You’ve heard a lot about it. You may have flipped past MSNBC and saw the green and red arrows and the acronyms and wondered “What does it mean?” and “Why do people care so much?” Before we go into what those arrows mean and why the talking heads on those networks continue to blab on let’s strip away all the opinion and discuss the facts concerning stocks. (You’ll notice I am not going to discuss much of the mechanics of how stocks are traded that is the subject of the next lesson).
- Stock (share or equity) represents a part ownership of a company.
- The return on a stock comes from capital gains and dividends.
- A brief lesson on corporate structure.
- Common stock and preferred stock differ in some key ways.
What is a Stock?
Stock (also commonly referred to as equity) is a piece of ownership of a company. Stocks are sold in shares. Say I have one share of Coca-Cola Inc. stock. Based on the approximately 4.38 billion shares currently held by investors I own 0.00000002% of the entire Coca-Cola Company which is pretty neat to think about. So a stock in essence represents your ownership of a company of your choosing. Now why would you want to own a piece of a company? Two main reasons:
1. Stocks are traded everyday on the NASDAQ and New York Stock Exchange with investors buying and selling different stocks. As a result of new information and other factors stock prices change and thus if you buy a share of stock in a company and the stock price increases, you can sell that share and you have made a profit. On the flipside you could buy a share of stock and then it could drop in value. Thus you would have a loss on the investment should you sell it.
2. As a stock owner you are entitled to a share of the net income the company makes. Companies distribute these payments to stockholders usually every quarter (3 month periods called Q1, Q2, Q3, and Q4) and these payments are called dividends. Thus by holding the stock you receive payments. An important warning about dividends: a company is not required to pay dividends. You will notice many young companies do not pay dividends as dividends decrease the cash a company has available and young companies wish to use this cash for growth. Companies have different dividend policies, this is something to pay attention to.
An Example of a Stock Investment
Say I buy a share of Stuff Inc., headquartered in Rainbowville, at $100. Let’s also assume that Stuff Inc. has a dividend policy pays a $1.00 dividend every quarter. At the end of the year the stock price of a share of Stuff Inc. is now at $200. My investment made me wealthier in two ways. The first way is that the stock became more valuable over the time period, thus I made money on the sale. This money made on the sale of the stock investment is referred to as the capital gains or capital appreciation (the value of my asset increased or appreciated in value). The second way I received income from the investment were the $1.00 dividends I received each quarter. Together these two components make up the return on my investment.
The Stockholders are in Charge
In theory a public company (a company whose stock is traded on an exchange) is run by its shareholders. Remember when you bought that Coca-Cola stock? You’re a shareholder. “But Colby,” you say “I don’t think Coca-Cola is going to call me and ask me how the company is going to be run.” You’re right! So how are you in charge of the company again?
A Brief Mini-Lesson on Corporate Structure
Many key players when it comes to running a public company, but we will focus on three main groups. The first group is the shareholders. These are either individuals or big institutions , like state pension funds or insurance companies that own stock of a company. The second group is the Board of Directors (BOD). The Board of Directors is a group of individuals (anywhere from 8-15 people) that usually are highly qualified and accomplished business people whose job is to oversee the management and operations of a company. The third group is the management of the company (CEO, CFO, COO). These men and women are responsible for the day-to day-operations and profitability of the company.
So how do the shareholders ultimately control the company again? Shareholders are allowed to vote for those who serve on the Board of Directors, while the Board of Directors serves as the “watch dog” on the company’s management, ensuring that management acts in the best interest of the shareholders.
When people refer to “buying stock” they are generally referring to buying common stock. Common stock gives the shareholder the right to vote on the elections of the board of directors and on important company policies. An important risk associated with common stock is that if the company is liquidated (goes bankrupt), the common stockholders are residual claimants; said otherwise, the common stock holders receive payment last after the government, bond holders, and everyone else associated with the business has been paid. In addition there is the basic risk that stock can increase or decrease in value and dividends may or may not be paid.
What is Preferred Stock?
Preferred stock is different than common stock in a few key ways.
- Preferred stock is usually nonvoting. (I.e. you don’t get to choose who serves on the Board)
- Preferred stock holders have a higher claim on assets in case of liquidation. (Preferred stock holders get their investment back before common stock holders)
- Preferred stock usually pays the stockholder a near guaranteed dividend semiannually (twice a year) that are paid before dividends to the common stockholders.
- Because preferred stock has an almost guaranteed payment, its price may not be subjected to the amount of price fluctuation common stock is; thus there is less chance for capital appreciation.
- Some preferred stock has a cumulative dividend property. This means that if the Board of Directors decide to skip a dividend payment, before anyone else is paid dividends the cumulative preferred stock holders must be paid the skipped payments first.
Now before you run off and try to buy Google stock, you may want to know how these stocks are actually traded. This will be explained in the next lesson.
- Stock: a percentage of ownership in a company (also called a share or equity)
- Shareholder: a person who owns stock in a company (also called a stockholder)
- Dividends: periodic payments usually made with cash or stock paid to stockholders
- Common stock: stock with voting privileges whose value is derived from possible capital appreciation and dividends
- Capital appreciation: an increase in the value of an asset
- Preferred stock: stock usually without voting privileges whose value is derived from almost certain semiannual dividend
- Board of Directors: business executives elected by the shareholders of a company who are charged with monitoring the activities of management and ensure they are acting in the best interest of the shareholders
- Common Stock (Investopedia)
- Common Stock vs. Preferred Stock
- A Very Comprehensive View of Corporate Governance