Everybody knows the old maxim buy low, sell high, and we all hear rumors around the water cooler about stocks that are poised to take off. Some people think that's all you need to know to make a killing in the stock market.
Those people are wrong.
Before you begin to invest in stocks or actively trade them, it's crucial for you to understand exactly what a stock is and the fundamentals of how the stock market works. After all, you're looking to put your money on the line and you should be informed before taking that first step. A stock is a type of security reflecting ownership in a publicly traded company.
Included here are important items to know before plunking down money for that first investment or initial trade, including: what it means to own stock; a comparison of stocks to bonds and a list of potential risks and rewards; an explanation of how stocks are bought and sold in the primary and secondary marketplaces; a discussion of the rights and protections of stockholders; a comparison of common and preferred stock; and insight into the NYSE and NASDAQ markets. Last, but certainly not least, you'll learn about two major forces on stock prices – supply and demand and quarterly earnings reports. All of this is essential knowledge for any aspiring trader or investor.
Stock and bonds: How companies raise money
As companies evolve over time, sometimes they need to raise capital in order to expand operations, buy new equipment, build a new factory or office building, and myriad other purposes. For smaller endeavors, it may be possible to borrow money from a bank to cover expenses. When very large sums are needed, however, companies may instead decide to issue securities to the general public.
One way to go about this is to borrow money by issuing debt securities like bonds. When corporations sell bonds, they're borrowing money from the institutions and members of the public who buy them. In return for the loan, bond buyers expect to receive interest payments and then receive the full face value of the bond at a specified date in the future.
However, if a company does not wish to be saddled with interest payments to creditors and face repayment of the debt on a specified date, they may instead choose to issue equity securities like stock in order to raise the money they need.
Risks and rewards of stocks vs. bonds
When you own a stock, nothing is guaranteed. If the firm goes bankrupt, you can potentially lose your entire investment. There may be nothing left over for you as a stockholder once the banks and bondholders have been paid off during liquidation _ stockholders claim lower priority in a bankruptcy filing than creditors.
On the other hand, if the company does well, you may stand to gain much more than bondholders. Not only might you receive dividends if the company is profitable, the value of the stock itself may also increase over time — sometimes with spectacular results. Although bondholders are typically exposed to less risk, they only stand to gain interest payments over time, which generally is less than potential gains from stocks.
When investing in stocks, your objective is to take calculated risks so that your assets will appreciate at a rate greater than potential interest payments. When investing in bonds, the objective is to preserve your assets at lower risk while generating income from interest payments over time.
Differences between stocks and bonds
|Issuer sells equity to investors||Issuer sells debt to investors|
|Owner obtains ownership stake in the issuer||Owner is a creditor to the issuer (lends money)|
|Principal is completely at risk||Return of principal is promised|
|Usually entail voting rights||No voting rights|
|May generate periodic dividends if issuer is profitable||Usually generates periodic interest payments typically not dependent on issuer's performance|
|Voting rights to address non-performance||Limited legal rights for non-payment|
|Low priority for repayment in case of issuer bankruptcy||High priority for repayment in case of issuer bankruptcy|
What it really means to own stock
When you buy a stock you literally become part owner of that company. Then you've become a stockholder or shareholder, which are simply other ways of saying part owner. If a stock is publicly traded, there will usually be a large number of shareholders at any given time.Stock purchases are measured in the number of shares you purchase. For example, if you want to buy stock in Acme Gimcrack Corp., you might decide to purchase 100 shares. At any given time there are a finite number of shares outstanding, or available to trade, on any given company. The more stock you buy, the higher your percentage of ownership (or equity) in that firm will be.
To put it in perspective, if Acme Gimcrack Corp. has 1,000,000 outstanding shares, then your purchase of 100 shares represents a .01% stake in the company. Keep in mind this is an entirely fictitious example. Some very large firms might have more than one billion shares outstanding. For instance, a 100-share stake in Ginormo Industries Inc. with 1,000,000,000 shares outstanding would only represent .00001% ownership.
As a shareholder, you're entitled to a portion of the company's earnings and assets. If the company turns a profit, you share in the benefits, often in the form of dividends paid to you. Dividends are usually paid quarterly. If the company doesn't pay a dividend, then any profits are reinvested in the company's business. Some investors wonder why it's reasonable to buy shares in a non-dividend-paying company instead of one that shares profits via dividends. The answer is the stock price. Theoretically, an increase in profits will cause a stock's value to appreciate. (In other words, the stock price should go up.) With a non-dividend paying company, your share of the profits should be reflected in an appreciation of your principal investment.
