What is a Stock and How Does it Work?

Andrew Ely

Whether you’re planning for retirement, to help fund your children’s education, or simply want to see your hard-earned money grow, understanding your investment options is key to your success. One of the most popular types of investments out there are stocks.

On the whole, whatever your goals, stocks are an integral part of any well-designed portfolio. In fact, they are frequently the foundation of younger investors’ portfolios. Understanding what they are and how they work can make all the difference in your ability to reach your goals.

Before we continue, Financial Professional wants to remind you that this article is educational in nature. Any securities or firms named are for illustrative purposes only and do not constitute financial advice. Always do your due diligence and consider your situation – and the help of a licensed financial professional – when making investment decisions.

If you don’t yet have industry professionals handling your portfolio, we can help! Check out Financial Professional’s investment marketplace, where we partner with some of the best in the business to help find the right investment for you.

So… What is a Stock?

In simple terms, a stock is a security that represents partial ownership of a corporation. Stocks are measured in single units, known as a share. Owning shares entitles the buyer to a percentage of the selling company’s profits and assets in proportion to the amount of stock they own.

However, this does not mean that shareholders own the corporation (although they can influence a corporation’s decisions). This is due to the complex nature of corporations, as well as the regulations guarding investors – and the issuing companies – from fraud.

How are Stocks Bought and Sold?

Stocks primarily trade (are bought and sold) on exchanges. However, this is not the only way to get your hands on a stock. For instance, some companies may give their employees stock or offer them a compensation package. Corporations can also elect to sell privately to individuals.

Regardless of the circumstances surrounding the transaction, all stock sales must adhere to set government ordinances. These regulations protect investors from potential fraud on the part of the corporations as well as brokers and investing firms.

When it comes to issuing new stocks, corporations may do so whenever they feel the need to raise capital. While this process dilutes ownership for current shareholders, doing so can be hugely beneficial to the corporation itself. Corporations may also buy back their outstanding shares, which benefits shareholders who choose not to sell by causing the remaining shares outstanding to increase in value.

How Does a Stock Work?

A corporation issues (sells) stock when it wants to raise capital for the purpose of growing its business. Once the money has transferred hands, the corporation may use the funds for whatever purposes it deems necessary.

The shareholder, or stock buyer, now owns an interest in the corporation’s future. Depending on the company and type of stock, the shareholder may even own the rights to the profits or assets of the corporation. Another way to say this is that stock investors own a part of the companies in which they invest.

Individual ownership is calculated by the percentage of shares owned relative to the shares outstanding (the total number of shares a company has). For instance, if Company X has 100 shares of stock, and Sally Smart owns 10 shares, this means that Sally owns 10% of a company’s earnings.

However, this does not mean that the stockholder actually owns the corporation itself. A shareholder who owns 51% of the stock cannot by themselves sell the company and pocket the profits, for example. It’s more correct to say that shareholders own the shares issued by the corporation in question.

Corporations as Persons

This is due in part to the fact that corporations are treated as persons in the eyes of the law. As a result, they are subject to many of the same laws and rights that an individual is. They pay taxes, borrow money, purchase assets, and must send a representative to court when someone sues them.

The purpose of designating a corporation as a person is related to the idea that corporations can own their assets. For example, the building out of which a corporation operates is owned by the corporation, not the shareholders. The same is true for tools of the trade, such as forklifts in a warehouse or Amazon’s delivery trucks.

This distinction legally separates a corporation from its shareholders in terms of liability. When a corporation goes bankrupt, for instance, a judge may order it to divide or sell its assets. However, the judge has no legal jurisdiction over your personal assets or finances.

Furthermore, a court cannot force you to sell your shares, as you have legally purchased them. On the other hand, the judge cannot force the company to compensate you for your losses on their falling stock.

In the reverse, if a shareholder was to file for bankruptcy, they could not claim the corporation’s assets to pay off their debts. Likewise, they could not use the company’s wealth to pay back their dwindling bank accounts.

Stockholders and Share Ownership

It’s most accurate to say that shareholders own shares that a corporation issues. In turn, the corporation owns its assets, which are held by a firm.

In our example above, Sally Smart owns 10% of Company X’s shares. However, it’s incorrect to say that Sally owns 10% of the company. Rather, Sally owns 100% of one-tenth of Company X. This means that, while Sally has a claim to the company’s profits and assets in some circumstances, such as via dividends or during bankruptcy, she can’t do as she pleases with the company. For instance, Sally can’t bill her new car to Company X or walk out with its office supplies.

This is known as “separation of ownership and control,” because individual shareholders can’t determine the fate of a corporation or its assets.

Why Should You Own Stocks?

What owning shares of stock does give you the right to:

  • A company’s profits (by receiving dividends)
  • Vote in shareholder meetings
  • Sell your shares

Owning a majority of shares increases your voting power. For example, let’s say that Sally Smart owns 51% of Company X. Because she owns the majority of shares, she can control the company indirectly by appointing its board of directors.

