When you purchase stock you are purchasing a portion of a business. If a business has 1 million shares and you only have 100, then that’s just a small piece of the business. You do not have control over the company, but you have a stake in it and could gain if the company becomes more valuable on the stock market or pays a dividend.
This may sound like a simple question, but new investors often have no idea what they are purchasing, why the share price moves, or how people can make or lose money. Once you know those key principles, investing seems less like a black art and more like a science.
What Is a Stock?
A stock is a share of a company’s ownership. Businesses sell shares to generate capital to expand operations, to purchase additional equipment, for research and development, for acquisition or for other business expenses.
Assume a company has 1 million shares outstanding, and the value of the company is $10 million. In other words, every share is a small piece of ownership that is worth approximately $10. At this price, you would have invested $500 for 50 shares.
Having stock doesn’t give you the right to walk into the company’s office and take a desk or laptop! Financial ownership of the item. You can vote, get dividends, and have increased value if the business improves.
Stock, share and equity are used interchangeably. A share is a single share of ownership. Stock is the general term for an ownership in a company. Equity is the value of the company that is owned by the shareholders.
What are the reasons why companies sell shares?
A business might require capital to grow, to employ staff, to construct factories, to gain access to new markets or to create products. It doesn’t have to take out a loan from a bank, it can sell a stake in the business to investors.
Suppose that a company is expanding and requires $20 million to open new stores. It could sell 2,000,000 shares at $10 a share. Investors give the investment and receive a share of the company.
The company does not pay shareholders back on a specific schedule as with a loan. The investors assume the risk of the business falling short. They are also given the chance to benefit from the company’s success.
Private companies can go public by offering stock for sale to the general public, also known as an IPO. Following this, its stock can be traded on a stock exchange.
The share price is determined by the following
The primary factor determining a share price is supply and demand. When buyers are increasing, but sellers are decreasing, then the stock price tends to go up. More sellers, lower price.
Those demands are affected by business performance. Investors’ perception of a company may vary based on a variety of factors, such as revenue, profits, debt, new products, competitive standing, leadership changes, and economic conditions.
Assume that a stock is currently $40 per share. The company reports a stronger sales than expected and becomes more optimistic about the sales. The stock price could climb up to $46. If the company later reports falling profits, the price could drop to $35.
The price of any stock is not a measure of its affordability or unaffordability. It is possible for a company to have a higher value when the shares are $20, than when the shares are $200. Market capitalization is the share price times the number of shares outstanding, and is a factor that investors may consider when looking at a particular stock.
The market value of a company with 100 million shares that are valued at $20 each is $2 billion. Another company that has 5 million shares valued at $200 has a value of $1 billion.
How Investors Make Money From Stocks
There are two ways for investors to make money. The first is capital appreciation, when the share price goes up. The second is income from dividends.
If you purchase 20 shares at $25, you put in $500. If the price goes up to $32 later, and you sell, you will have made a profit of $640. You make a $140 profit before taxes and trading fees.
A dividend is an amount of money paid to shareholders of a company from the profits of the company. The quarterly dividend for a company may be $0.50 per share. If a company pays a dividend of $5.00 on 100 shares, the dividend on each share would be $5.00/4 or $200 per year, if the dividend remains unchanged.
Not all companies pay a dividend. Younger firms might use their profits for reinvestment in expansion. Dividend payments aren’t an absolute certainty, but they are more likely to be made by mature companies.
What does it mean when a stock drops in price?
Share prices can drop—sometimes rapidly. When you purchase 50 shares at $30, you are making a $1,500 investment. The price falls to $20, the position is valued at $1000. This is a drop of $500.
You don’t have the loss if you don’t sell, but its lower value is a reality. The price could bounce back, stay down or stay low for years.
A company may also be completely bankrupt. In the event of bankruptcy, shareholders will typically be the last to receive repayment after creditors, employees, bondholders and lenders. Sometimes the stock can drop in value to almost zero.
This is the reason it’s dangerous to invest all of your funds in just one company. A diversified portfolio is a portfolio that is divided into several businesses, industries, and sometimes countries.
Common and Preferred Stock
Common stock is purchased by most individual investors. Common shareholders can vote on issues and can be paid dividends if the board decides to pay.
Preferred stock is different. Typically, preferred shareholders are expected to be paid dividends before common shareholders and are likely to receive a more stable dividend payment. But they typically lack the right to vote or they do not vote at the same rate as the general public.