In addition, as a shareholder you own a part of everything the company owns — from the office building, machinery, computers and furniture all the way down to the coffee maker in the break room. Imagine that.
Commissions and the tax man are part of investing
When you buy or sell shares of stock, you will incur costs, most notably commissions. The more frequently you buy and sell, the more commissions you rack up. Commissions are part of the investing process, and they may negatively reduce your investment results. Besides commissions, you may bring about a taxable event when investing. Be sure to consult a tax professional to help manage any tax liability you could face.
Stocks in the primary and secondary markets
When a stock is first issued to the general public, it is released through an initial public offering, or IPO. The company issuing the stock will enlist the aid of an underwriting firm that helps determine the optimal initial offering price and timing in bringing it to market. The stock is then offered for sale with the underwriting firm acting as the middleman.
Usually an IPO will be conducted by a newer company that's undergoing an expansion phase, but they may also be issued by older privately held firms that want to become publicly traded. The IPO for a stock is also known as the primary market. Anyone purchasing a stock through an IPO must read the prospectus before investing. Once the stock begins to trade on stock exchanges between individual investors and / or institutions, that's known as the secondary market.
Stock certificates vs. shares held in street name
Before the computer era, when you bought shares in a company you'd receive physical stock certificates that you could store in a safe, stuff under your mattress, or frame and hang on the wall if you were so inclined.
Stock certificates were your proof of ownership of those shares, and in the old days if you wanted to sell them, you'd have to physically hand them over to your broker. Nowadays, brokers keep records of stock ownership electronically, which is called holding them in street name.
Not having to register every share in an individual investor's name and transfer physical certificates makes it much easier and more cost-effective to trade. So now instead of jaunting downtown to your broker's office or enlisting the services of a courier, all you have to do to buy or sell stocks is log onto Ally Invest.
Stockholders’ rights: Voting
Shareholders typically don't have a say in the day-to-day operations of companies in which they own equity. However, every year publicly traded companies hold meetings to give investors a voice in some important decisions. At annual shareholder meetings common stock owners are given the opportunity to vote in person or by proxy on things like elections for the board of directors, whether or not to acquire other companies, issuance of additional securities and other major decisions.
Generally, common shareholders get one vote per share owned. The more stock you own, the greater your influence will be. However, individual investors' influence is usually quite limited compared to large institutions and funds that hold much greater percentages of the company's stock. Don't expect to steer the ship, but don't completely overlook the power of your vote.Top brass will typically be in attendance at shareholders meetings to field questions about how the company is being run. If shareholders aren't happy with current management, it's not unheard of for certain members to be shown the door when it comes time to elect the board of directors.
Stockholders' rights during bankruptcy
When you buy shares in a company, naturally you think everything is going to go splendidly – you'll participate in the profits of a successful enterprise and the share price will increase. However, you do run the risk that something (or many things) will go drastically wrong and the firm may go belly-up.
As a common shareholder, unfortunately you're last in line when it comes to bankruptcy and liquidation proceedings. Creditors and bondholders get dibs on assets during bankruptcy and liquidation. Preferred stockholders come next followed by common stockholders, who get whatever is left over, which may in fact be nothing at all.
When certain types of companies like general partnerships go bankrupt, creditors are entitled to go after the owners' personal assets. If liquidation doesn't pay off what the company owes, creditors can attempt to seize the partners' homes, cars, and other items of value.
As a shareholder in a publicly traded company you don't have to worry about that, because you're protected by limited liability. That means the most you can possibly lose is the amount you invested in the stock. Beyond that, you're not personally liable for any of the company's outstanding debts if everything goes awry.
Different types of shares: Common stock
Stocks are usually issued in two main types: Common stock and preferred stock. Some companies go one step further and issue shares separated into several classes, such as class A, class B, etc. Although they're similar insofar as they represent partial ownership of a publicly traded company, each type has unique benefits and drawbacks compared to the other.
Common stock vs. preferred stock at-a-glance
|COMMON STOCK||PREFERRED STOCK|
|Lower priority for dividends||Nearly assured dividends|
|Dividend payments can vary||Dividend payments are usually fixed|
|Usually has voting rights||Usually without voting rights|
|Lowest priority in case of bankruptcy||Better priority than common stock in case of bankruptcy (but usually lower priority than bond holders)|
|Only sold at owner's discretion||May be callable by issuer|
Common stock lives up to its name by being the most commonly traded type of stock in the marketplace. When investors talk about plain old stocks, it's most often common stock to which they're referring.
Holders of common stock are entitled to a share of profits either through variable dividends or by appreciation in the stock price, but neither is guaranteed. They also get one vote per share during annual shareholder meetings, which are used to elect the board of directors and make other important decisions.
