Do you actually know what a “stock” is? Don’t be afraid to admit that you don’t. I would bet that a lot of people who say they do (or think they do) do not in fact actually understand what one really is.
One of the fundamentals I preach on MyMoneyDesign is to know what it is that you’re putting your money into when you invest. So if you invest in stocks, let’s explore of the introductory basics of what they are.
A stock is a stake of ownership in a company. Whenever a company needs money and it doesn’t want to borrow it (debt), it sells “slices” of its ownership called shares. Ownership of these shares is also called having equity.
Why do companies issue stock? Pretend I wanted to raise a bunch of money for MyMoneyDesign. I could go to the bank and borrow some money (say $10,000). But that would put me in debt and I don’t want that! Instead, I could sell you and nine other people each 10 shares of my blog at $100 each (10 shares x 10 people x $100 = $10,000).
Why Would We Want to Buy A Share of Your Blog?
The reason you’d want to do that (or buy any stock) is because you’re hoping to make money from it. Say MyMoneyDesign gets really popular and the company really starts to take off generating earnings. A few things would happen:
• The value of your stock shares would increase (called capital appreciation). This gives you the opportunity to sell them at a higher price and make a profit.
• You may receive a small percentage of the profits in the form of quarterly payments called dividends.
Going back to the definition, being an owner in the company gives you certain privileges. For example, each (common) share counts as a right to vote. This means you can elect board members or have a say in what goes on with some of the activity. If you own enough shares (usually millions of them) you could become a majority shareholder and dominate control!
Also, being an owner means that if the company were to be dissolved, you’d also be entitled to a share of the remaining assets (assuming there was anything left).
What Determines a Stock’s Price?
Like all things, a stock is only worth what someone will pay you for it. Luckily, there is an active place where this is happening all the time: The stock market.
When a company first offers stocks, the company and the broker arranging the initial public offering set a price. But after that, the economic principles of supply and demand within the stock market take over.
For example, say MyMoneyDesign has a really strong balance sheet or is about to release something really cool that people want. Demand would take over and the stock price would flare up to $110.
But now let’s say my competitor does something even better. Perhaps now my stock value goes down to $90. It may even go down even though the health of my company is just fine.
There are some intrinsic factors about the company that help sway a stock’s price (like its book value). But ultimately, the market still determines the price you see on the ticker.
Does a Company Benefit From Stock Price Increases?
Not directly. In terms of the shares, once a share of stock enters the market, the issuing company has no control over what happens to them. They can change hands any numbers of times and get sold for whatever people will pay for them.
Say MyMoneyDesign’s $100 share value goes up to $150 and you sell it on the stock market. MyMoneyDesign doesn’t get the $50 increase, you do!
So why would MyMoneyDesign care about its own share price if they don’t get anything from it? Because indirectly this would now give me the ability to issue (sell) new shares at $150 each – resulting in a lot more money for me! Alternatively, if my shares decreased all the way down to $0, then I wouldn’t have a pray of anyone wanting to buy any new shares of my company, so I wouldn’t be able to raise any new money!
Be aware that a company’s Board of Directors ultimately answers to its shareholders. So it is in the interest of the Board along with every executive below them to ensure that the stock remains profitable.
What Makes a Good Stock?
In a later post, we will explore some of the valuation techniques that one can apply to quantify the value of a stock.
I hope this introduction was helpful. Did you understand what stocks are or how they work?
Photo Credit: Microsoft Clip Art