The board of directors then influences and increases the company’s value by making intelligent business decisions, investing and divesting assets, and hiring persons such as the CEO (Chief Executive Officer) to run the corporation.

However, most shareholders will never own the majority shares of a company’s stock – and that tends to suit them just fine. When it comes to buying stock, investors usually do it for one of two main reasons. Some investors purchase stocks to earn dividends. On the other hand, many investors purchase stock to sell it at a higher value later.

The Two Main Types

One of the many complexities in investing in the stock market is that there are several ways to divide stocks, one of which is by type. There are two main types of stocks beginning investors need to be aware of: common and preferred.

Common Stock

Common stocks conform to the typical understanding of the stock.

Holding this type of stock confers several rights to the shareholders, in particular the right to vote for board members who manage the corporation (thereby, the person who owns the majority shares gets to decide the next board members).

Furthermore, if the board votes to distribute a dividend to shareholders, each shareholder receives a portion of the company’s profits.

In the instance that the corporation is liquidated, be it by choice or by court order, shareholders receive a portion of the proceeds.

Perhaps the best way to understand common stock is to imagine that you own 100% of a company’s shares. While you wouldn’t be able to borrow against its assets or remove supplies from its buildings, you would have 100% say in how the company was run. You would appoint the board of directors, receive all profits from dividends, and lay claim to all proceeds from liquidation proceedings. Common stock merely divides this power amongst all shareholders.

Or, in other words, holders of common stock are part owners of the corporation in the way most individuals understand.

Preferred Stock

Preferred stocks are quite a different animal entirely. In many ways, the best way to understand them is to think of them as the halfway point between a bond and a stock. (A bond is a type of tightly defined loan with an agreed-upon date of repayment as well as terms of interest).

The most important difference is that preferred stock does not confer voting rights in the corporation. Additionally, preferred stockholders will typically receive a specific dividend yield in perpetuity, even if common shares receive no dividend at all.

Furthermore, preferred stocks have a specified date on which they can be redeemed, much like a bond’s maturity date.

Finally, preferred stocks lay a stronger claim to the assets and earnings of a corporation. For instance, dividend payments go first to preferred shareholders, and then to common stockholders. In the event of liquidation, they’re ahead of common stock investors in terms of proceeds, as well. This means that if a corporation only has enough after bankruptcy proceedings to pay out the preferred stockholders, then that’s what they’ll do – and the common stockholders may be left with nothing.

The Two Main Styles

Another way to classify stocks is by style. The two basic styles are growth and value. Both of these are, to some extent, a judgment call (as opposed to the hard-set types listed above), which means you should look to buy based on what kind of investor you want to be. You should also consider your risk tolerance before investing in either style.

Growth Stocks

A growth stock is a share in a company that an individual expects to grow significantly. If the company does achieve growth, then the price of the stock will rise with the company – hence the name. Since these stocks are earmarked for success, at first glance it may appear like the type of stock everyone should want to buy.

However, growth stocks come with many serious risks.

Chief among these is the fact that growth stocks are more expensive, which makes them prohibitive to small-time investors. If share prices have a history of rising and are expected to do so again, more people will want to purchase the stock, which will further drive up the price.

Secondly, there is no guarantee on when growth will occur or how long it will continue.

Not only that, but growth stocks come from companies that are actively pursuing aggressive growth. This means that the companies are plowing profits back into their operational and acquisition expenses. They’re also more likely to borrow credit to further expand their enterprises.

This mode of operation also means that growth stocks are very unlikely to offer a dividend, which is a turn-off for investors who may want to build a portfolio around dividend earnings.

All of this comes together to mean that growth stock companies have a greater risk of failing and share price volatility. While these things are expected in the market, that doesn’t make them any easier for individual investors to stomach either psychologically or financially.

In short, which growth stocks can potentially be high-reward investments, they’re also incredibly high-risk as well.

Value Stocks

Value stocks are in many ways the opposite of their growth stock counterparts. That’s not to imply that the company (and shares) won’t grow more valuable – they very well might. Rather, investing in value stocks reflects a different investing strategy.

Value stocks are those that an investor considers underpriced compared to the fundamentals of the business. This may be because the company offers high dividends, earnings, or book value (the calculated net value of its assets) compared to the price of its shares.

A good example of where to look for value stocks is large, well-established companies that are temporarily struggling (often due to bad news or, say, a global pandemic). The market responds to bad news by lowering the price of the stock. If an investor believes the setbacks are temporary, that low price might suggest that their shares are currently value stocks.

Of course, there are risks to this strategy as well. If it’s not the case that unprecedented news or a global illness has unfairly lowered the share price, but in fact, the shares are low due to poor company performance, the investment may not pay off.

On the other hand, investing in value stocks does have the key advantage of naturally adhering to one-half of the simplest rules in investment: buy low and sell high.

A Final Word

Stocks are an essential piece in every investor’s portfolio, but how and when to leverage them depends on your age, your current situation, and your financial plan. Having a basic understanding of what a stock is, is the best place to start.

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Andrew Ely