Stock
A stock, also called capital stock, of a business entity symbolizes the initial capital paid into or invested in the business by its promoters or founders. A stock stands as a guarantee for creditors as it cannot be withdrawn to the disadvantage to the interest of creditors.
Shares
The stock of a business is divided in multiple numbers of shares. Given the entire sum of money invested in the business, a share has a definite declared face value, commonly known as the par value of a share. The par value is the minimum amount of money that a business may issue and sell shares for in many jurisdictions and it is the value corresponds to as capital in the accounting language of the business. In some other laws, though, shares may not have any par value at all. Such stock is called as a “non-par stock”.
Shares signify a fraction of ownership in a business. A company may decide on different types (classes) of shares, each having unique ownership rules, privileges, or share values.
Stock certificate is issued when shares are sold. A stock certificate is an official document that denotes the amount of shares owned by the shareholder. It also provides information on the class of shares and its par value.
In countries such as United Kingdom, South Africa, Republic of Ireland, and Australia, the stock can be also referred to completely different financial instruments like government bonds and some other marketable securities.
Types of Stocks
Stock can be typically composed of two kinds of shares: preferred stock and common stock. An ownership in common stock gives the holder the right to vote in corporate meetings; on the other hand, owners of preferred stock do not have the right to vote in corporate board meetings, however, they are legally entitled to receive a definite level of dividends before profits are divided among other shareholders.
There is also one more class of share called as convertible preferred share. Under this class, preferred stocks holders have an option to convert preferred shares into fixed number of common shares, usually at some predetermined date.
New equity issues may have certain legal clauses attached that distinguish them from earlier issues of the issuer. For example, some shares of common stock may be floated in the public without offering the usual voting rights.
In some cases, shares might have some special rights unique to them and issued only to certain parties. More often than not, new issues of shares that have not been registered with a securities governing body may be restricted from resale for definite periods of time.
Sometimes preferred stock can be called as hybrid if it has the qualities of bonds that provide fixed returns along with carrying common stock voting rights. Owners of such shares are also given the preference in the payment of dividends over common stock. Also during the time of the liquidation of a company, preference is given to this class against holders of common stock.
Stock Derivatives
A stock derivative is a financial instrument whose value is dependent on the price of the underlying stock. The two main types of derivatives on stocks are futures and options. The underlying security may be a stock index or an individual firm’s stock, e.g. single-stock futures.
Stock futures are contracts where the buyer is said to be “long”, i.e., takes on the obligation to buy on the contract maturity date, and the seller is “short”, i.e., takes on the obligation to sell.
A stock option is a kind of option. That is, a call option gives the right but not obligation to buy stock in the future at a fixed price and a put option is the right (not obligation) to sell stock in the future at a fixed price.
Accordingly, the value of a stock option changes in response to the underlying stock of which it is a derivative. The most followed approach for valuing stock options is the Black Scholes model. Leaving aside, those call options granted to employees, most stock options are transferable.
History
During Roman rule, the empire used to contract out many of its services to private groups called publicani. Shares in publicani were known as “socii”, if the cooperatives were large, and “particulae” which were equivalent to today’s Over-The-Counter shares of small companies.
Even though the records available are not sufficient, Edward Chancellor writes in his book Devil Take the Hindmost that there is some support that a speculation in these shares became more and more extensive and at that time perhaps the first ever speculative bubble was seen in “stocks”.
Around 1250 in France (Toulouse) 96 shares of the “Société des Moulins du Bazacle”, or Bazacle Milling Company were traded at a value that depended on the profitability of the mills the society owned. The Swedish company Stora has acknowledged a stock transfer for 1/8 of the company (or more specifically, the mountain in which the copper resource was available) as early as 1288.
The first ever recognized joint-stock company in contemporary era was the English (later on British) East India Company, one of the most well-known joint-stock companies.
It was awarded an English Royal Charter by Elizabeth I on December 31, 1600, with the goal of favoring trade privileges in India. The Royal Charter subsequently gave the newly formed Honorable East India Company (HEIC) a 15-year monopoly on all trade in the East Indies. Later the Company changed from a commercial trading venture to one that nearly ruled India as it acquired auxiliary governmental and military functions, until its termination.
The East India Company’s flag originally had the flag of England, St. George’s Cross, in the corner.
Soon afterwards, in 1602 the Dutch East India Company issued shares that were considered as tradable on the Amsterdam Stock Exchange, a development that improved the ability of joint-stock companies to draw capital from investors as they now easily could arrange of their shares.
