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?
1) What Does “Stocks Return 8 Percent Each Year” Actually Mean?
3) Why I Finally Sold My Apple Stock
Photo Credit: Microsoft Clip Art
This was a great description MMD! It would be nice to sell shares of your website for $100 a pop. I think that’s a little too rich for my blood. 🙂
What? 🙂 10 shares x 10 people x $100 is only $10,000! I’d say that’s a bargain! Especially since I’m taking this baby all the way to $1M!!
[email protected]&More says
I knew what stock was but this was a great explanation. Most people should be able to understand it after reading this post.
Thanks Lance! I’m trying to make sure I cover all the basics as well as the more complicated things.
Modest Money says
Thank you for this explanation MMD. I do know the basics, but I realize that some people are still just learning this stuff. While it would be nice to be able to sell shares of a blog, I’m sure most bloggers would hate to give up the control they have over things.
Doing posts like this helps me to get more solid on my own understanding. Although the example is hypothetical, it would be kinda cool to issue your own stock shares. Think Modest Money will ever go public??
Great 101 piece, MMD! Also, stock price going up helps the company take on new debt or negotiate a lower cost structure for debt (traditional loans, not bond sales). A couple CFO friends of mine are always looking at the stock price in hopes of either expanding the company or relieving some interest rate pressures. In that way, I think the stock price going up DOES very nearly directly benefit the company.
Good point! I’m sure there are many other more technical reasons why managers and stakeholders want the price to go up. I plan to write several of these types of 101 pieces so that I can build upon them later in more intermediate and complicated posts.
a blinkin says
I like your explanation. A lot of people view stock as an investment but do not view it as ownership. They have no desire to understand the business they’re buying into.
Thanks! I feel as though the whole ownership aspect sometimes gets lost; probably since most of us buy such few shares for it to make a difference.
Anthony Thompson says
This is the best explanation of stock investing if I’ve ever read one. It’s not only clear, but it’s also idiot-proof. This is to insult those who don’t know much about stocks. It’s as you stated, “lot of people who say they do (or think they do) do not in fact actually understand what one really is”.
I love how you used blog ownership to illustrate your points about investing in stocks.
Thanks! I’m glad it came across easy to understand and concise. I thought using the blog would be something that most of the readers could relate to (since most of my commenters are fellow bloggers!)
Wonderful explanation! While I know what a stock is I don’t know a lot about investing. But I bet this post will be quite useful for those wanting a clear cut definition.
I’m here to help! I’ll be adding this one to the Start Here page for easy future reference if you ever need it!
excellent description!.. i am going to send this to a few folks i know.
Thanks! And please do pass this around! I plan to build upon these concepts with more posts to follow.
Being a shareholder gives you the opportunity to grow with the company and reap the rewards if the company does well! Pick wisely though, you can lose your money very quickly if valuation on the stock goes down dramatically. The big boys control the market I think… for retail investors like us, we just have to follow the trend and try not to get left behind! It’s been really choppy in the markets lately. May seem a little daunting for new investors, but look for opportunities when the stocks are a bloody mess. I knew what a stock was but never really thought of it that way… Thanks for explanation, love your examples!
Thanks! I’m suspicious that the big boys have more control than they let on. But for us regular people, I still think there are opportunities – just not at the same magnitude. For example, I don’t remember Bank of America offering me preferred shares with 6% dividends like they did for Warren Buffet. But regardless, I still give a try. With interest rates as low as they are, I’m pretty good with just getting an Index Fund 8% return.