Stock: Exactly What Is It?

Editor’s note: This is the first in a series of articles on the basics of investing, contributed by

Stock. The word is used freely to describe ownership in the stock market based on a specific company. But when you buy a company’s stock, exactly what are you buying?

A share of stock gives you an ownership position, also called “equity,” in the company that issued the stock. For example, if you buy 100 shares of IBM, you own a very small part of the company. This does not mean you own any specific asset held by the company; it does mean you own a piece, or proportional share, of the overall corporation.

Companies pay for their operation with two primary sources of funding. They issue bonds or notes to raise “debt” capital, or they sell shares of stock to raise “equity” capital. As an equity owner (stockholder), you acquire some rights. Most people buy common stock, which entitles them to dividends if the company declares them, to vote on matters that come up before the Board of Directors at an annual meeting, and to sell shares whenever they want over the stock exchange. (Buyers of preferred stock do not have voting rights, but in the event of liquidation, they are paid before common stockholders.)

A company that issues stock is a corporation. This distinguishes the formation of a company from the less formal partnership or sole proprietorship. A corporation’s stock experiences increases or decreases in market value based on the market’s supply and demand for shares.

This market value is based partly on the earnings record of a company, as well as on the market’s perception of its future growth potential. For example, if you buy 100 shares at $30 per shares and invest $3,000, the stock’s price may rise or fall. If it falls to $28 per share, your 100 shares loses $200 in market value. If the stock’s price per share grows to $33, you have a $300 profit.

Besides market value, you are entitled to any dividends declared. This is a distribution of the company’s earnings. For example, if a company declares a dividend of fifty cents per share, your 100 shares earn you an additional $50 per year. If you paid $3,000 for a $30 stock, that is a 1.7% dividend yield ($50 ÷ $3,000).

So a stockholder is any individual who buys shares of stock in a corporation (usually common stock). Stock of publicly traded companies is listed on an exchange such as the New York Stock Exchange. You can buy and sell shares online through a discount broker, or through a brokerage firm that also provides advice but charges more money per trade.

Stockholders build a portfolio of stocks through direct ownership or by purchasing shares of a mutual fund, a company that manages the funds of thousands of people and picks a portfolio of many stocks. The long-term appeal of the stock market is based on historical price appreciation. Of course, markets not only rise but may also fall. Dramatic changes in value have occurred many times through history, including some very rapid and dramatic price retreats early in 2010.

Over the long term, companies that are exceptionally well managed, competitive, and well capitalized (through both equity and debt) have tended to out-perform the market averages. Buying stock is the preferred method people use to own a small piece of the big action.

Most investors who are just starting out, of course, probably don’t have the money to build a well-diversified portfolio of individual stocks and would be better off getting started with a selection of low-cost index mutual funds. We will tell you more about those in a later installment of this series.

Stock: Exactly What Is It? was provided by

Michael C. Thomsett is the author of over 60 books, including Winning with Stocks and Annual Reports 101 (both published by Amacom Books), and Getting Started in Stock Investing and Trading (John Wiley and Sons, scheduled for release in Fall, 2010).