Stocks: How do they work?

Understanding what stocks and how they work may seem like a tricky thing to do for the layman. In reality, everyone can understand stocks and how they work with just a few simple explanations. 

What is a stock?

A stock is simply a type of financial security that represents a fraction of a larger company or corporation in equity interest and ownership. When you own stock, you are entitled to a percentage of the company’s profit and assets, depending on the number of shares you have acquired. 

Units of stock are known as shares. Investors can procure company shares on the stock market. These shares, as stated, entitle you to a share of a company’s future profits and assets. Let’s take a look at a simple example of what owning stock looks like and what it means for your portfolio. 

An example of how a stock works

Let’s say you are looking to purchase shares in a company. The company has a total of 1,000,000 shares outstanding. You decide to purchase 10,000 shares at $10 each. That means you have spent $100,000 on the company’s shares. Moreover, you now own 1% of the company. (1)U.S. Securities and Exchange Commission.“Stocks.”

In this example, if the value of stock of the company rises to $15, then you would have made an additional $50,000 on your initial $100,000 investment. 

Why do companies issue stock in the first place?

You can probably take a few guesses at why a company may sell stock to the public in the first place but there are a number of reasons why they do this. 

• Avoiding debt: by issuing stocks, a company can avoid taking on burdensome debts. This helps the company to grow its capital without going to banks for large scale loans. 
• To launch new products: by selling stocks and growing capital, a company can reinvest into expanding their lines or releasing new products which in turn, will help the company grow. 
• In preparation of a merger: a company may require more liquidity in the wake of a merger with another company. As such, they will issue more outstanding shares to help with the transition. 
• To grow staff: with greater capital in the bank, a company can expand their workforce. 

There are plenty of other reasons, both tangible and intangible, that a company may want to sell stock to the public. The point is, it is almost always to give themselves more liquidity to work with to invest back into the company. 

Types of stock: common stock vs preferred stock

There are 2 types of stock that you can purchase from corporations. These are known as common and preferred stocks. A common stock is what we have already been describing, it is a stock that gives the shareholder voting rights and the chance to receive dividends paid by the corporation. 

A preferred stock does not entitle the stockholder to voting rights in the corporation. Instead, a preferred stock gives the stockholder higher claims on assets and earnings, more so than your common stockholders. These preferred stockholders will also receive their dividends sooner than common stockholders and will also receive priority should the company be liquidated. (2)American Bar Association.“Does We the People Include Corporations?”

Why do people buy stocks?

We now know why companies issue stocks to the public and what kind of stocks you can acquire but why do people decide to buy shares of a company? Well, there are a few reasons, all of which revolve around earning a profit. 

Capital appreciation

A key reason for buying shares in a company is the potential for capital appreciation. In short, you purchase a stock in the hope that it will rise in value from the initial point that you bought it. For example, if you buy stock at $10 initially and after a period of time that stock’s value rises to $20, then you would have made a $10 profit on every share that you purchased. (3)Small Business Chron.How Does a Shareholder Make Money?

Dividends/passive income

If you own shares in a company, that company will almost always pay out dividends to those who own stock. They may do this monthly, quarterly or yearly. This will generate passive income for the investor, with the chance that your dividends may rise depending on the growth of the company. 

Portfolio diversification

The chance to own various shares from multiple companies provides a good opportunity for avid traders to diversify their portfolios. Put simply, you don’t want all your eggs in one basket. Owning various shares allows you to generate income from different sources while keeping your trading portfolio as diverse as possible. 

Liquidity

As stock is able to be purchased on the stock market, you are also able to sell your stock at any time. This gives you far more liquidity, meaning you can turn your shares into cash at any time with fairly minimal transaction costs. Essentially, if you see a stock plummeting or if you simply need access to cash quickly, you can swiftly sell your shares to get your hands on tangible cash. 

What are the risks of owning stock?

There are a couple of risks involved with purchasing stocks that you should keep in mind before you undertake such a venture. Let’s have a look at some of the more prevalent risks you should know about. 

Financial risk

This may seem like an obvious risk but it’s one that newbie traders often forget. You get blinded by the ponytail of profit without thinking about the fact that you can also lose money. If you purchase a stock that plummets in price and you decide not to sell, you can make a loss on your initial investment. (4)FINRA."The Reality of Investment Risk."

Capital gains tax

The thing about tax when it comes to stocks is that it can either be quite forgiving or it can be relatively harsh. For example, if you take a loss on your investment and you decide to sell, you have a good chance of getting a tax break. However, if you sell your stock at a higher value than when you bought in, you well then have to pay capital gains tax. You won’t pay this tax while you still hold the stock but as soon as it becomes a realised profit, you will then need to pay hefty capital gains tax. 

Stock type

As we mentioned earlier, if you are a preferred stockholder, then you will be first in line to be paid out if a company goes bankrupt. However, if you are a common stockholder, you will likely be the last to be paid out. At that time, who knows how much you might receive, it can be nothing at times. 

Where do you buy stocks?

Once a company goes public through an initial public offering or IPO, the public is then able to purchase shares. Shares can be bought through stock exchanges like NASDAQ (National Association of Securities Dealers Automated Quotations), the London Stock Exchange or the New York Stock Exchange. Your average investor will use a brokerage account to procure these stocks.