As an investment type, common stock has excellent potential for capital appreciation. In fact, common stocks have historically outperformed almost all other forms of investment over the long term. However, that potential performance comes with considerable risk. If a company goes bankrupt, common stock owners will be the last ones to obtain any remaining assets, and may in fact receive nothing at all.
Preferred stock holders receive a nearly assured, usually fixed dividend for as long as they own their shares. In fact, before common stock holders receive dividends, preferred stock dividends are paid out first. Plus, in the event of bankruptcy, preferred stock holders have a higher priority than common stock holders in receiving cash from liquidation. (However, they still rank below creditors and bondholders in this regard.)
The downside of preferred stock is that the shareholders usually don't have any voting rights. Additionally, preferred stock may be callable, meaning the company has the right (albeit usually with restrictions) to repurchase the shares.
Preferred stocks share some characteristics with bonds, so some investors like to think of them as a hybrid between common stocks and bonds. This is due to their higher priority in case of bankruptcy and to the fact that the stock may be callable by the issuer.
By classified we don't mean top-secret; instead, we're referring to a sort of caste system for stocks. In some cases companies issue stocks divided into multiple classes, usually class A and class B, while others may issue even more tiers (class C, D, etc.)
When a company issues classified stock, each class will have different privileges than the others. For instance, one company's class B stock may have one vote per share, whereas class A will have ten votes per share. Oftentimes, the reason for issuing different classes of stock is so that the founders can keep control of the company by retaining a significant portion of the voting rights. Other times, the objective may be to offer higher dividend payments to certain shareholders, or to offer shares on multiple price tiers.
In general, the class of stock with the lowest price and the fewest privileges will be the most widely traded on the open market.
IPOs and the marketplace
How stocks begin trading
A company first makes its stock available via an initial public offering (IPO). Investors and institutions buy shares from the underwriter and the underwriter represents the interest of the issuing company. This is known as the primary market. Anyone purchasing a stock through an IPO must read the prospectus before investing.
Active trading takes place in the secondary market. This is where investors and institutions buy and sell shares with each other. When most people talk about trading on the stock market, it's the secondary market to which they're referring.
The connection between the issuing company and the price of its stock in the secondary market may not be obvious. Even though the company already received the capital during the IPO, it still wants its stock to perform well, since the price affects the company's market valuation. A company may repurchase shares in the open market at times of perceived low valuation with the assumption the stock price will rise in the future. Plus, many executives and employees may own stock in the company where they work. The thinking is employee ownership may motivate desirable employee performance. That in turn may make the company more profitable, and therefore drive the company's stock price higher in the secondary market.
The stock market
A stock exchange provides a venue where trading in the secondary market occurs. This is where buyers and sellers come together to do business. When buyers and sellers in a particular security agree on price, their orders are matched and the trades are then executed. Although the term stock exchange is used, many different securities may trade on a particular exchange, like options, bonds, etc.
You've probably seen stock exchanges on TV or in the movies, where traders frantically shout out orders and signal each other with wild gesticulations. Although it may seem like craziness, think of this scene as a type of organized chaos, analogous to a flea market. You visit different booths in the market to see what goods are offered. When you see something you like, you inquire further, haggling may ensue, and then a sale may occur.
Sometimes beginners will try to compare the stock price of one company to another, and then make inferences about a company's value or worth as an investment. To compare apples to apples, though, you need to examine a company's market capitalization. Consider two stocks: Acme Gimcrack Corp. is $50 per share and Ginormo Industries Inc. is $20 per share. Is one overvalued and the other undervalued? Market capitalization helps explain the difference.
A company's market capitalization is its current stock price multiplied by its number of shares outstanding. Acme Gimcrack Corp., trading at $50 a share, has one million shares outstanding. Therefore its market capitalization would be $50,000,000 ($50 x 1,000,000).
On the other hand, Ginormo Industries is trading at $20 a share with one billion shares outstanding. Its market capitalization would be $20,000,000,000 ($20 x 1,000,000,000). So even though its stock is trading at a lower price per share, Ginormo Industries' market capitalization is much higher than Acme Gimcrack Corp.'s because it has far more shares outstanding.
The alphabet soup of the financial marketplace
The New York Stock Exchange (NYSE), located at 11 Wall Street in New York City, is inarguably a vital component of the financial industry. In fact, it is so prestigious and influential that the term Wall Street has become synonymous with stock market in popular culture.The NYSE's history dates all the way back to May 17, 1792 and it's been in continual operation ever since. Today, it's where stocks on many of the largest and most venerable corporations in the world are traded, earning it the nickname The Big Board.