Thanks to the progress made on joint ownership, a great deal of Europe’s economic growth was made possible after the middle Ages. The method of routing capital to finance the construction of ships, for instance, turned the Netherlands into a maritime superpower.
Before implementation of the joint-stock corporation, a costly venture such as the building of a merchant ship could be carried out only by governments or by very affluent individuals or families.
Economic historians consider the Dutch stock market of the 17th century very fascinating: there is comprehensible documentation of the use of stock futures, stock options, short selling, the use of credit to buy shares, a speculative bubble that burst in 1695, and a transformation in fashion that unfolded and reverted in time with the market.
Dr. Edward Stringham also observed that the uses of methods such as short selling were carried on during this time even though the government had passed laws against it. This is strange because it shows entities fulfilling contracts that were not lawfully enforceable and where the parties involved could suffers loss.
Stringham disputes that this example proves that contracts can be created and enforced without state sanction or, in this case, in spite of laws to the contrary.
Shareholder
A shareholder (or stockholder) can be a person or company that legitimately owns one or more shares of stock in a joint stock company. Both private and public traded companies are owned by shareholders. Those Companies that are listed on the stock market are expected to perform efficiently and professionally, to increase the shareholder value.
Shareholders are offered unique privileges depending on the class of stock, which includes the right to vote on affairs such as elections to the board of directors, the right to receive a share in distributions of the company’s profits, the right to buy new shares issued by the company, and the rights over company’s assets at the time of liquidation of the company. Nevertheless, shareholder’s rights to a company’s assets are secondary to the rights of the company’s creditors.
Shareholders are regarded as by some to be a small subset of stakeholders, which may comprise of anyone who keeps a direct or indirect equity interest in the business entity or someone with even a no commercial interest in entities not meant for profiting. Thus it might be common to describe volunteer contributors as an association’s stakeholders, even though they are not shareholders.
While the directors and officers of a company are bound by legal duties to act in the best interest of the shareholders, the shareholders themselves usually do not have such duties towards each other.
However, in a few strange cases, some courts have asked bigger stakeholders to act in the interest of smaller stakeholders. For example, in California, USA, majority shareholders of closely held corporations have an obligation to not destroy the value of the shares held by minority shareholders.
Generally, the largest shareholders in terms of percentages of companies owned, are often mutual funds, and, especially, passively managed exchange-traded funds.
Application
The owners of a company may desire for extra capital to invest in new projects within the company. They may also merely aspire to lessen their holding, releasing up capital for their own personal use.
By selling shares, founders/promoters can sell fraction or all of the company to various part-owners. The buying of one share gives the right to the owner of that share to literally share in the ownership of the company, a little bit of the decision-making power, and potentially earn fraction of the profits, which the company may distribute it as dividends.
Generally in the case of a publicly traded corporation – where there may be large number of shareholders, running in thousands- it is not practical to have all of them participating in the daily decisions required to run a company. Accordingly, the shareholders will make use of their shares as votes in the election of members of the board of directors of the company.
Typically, each share will count for one vote. Corporations, though, issue different classes of shares, which could carry different voting rights. Owners having majority of shares can easily out vote minority shareholders in annual board meetings. In other words, effective control lies with the majority shareholder of the company. Normally promoters or company’s founder/s owns the major part of shares, this way, the original owners of the company often control of the company.
Rights of shareholders
While ownership of 50% of shares does automatically convert into 50% ownership of a company, it does not provide the shareholder the right to use a company’s building, equipment, materials, or other property.
This is because the company is regarded as a legal entity, thus it is in control all its assets itself. This is very important in issues such as insurance, which must be in the name of the company and not the majority shareholder.
In several countries, boards of directors and company managers have a legal obligation to run the company in the best interests of its stockholders. However, Martin Whitman a noted American investment advisor disagrees.
He doesn’t hesitate in saying that there does not exist any publicly traded company where administration works entirely in the best interests of OPMI [Outside Passive Minority Investor] stockholders.
Instead, he believes, there are both “communities of interest” and “conflicts of interest” between stockholders (also called as principal) and management (also called as agent). This conflict is seen as the problem between principal and agent. It would be immature to think that any management would sacrifice management compensation, and management positions, just because some of these management rights might be seen as giving rise to a divergence of interest with OPMIs.
Even though the board of directors runs the daily administration of the company including taking decisions on important commercial projects, the shareholder has some say on the company’s policy, as the shareholders are the ones who elect the board of directors.
