand what stocks are, how they work, the various forms they can take, and how to invest in them. Knowledge is power when it comes to playing the stock market, so build on the base of information you’ve gained here before you start investing. With some research – and perhaps a little courage – you’ll be trading in no time and working toward more financial security and freedom.
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