Assume that a company pays a preferred dividend of $2 per share annually. If a company pays $400 annually, then a 200 share investor would get $400 annually.
Preferred stock can have characteristics of both bonds and stocks. It can generate income, but it also has company and market risk.
Understanding the basics of the Stock Market
The stock market is a system used by investors to purchase and trade shares. Major exchanges link buyers and sellers; brokerage firms link buyers and sellers to the exchanges.
As the customer makes an order with a brokerage, the broker submits that order to some sort of market where it can be matched with another investor’s order. Maybe you purchased 10 shares for $15 apiece and another investor sells those 10 shares.
Market prices fluctuate during the day of the week. Prices can be influenced by news, earnings reports, interest rates, economic data and investor emotions.
Stock market indexes are used to monitor the performance of the stock market of a group of companies. The index could track 500 of the largest companies or it could track a certain industry like health care or technology. Those who want to invest in a large number of stocks can do so via index funds and exchange-traded funds.
What is the best way to invest in stocks?
Typically, a brokerage account is required to purchase stocks. Many online brokers do not require a minimum deposit and offer fractional shares that enable you to invest a dollar amount rather than buying one full share.
What is the payment rate for the stock?If a stock is $250, but you only have $50 to invest in it, what is the payment rate for the stock? If the broker has fractional shares, he or she can allow you to purchase 0.2 of a share.
Be sure to learn about the company’s business, revenue, profit, debt, competitors, and risks before purchasing. Don’t purchase just because prices recently went up, or because another web page predicts a rally.
It is easier for the novice to invest in a broad stock market index fund than to pick individual stocks. A $100 investment in one fund can give you exposure to hundreds of businesses, $100 invested in one stock rests on the shoulders of one company.
Stocks, Bonds, and Funds
Stocks represent ownership. Bonds represent debt. A bond is a loan made to a company or government that pays interest and will return the money back to the lender if it is not to be redeemed.
Funds are a collection of investments. There can be hundreds of stocks and bonds in a mutual fund or ETF.
For instance, by investing $1,000 in one company, you have exposure to that one company. A fund with 500 companies distributes $1,000 of funds amongst a larger population of companies.
The price volatility associated with stocks is typically higher than the price volatility associated with cash or many bonds, but this volatility can be expected to be higher in the long-term. This combination will vary based on your objectives, time horizon, and tolerance for risk.
Before you invest, here are a few things you need to know
If you have the funds to invest in the next several years, it is probably not a good idea to put them into stocks. The stock market can fall just when you need to withdraw.
Suppose that you have $5,000 set aside as a home deposit for next year. The account may drop to $4,000 if the market declines 20%. You’d end up $1,000 out when you’re in the middle of the event.
The longer the time horizon the more time the investor will have between declines, but there is no guarantee of recovery. If you have emergency savings that are separate from investments, you may not be tempted to sell them when the market is down.
There is also a factor of fees and taxes. A 1% annual fee costs $10 per year on a $1,000 investment and $500 per year on a $50,000 portfolio. Depending on your country and account type, investment gains and dividends could be taxable.
The Bottom Line
A stock is a small share in the ownership of a company. It can fluctuate depending on the performance of the business, expectations of investors, and the general state of the stock market.
Income can come from a higher share price, or a dividend, but not necessarily. While stocks might appreciate over time, they can also depreciate.
Novices can minimize risk by educating themselves about investing, diversifying, keeping costs low, and investing funds they wouldn’t need in the near future. To make informed investment decisions, the first step is to understand what is a stock.
Frequently Asked Questions
What is a stock in layman’s terms?
Stock is a small percentage of ownership of a company. If you purchase one you are also a part owner of that business and could profit if its value increases or it generates a dividend.
May you lose 100 percent of your investment in stocks?
Yes, if the company fails, then a stock can go from close to being worthless to losing its value entirely. By spreading your investments across numerous companies, you won’t lose everything if one company fails.
What is the amount of money you have to invest in a stock?
There are some brokers who will offer to allow you to begin with as little as $1, even making use of small shares. It varies by brokerage company, investment type and regulations by country.
Disclaimer:
This article is for general educational purposes only and does not provide personalized financial, investment, tax, or legal advice. Stocks can lose value, dividends are not guaranteed, and past performance does not predict future results.