Historically, the exchange has operated as an open outcry auction market. That means brokerages route their clients' orders to the trading floor, where brokers shout out or signal the orders to specialists. Specialists stand at the ready at a designated trading post to match buyers with sellers, or they will step in to fill customer orders if buyers or sellers are not present. Today, however, much of the order matching is done electronically with oversight from specialists.
NASDAQ is the most prominent example of a virtual market and stands for National Association of Securities Dealers Automated Quotations. On TV you may have seen the NASDAQ MarketSite, which is a huge wall of computer screens displaying the intraday price changes of many NASDAQ stocks. However, the NASDAQ has no physical trading floor. Instead it's a network comprised of live traders working through thousands of computers on which all transactions are conducted electronically. This is also referred to as the over-the-counter market.
Unsurprisingly, this high-tech marketplace is home to many of the most important tech stocks in the world. While it's not quite as prestigious as the NYSE, thanks to the rise of tech stocks over the last couple of decades, NASDAQ is now one of the most formidable exchanges on Wall Street. Although it was only founded in 1971, NASDAQ is the new kid on the block no more.Unlike the NYSE, which relies on specialists, transactions in the over-the-counter market are facilitated by market makers. Buyers and sellers are matched against each other when both parties agree on price. However, market makers may trade for their own account and take the other side of the buy or sell order under certain conditions.
Why stock prices fluctuate
What makes a market interesting and active is that many people have many different opinions about the price of a security. Some are bullish and expect the stock price to rise, and others are bearish and expect the stock price to fall. It's this mix of bulls and bears which makes up the market participants.
The more participants in the market, the more traders there are out there with which you could potentially do business. Another term for this is liquidity. High liquidity is optimal in the investment world because it usually means there is a competitive marketplace with people vying to fill your order at the best available price.
Supply and demand
Participants come to the market with ideas for buying or selling. But ideas alone will not become transactions until buyers and sellers agree on price. This is known as price discovery.Since each transaction involves a buyer and a seller, it is not the number of buyers or sellers which moves the price of a stock. It is the aggressiveness with which a buyer or seller acts. If buyers are more forceful than sellers, demand takes over and prices rise. If sellers are more powerful, supply becomes abundant and prices fall. If the strength of either side is closely matched, a tug-o-war ensues and prices don't change much.
You may wonder, where do these market ideas come from? How well a company performs in its core business, also known as its earnings, is one source.
Earnings: It's all about the Benjamins
A strong factor influencing stock price is the company's earnings, or how profitable it is. Every quarter, the Securities and Exchange Commission (SEC) requires publicly traded companies to release earnings statements which indicate exactly how much they've profited (or lost) during the prior three months. These earnings statements are released following the end of each quarter. The majority of companies report earnings to the public in January, April, July or October. As a result, these months are known collectively as earnings seasons.
Earnings reports are important to both short-term and long-term traders, but for different reasons. Long-term traders want to be sure the company is doing what it promised to do. If so, a longer-term trader may deem the investment one to keep in his or her portfolio. Things are much different for a trader focused on the near-term, since price movement can become quite volatile.
A short-term trader may try to anticipate price movement with regard to earnings reports. This is tricky business for many reasons. Throughout each quarter, stock analysts try to predict the earnings of publicly traded companies, and their predictions tend to influence stock prices. The problem is, the analysts aren't always right. Sometimes a company's earnings are better than expected, and sometimes earnings fall short of projections. Even more confusingly, often analyst expectations are already priced into the stocks, so good expectations may have driven the stock price higher (or conversely, poor ones may have pushed it lower) in advance of the actual report.
It gets even trickier: even if the company performs as well as expected, the stock price could decline, as if the report is now old news. If numbers are as bad as expected, the stock price might bounce a bit. The logic implies the bad news is out in the open and the market has moved on to the next quarter. Just when you thought all of this hullabaloo was about the current quarter, the projections for next quarter could actually have a bigger impact on the stock's price in the short term. All of these factors can come into play as investors react to earnings announcements.
Knowing the basics of stocks
If you are going to put your money at risk in a stock investment, you should understand a stock is a type of security reflecting ownership in a publicly traded company. But this alone is not enough to begin the journey of informed investing.
You should also understand how the stock market functions, how stocks compare to bonds and the potential risks and rewards of each, how stocks trade in the primary and secondary markets, and what rights stock ownership provides. It's also helpful to know how stocks trade on the NYSE and NASDAQ markets, and realize how market forces and quarterly earnings reports can impact stock prices. This knowledge will help you become a more responsible self-directed investor.