Each shareholder in general holds a percentage of votes equal to the percentage of shares he or she owns. So provided that the shareholders have the same opinion that the management (agent) are performing badly, they can elect a new board of directors which in turn can hire a new management team.
In reality, however, genuinely contested board elections are not very common. Board candidates are typically nominated by insiders or by the board of the directors themselves, and a significant amount of stocks are held or voted by insiders.
Owning shares does translate into obligation for liabilities. If a company seizes its operations and has to default on loans, the shareholders are not accountable in any way. Nevertheless, all money gathered by converting assets into cash will be channeled towards the repayment of loans and other debts first, so that shareholders cannot get any money unless and until creditors have been paid off their dues. In most cases when a company is liquidated, shareholders end up getting no money whatsoever.
Means of financing
Financing a company by selling the stock of a company is known as equity financing. However, one more way through which a company could also raise its finance is called as debt financing, for instance, issuing of bonds can be preferred over shares just to avoid the giving up ownership of the company.
Unofficial financing also called as the trade financing usually provides the substantial part of a company’s working capital which is required for day-to-day needs.
Trading
Stock trader
Generally, the shares of a company may be transferred from shareholders to other parties by sale or other market mechanisms, if not prohibited. Most countries –developed or developing have established laws and regulations that take care of such transfers, especially if the issuer is a publicly-traded company.
The desire among stockholders to trade their shares has resulted in the creation of stock exchanges, organizations which offer marketplaces for trading shares and other derivatives and financial products. Today, stock traders are typically characterized by a stock broker who buys and sells shares of a broad range of companies on such legal entities. A company may start listing its shares on an exchange by fulfilling and upholding the listing requirements of a particular stock exchange.
In the United States, with the help of inter-market trading system, stocks listed on one exchange can also be easily traded on other associated exchanges which includes electronic communication networks (ECNs), such as Archipelago or Instinet.
Several large non-U.S companies select to list on a U.S. stock exchange in addition to an exchange in their home country, aiming to widen their investor base. These companies must keep a block of shares at a bank in the US, normally a certain percentage of their capital. Subsequently, the holding bank creates American depositary shares and issues an American depositary receipt (ADR) for each share a trader acquires.
Similarly, many large U.S. companies list their shares at foreign exchanges to tap the money from oversees market.
Small companies that do not meet the criteria and cannot qualify for the listing requirements of the major exchanges may be traded over-the-counter (OTC) by an off-exchange method in which trading takes place directly between parties. Some of the prominent OTC markets in the United States are the electronic quotation systems OTC Bulletin Board (OTCBB) and OTC Markets Group where brokerage firms represent individual retail investors. The quotation service’s requirements for a company to be listed are negligible. Normally, shares of companies that are in the middle of bankruptcy proceeding are listed by these quotation services after the stock is delisted from an exchange.
Buying
There are various ways for both buying and financing stocks, the most frequent being through a stock broker. Whether an agent is a full service broker or discount broker, they can help in transferring of stock from a seller to a buyer. Most trades are in fact executed by brokers listed with a stock exchange whereas the full service brokers generally charge more fees on every trade, but give investment recommendation or several other personal service; the discount brokers provide little or no investment suggestion but charge less for trades.
There is one more type of broker – a bank or credit union that may have a deal arranged with either a full service or discount broker.
Besides brokers, there are other ways of buying stock. Investor can directly purchase shares from the company itself. In case of one share is already owned, most companies will agree to the purchase of shares directly from the company through their investor relations departments. But, the initial share of stock in the company will have to be acquired through a regular stock broker. Another method to buy stock in companies is through Direct Public Offerings also known as Initial Public Offerings (IPO) – which are usually sold by the company itself. In this method, stock is bought directly from the company, more often than not without the aid of brokers.
In order to finance the purchase of shares, two ways can be employed: buying a stock with money that is at present in the buyer’s ownership, or by buying stock through a margin. Buying stock on margin is a transaction where the investor is buying stock with money borrowed against the value of stocks in the same account.
These stocks, which are kept as collateral with broker acts as guarantee that the buyer can repay the loan; or else, the stockbroker have the right to sell the stock (collateral) to repay the borrowed money.
He can sell if the share price falls below the margin requirement, at least 50% of the value of the stocks in the account. Buying on margin is same as borrowing money to buy a car or a house, by keeping a car or house as collateral. Nevertheless, borrowing is not free; the broker typically charges 8–10% interest.
