What is a Stock?

What It's About

Representing an ownership share in a company, investors buy stocks that they think will go up in value over time.

A stock is an ownership share in a company. A company issues stock to raise cash to fund its business, giving the buyer ownership in the business. As a stockholder, a stock entitles you to certain rights: the right to any dividends paid, the right to vote on who sits on the board of directors, the right to attend the company’s annual meeting, and others. While many investors and traders forget, it’s important to remember that a stock is a share in a real business, not just a fluctuating number on a computer screen.

Stocks are among the most widely followed securities because of their potential to build wealth over time. Stocks also allow individuals to have an ownership stake in a business, preserve wealth against the ravages of inflation, and enjoy a comfortable retirement. Most of the world’s wealthiest individuals and families have huge stock holdings, and owning stocks helped them get there.

At any moment in time a stock’s price is what investors think the underlying company is worth.

Stocks often trade on an exchange where investors can see what other investors are paying per share. This is called publicly-traded stock, and anyone with enough money (and a brokerage account) can purchase a share in the business and become a real owner of it. Many companies issue stock, but only a relatively few trade in the stock market, and these companies tend to be among the world’s best.

How stocks can make people wealthy

Stock offers a number of benefits, but investors are most interested in it because it has the potential to make them wealthy over the long term, if they can find attractive companies to buy. But at any moment in time a stock’s price is what investors think the underlying company is worth. That depends a lot on how the business performs, but in the short term it also depends on investors’ fear and greed, hopes and expectations. However, over time the stock price reflects the performance of the company, not investors’ short-term fears and worries. As the business grows, investors recognize that and bid up the price of the stock.

In theory, a stock price is the present value of all the company’s future cash flows. In practice, the stock price wiggles around a lot day to day. Sharp investors look for when investors are too pessimistic or fearful so that they’re willing to sell their stocks for much less than what the stock is worth over time.

Huge companies such as Google have seen their stocks grow many time times in value over the last ten years, because they are consistently and rapidly growing their earnings. But the stock market is forward-looking, so even companies such as Amazon — which has very high sales growth but low profits — can perform well if they continue to dominate their industry, as Amazon has done in online retail.

Investors who earn this kind of gain are those who research and invest long-term, buying to hold. (For investors who want stock-like profits but not the hassle of researching individual companies, there are exchange-traded funds (ETFs) that package stocks into a diversified fund that trades like a stock.)

When a stock goes up, investors have made money on paper, though they don’t have cash in hand until they actually sell the stock (and incur a tax, if they’ve made a profit, or capital gain). But there’s another way to get cash from a stock without selling it, and that’s the dividend. A dividend is a cash amount that the company pays, often quarterly, to holders of its stock. It’s like a reward for being a stockholder.

American companies prefer to pay a consistent and growing dividend over time, and they’ll pay a per-share amount, usually each quarter. If a company pays a $0.50 dividend and you own 100 shares, you’ll receive $50 on the company’s next dividend date, assuming you hold the stock then. Not every company pays a dividend, but most well-established companies do, and dividend stocks are popular with investors (such as retirees) who are looking for income, rather than capital gains.

Of course, dividend stocks can rise, too. If the company consistently grows its dividend, investors will pay more for the stock over time. So dividend investors can often get their payout and a capital gain.

What is a stock price?

A stock price on its own doesn’t tell you a lot of information, but it does tell you what investors are willing to pay for a slice of the business. But just how big a slice, and how big is the business?

A useful analogy is a pizza cut into slices. Which is more valuable — a slice of pizza from a pie cut into 10 slices or a slice from a pie cut into 50 pieces? Well, the first sounds better, but you don’t actually know until you understand how big the total pie is. A tiny slice from the world’s biggest pizza could be huge.

The important point to know is that all of a company’s shares (its slices) added up together comprise the value of the company, what investors call the its market capitalization. The market cap shows how investors are valuing the company as a whole, not just a slice of it.

So how big is each company’s pizza pie?

It’s easy to figure out. (In fact, finance websites report this information for you.) Some companies have billions of shares, while others have just a few million. You just multiply the number of shares by the stock price. That’s the total value of the company.

For example, imagine two different companies, with stock prices of $10 and $20. It seems like the second company is twice as valuable as the first. But if the first company has 100 shares issued, while the second has 50 shares, then what is the market cap of each company? In both cases, it’s $1,000. So the market values the companies the same, yet the stock price of one is twice that of the other.

Understanding the size of the pie helps investors understand what they’re actually buying when they pay $10 or $20 or $100 per share. The actual number of shares and the stock price depend on each individual company, and so investors can’t say a $100 stock is twice as valuable as a $50 stock.

By Mackenzie O'Connor
Wealthbase Contributor

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