2) Stocks Basics: What Are Stocks?

by · August 25, 2010

Stock is a share in the ownership of a company.  It is a claim of the company’s assets and liabilities.  The more stocks you have, the higher your ownership stake in the company.  Stock, equity, shares – these all mean the same thing.

Being a Stocks Owner

If you own stock in a company, then you are one of the shareholders (also called stockholder).  This means that you have a claim to all that the company owns, even if a very small share.  With this, you are entitled to the earnings of the company and voting rights with it. Being a shareholder, however, does not mean that you have a say in how to run the business.  It only entitles you one vote per share in electing the board of directors at annual meetings.

As proof of your stock ownership, you are given a stock certificate.  At this age, it is kept electronically, not in paper, otherwise known as holding shares “in street name.”  In the past, when the stock owner wanted to sell his share, he has to physically take the certificate to the brokerage.  Now, one can just use a computer or make a phone call.  In essence, the electronic version makes shares easier to trade.

The company’s management aims to increase the value of the firm.  If not, then the shareholders can vote to have the management replaced – at least in theory.  In reality, individual investors do not have enough shares to have that big an influence on the company.  Large institutional investors and billionaires are really the ones who make the decisions.

Not being able to make decisions is not a big deal as a shareholder.  The idea after all is having someone else make the money.  What is important is getting a portion of the company’s profits and a claim on assets.  These profits are sometimes referred to as dividends.  This loosely translates to:  more shares = more profit.  Asset claim only becomes significant if a company goes bankrupt.  If it is a liquidation case, you get paid after all creditors have been paid.

Another important stock feature is limited liability.  If a company is not able to pay its debts, you hold no accountability.  Partnerships, on the other hand, are designed such that if the partner goes bankrupt, creditors can come after the partners (shareholders).  Owning a stock, therefore, means losing only the value of your investment but not your personal assets.

Debt and Equity

What is the purpose of issuing stock?  Why should founders sell stocks to thousands of people they don’t know?  This is because of the company’s need to raise money.  They can do this by borrowing or selling part of the company.  To borrow, the company either loans from a bank or issues bonds.  These methods are called debt financing.  Stock issuance is called equity financing.  When issuing stocks, the company does not have to pay back the money or pay interest payments.  Shareholders only hope that their shares will earn more than what they paid for.  Initial public offerings (IPO) is the first sale of a stock issued by the private company.

Now we come to understanding between a company that finances through debt and one that finances through equity. The former guarantees the return of your money along with interest payments.  In the latter, you assume the risk of a company’s demise by being an owner.  If the company goes bankrupt and liquidates, you do not get any money until the bondholders have been paid.  This is called absolute priority.  If the company is successful, shareholders earn a lot and vise-versa.

Risk

Individual stocks have no guarantee.  Other companies may pay out dividends, others may not.  Without dividends, investors can make money only through a stock’s appreciation in the open market.

Taking on a risk is not at all negative.  A greater risk may signal greater return of investment.  This is why stocks have historically performed better than bonds or savings account.  On a long-term basis, stock investment has an average return of 10-12%.

Next Section: Different Types of Stocks