Selling
The process of buying and selling a stock is very much the same. Normally, an investor wants to buy at low price and sell higher price, the difference being the profit.
However, there are a number of reasons that may induce an investor to sell at a loss, e.g., to steer clear of further loss.
As with purchasing of a stock, there is a transaction fee, also called as commission or brokerage, for the broker’s efforts in facilitating the transfer of stock from a seller to a buyer. This fee can be either high or low, mainly depending upon which type of brokerage, full service or discount, handles the transaction.
After the transaction has been executed, the seller will get all of the money. The most essential part of selling is to keep a close eye on the earnings. One more important thing to keep in mind while selling a stock is, capital gains taxes will have to be paid on the profits-which can vary, depending on the jurisdictions.
Stock price fluctuations
The price of a stock moves up and down primarily due to the theory of supply and demand. Just like all commodities in the market, the price of a stock is responsive to demand. However, there are many factors that boost the demand for a particular stock. Financial tools like fundamental analysis and technical analysis try to understand the market conditions that lead to price fluctuations, or even predict future price levels. A recent study illustrates that customer satisfaction, as calculated by the American Customer Satisfaction Index (ACSI), is very much correlated to the market value of a stock. Stock price may be influenced by analyst’s business expectations for the company along with the projections for the company’s general market segment. Stocks can also swing wildly due to “pump and dump” scams.
Share price determination
For any given moment, equity’s current price is determined by the forces of supply and demand. The supply, also known as the float is the number of shares accessible for sale at any one moment. The demand is the number of shares investors yearn to buy at exactly that same time. The price of the stock oscillates in order to reach and keep equilibrium.
If Potential number of buyers outnumbers sellers, the share price moves up. Ultimately, sellers attracted to the high selling price come in the market and/or buyers leave, reaching equilibrium between buyers and sellers. Similarly, if sellers outnumber buyers, the price drops. Sooner or later buyers enter and/or sellers exit, again reaching equilibrium.
Accordingly, the value of a share of a company at any given time is determined by all investors voting with their money. If more investors wish for a particular stock and are prepared to pay more, the price will climb up. If more investors are selling a stock and there aren’t sufficient buyers, the price will fall.
Nevertheless, the forces of demand and supply and the point of equilibrium does not explain why people decide the maximum price at which they are prepared to buy or the minimum at which they are eager to sell. In the world of investment and finance, the efficient market hypothesis (EMH) continues to be widely accepted, even though this theory is generally discredited in academic and professional circles. In short, EMH says that investing on the whole (weighted by the standard deviation) is a rational act; that the price of a stock at any certain moment represents a rational assessment of the known information that might bear on the future value of the company; and that share prices of equities are priced efficiently, which is to say that they signify correctly the projected value of the stock, as best it can be known at a given moment. In other words, prices are the result of discounted projected future cash flows.
The EMH model, if correct, has at least two remarkable consequences. First, because financial risk is supposed to require at least a small premium on anticipated value, the return on equity can be estimated to be slightly greater than that provided from non-equity investments: if not, the same rational calculations would guide equity investors to shift to these safer non-equity investments that could be estimated to give the same or better return at lesser risk. Second, because the price of a share at every given moment is an “efficient” indication of expected value, then—relative to the curve of expected return—prices will tend to follow a random walk, determined by the emergence of information (randomly) over time. Professional equity investors as a result try to get as much information as possible; seeking to get advantages over their competitors (mainly other professional investors) by more astutely interpreting the emerging flow of information.
The EMH model does not appear to give an entire description of the process of equity price determination. For example, stock markets are more unpredictable than EMH theory would suggest. In recent years it has come to be accepted that the share markets are not completely efficient, perhaps particularly in emerging markets or other markets that are not run by well-informed professional investors.
Prices of share are also affected due to human emotions. According to Behavioral Finance, humans often make irrational decisions- mainly, related to the buying and selling of securities. The decisions are based upon fears and misperceptions of outcomes. The irrational trading of securities can often result in securities prices which differ from rational, fundamental price valuations. For instance, during the technology bubble or the dotcom bubble of the late 1990s which was followed by the dot-com bust of 2000–2002, technology companies were often valued at beyond any rational fundamental value because of what is commonly known as the “greater fool theory”. The “greater fool theory” suggests that, because of the predominant method of realizing returns on equity is from the sale to another investor, one should choose securities that someone else will price at a higher level at some point in the future, without regard to the basis for that other party’s willingness to pay a higher price. Thus, even a rational investor can take advantage from others’ irrationality.