What Is a Stock?
A stock is a security that represents the ownership of a fraction of a company. This entitles the owner of the stock to a proportion of the company’s assets and profits equal to how much stock they own. Units of stock are called “shares.”
Company issue (sell) stock to raise funds to operate their businesses. The holder of stock (a shareholder) has now bought a piece of the company and, depending on the type of shares held, may have a claim to a part of its assets and earnings. In other words, a shareholder is now an owner of the issuing company. Ownership is determined by the number of shares a person owns relative to the number of outstanding shares. For example, if a company has 1,000 shares of stock outstanding and one person owns 100 shares, that person would own and have a claim to 10% of the company’s assets and earnings.
Why do companies issue stock?
Companies issue stock to get money for various things, which may include (but not limited to):
- Paying off debt
- Launching new products
- Expanding into new markets or regions
- Enlarging facilities or building new ones
What kinds of stocks are there?
There are two main kinds of stocks, common stock and preferred stock.
Common stock entitles owners to vote at shareholder meetings and receive dividends.
Preferred stockholders usually don’t have voting rights but they receive dividend payments before common stockholders do, and have priority over common stockholders if the company goes bankrupt and its assets are liquidated.
Common and preferred stocks may fall into one or more of the following categories:
- Growth stocks have earnings growing at a faster rate than the market average. They rarely pay dividends and investors buy them in the hope of capital appreciation. A start-up technology company is likely to be a growth stock.
- Dividend stocks pay dividends consistently. Investors buy them for the income they generate. An established utility company is likely to be an income stock.
- Value stocks have a low price-to-earnings (PE) ratio, meaning they are cheaper to buy than stocks with a higher PE. Value stocks may be growth or income stocks, and their low PE ratio may reflect the fact that they have fallen out of favor with investors for some reason. People buy value stocks in the hope that the market has overreacted and that the stock’s price will rebound.
- Blue-chip stocks are shares in large, well-known companies with a solid history of growth. They generally pay dividends.
Another way to categorize stocks is by the size of the company, as shown in its market capitalization. There are large-cap, mid-cap, and small-cap stocks. Shares in very small companies are sometimes called “microcap” stocks. The very lowest priced stocks are known as “penny stocks.” These companies may have little or no earnings. Penny stocks do not pay dividends and are highly speculative.
What are the benefits and risks of stocks?
Stocks offer investors the greatest potential for growth (capital appreciation) over the long haul. Investors willing to stick with stocks over long periods of time, say 15 years, generally have been rewarded with strong, positive returns.
But stock prices move down as well as up. There’s no guarantee that the company whose stock you hold will grow and do well, so you can lose money you invest in stocks.
If a company goes bankrupt and its assets are liquidated, common stockholders are the last in line to share in the proceeds. The company’s bondholders will be paid first, then holders of preferred stock. If you are a common stockholder, you get whatever is left, which may be nothing.
Even when companies aren’t in danger of failing, their stock price may fluctuate up or down. Large company stocks as a group, for example, have lost money on average about one out of every three years. If you have to sell shares on a day when the stock price is below the price you paid for the shares, you will lose money on the sale.
Market fluctuations can be unnerving to some investors. A stock’s price can be affected by factors inside the company, such as a faulty product, or by events the company has no control over, such as political or market events.
Stocks usually are one part of an investor’s holdings. If you are young and saving for a long-term goal such as retirement, you may want to hold more stocks than bonds. Investors nearing or in retirement may want to hold more bonds than stocks.
The risks of stock holdings can be offset in part by investing in a number of different stocks. Investing in other kinds of assets that are not stocks, such as bonds, is another way to offset some of the risks of owning stocks.