Stock basics

Over the last few decades, interest in the stock market has grown exponentially. What was once a toy of the rich has now become accessible to anyone who wants to grow his or her wealth. Advances in trading technology have opened up the markets.

Despite their popularity, however, most people don't fully understand stocks. They aren't a magic answer. And although stocks can–and do–create massive amounts of wealth, they aren't without risks. The only solution to this is education. The key to protecting yourself in the stock market is to understand where you're putting your money.

Definition

Plain and simple, stock is a share in the ownership of a company. Stock represents a claim on the company's assets and earnings. As you acquire more stock, your ownership stake in the company becomes greater. Whether you say shares, equity, or stock, it all means the same thing.

Owning stock

Holding a company's stock means that you're one of the many owners (shareholders) of a company. As such, you have a claim (albeit usually very small) to everything the company owns.

Technically, you own a tiny sliver of every piece of furniture, every trademark and every contract of the company. As an owner, you're entitled to your share of the company's earnings as well as any voting rights attached to the stock.

Stock certificates

A stock is represented by a stock certificate. Before the computer age, it was a fancy piece of paper that was proof of ownership. Today, your brokerage keeps these records electronically, which is also known as holding shares "in street name."

This is done to make the shares easier to trade. In the past, when a person wanted to sell his or her shares, that person physically took the certificates down to the brokerage. Now, trading with a click of the mouse or a phone call simplifies transactions.

Limited power

Being a shareholder doesn't give you the right to intervene in the day-to-day running of the business. Instead, one vote per share to elect the board of directors at annual meetings is the extent to which you have a say in the company.

What are voting rights for? The management of the company is supposed to increase the value of the firm for shareholders. If this doesn't happen, the shareholders can vote to have the management removed. In reality, individual investors don't own enough shares to have a material influence on the company. It's really the big boys like large institutional investors and billionaire entrepreneurs who make the decisions.

Regardless of your limited power, the idea is that you don't want to have to work to make money. Being a shareholder means that you're entitled to a portion of the company's profits and assets. The more shares you own, the larger the portion of the profits you get.

Your claim on assets is only relevant if a company goes bankrupt. In case of liquidation, you'll receive what's left after all the creditors have been paid.

Limited liability in case of bankruptcy Another extremely important feature of stock is its limited liability. As a shareholder, the maximum amount you can lose is the amount of your investment. Even if a company of which you're a shareholder goes bankrupt, you can never lose your personal assets.

Other companies, like partnerships, are set up differently. If a partnership goes bankrupt, creditors can go after the partners (shareholders), who can be forced to sell off their personal assets (house, car, furniture, etc.) to pay the company's debts.

Debt vs. equity

Why does a company issue stock? Why would the founders share the profits with thousands of people when they could keep profits to themselves?

The reason is that at some point every company needs to raise money. To do this, companies can either borrow it from somebody or raise it by selling part of the company, which is known as issuing stock.

A company can borrow by taking a loan from a bank or by issuing bonds. Both methods fit under the umbrella of debt financing.

Issuing stock is called equity financing. Issuing stock is advantageous for the company because it doesn't require the company to pay back the money or make interest payments along the way. All that the shareholders get in return for their money is the hope that the shares will some day be worth more.

The first sale of a stock, which is issued by the private company itself, is called the initial public offering (IPO).

Risk

It's important that you understand the distinction between a company financing through debt and financing through equity. When you buy a bond, you're guaranteed the return of your money (the principal) along with promised interest payments.

This isn't the case with an equity investment. By becoming an owner, you assume the risk of the company not being successful. Just as a small business owner isn't guaranteed a return, neither is a shareholder. As an owner your claim on assets is lesser than that of creditors. This means that if a company goes bankrupt and liquidates, you, as a shareholder, don't get any money until the banks and bondholders have been paid out; we call this absolute priority.

Shareholders earn a lot if a company is successful, but they also stand to lose their entire investment if the company goes bankrupt.

Dividends

Some companies pay dividends to their shareholders, but many others do not. Dividends come out of net profits, and there's no obligation to pay out dividends even for those firms that have traditionally given them.

Without dividends an investor can make money on a stock only through its appreciation in the open market. On the downside, any stock may go bankrupt, in which case your investment is worth nothing.

Although risk might sound negative, there are benefits. Taking on greater risk earns you a greater return on your investment, which is why stocks have historically outperformed other investments such as bonds or savings accounts.

Types of stock

Common stock. The majority of stock issued is in this form. Investors get one vote per share to elect the board members, who oversee the major decisions made by management.

Over the long term, common stock, by means of capital growth, yields higher returns than almost every other investment. This higher return entails the most risk. If a company goes bankrupt and liquidates, common shareholders will only be paid after creditors, bondholders and preferred shareholders.

Preferred stock. With preferred shares investors are usually guaranteed a fixed dividend forever. This is different from common stock, which has variable dividends that are never guaranteed. However, voting rights differ: investors only vote if the company hasn't paid dividends for a stipulated length of time.

Conversely, in the event of liquidation, preferred shareholders are paid off before the common shareholder (but still after debt holders).

Preferred stock may also be callable, meaning that the company can buy back the shares at anytime for any reason (usually for a premium).

Different classes of stock

Common and preferred are the 2 main forms of stock; however, companies may customize different classes of stock in any way they want.

The most common reason for this is the company wanting the voting power to remain with a few shareholders. For example, 1 class of shares would be held by a select group who are given 10 or even 100 votes per share, while a second class would be issued to the majority of investors who are given one vote per share.

Single vote (or restricted-voting) stock are designated as Class A, and superior (or high-voting) stock are Class B.

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