Definition of Stocks
Stock, equity or share as used in finance represents a part ownership in a company. Ownership of a stock entitles the owner (stockholder or shareholder) with all the profits distributed in form of dividends in direct proportion to the amount of shares owned. For example, consider a hypothetical company that has issued 100 shares to the public. A shareholder that owns 10 shares of the company has claims to 10% (10/100) of all the profits distributed in form of dividends.
Ownership of a stock may be evidenced by a stock certificate that lists the number of shares, par value of the stock and other details. Increasingly, most investors today hold the stock at their brokers in the “street name”. These share details are kept electronically and company or the broker does not issue a stock certificate unless the investor asks for it, in which case the certificate is issued and transferred to the investor.
A stock is often traded on the public exchanges in the secondary market. This provides the stock owner the liquidity to buy and sell stocks of any publicly traded company at will. As a result, stocks are often viewed as pieces of paper. This is a mistake. Stocks have many characteristics that an investor needs to be aware of, and are best understood in terms of part ownership in the underlying business.
A Stock Owner Gets Paid Last
If you have ever owned a business, you are well aware that as a business owner you get paid after all the employees, suppliers and creditor claims have been satisfied. As a shareholder, the same principle holds true. Dividends are paid to the shareholders from the net profit of the company, which is calculated net of all the expenses in the normal business operations, bond and other secured and unsecured debt payments and corporate income taxes. Therefore it is important to keep the business fundamentals and assorted liabilities in mind when evaluating the value of a stock.
This hierarchy of claims also makes equities one of the riskiest instruments to hold. Payments to other stakeholders such as employees, suppliers and lenders are contractual in nature and a company is legally obligated to make them if they wish to continue in business. When the business is not profitable, the stock holders may not be paid. In extreme situations when a company faces bankruptcy reorganization, there may be nothing left over for the stock holders and the entire investment may end up worthless.
This risk is compensated with higher rewards when the company is profitable and growing. Other claimants are only entitled to a fixed payment regardless of business profits. In a growing profit scenario, increasingly larger returns accrue to the stock holders, who are either paid through increasing dividends or receive a capital appreciation in the value of the stock they hold.
Types of Stock
Two of the most common types of stocks are
- Common stock, and,
- Preferred stock
A common stock is the junior most claim on the business and represents true ownership of the business. All left over profits accrue to the common stock holder. If dividends are paid, a part of the profit is returned to the shareholder. If the company reinvests all or part of the profits in profitable projects, the value of these projects tend to lift the stock price, thus making the stock more valuable. Common stock may be issued in different classes of shares, each with its own set of rules, voting privileges and shareholder rights.
A preferred stock acts like a perpetual bond but is junior to all debt. The company is not required to buy back a preferred stock, although they may often choose to do so at a pre-determined price. Preferred stocks are generally paid preference dividends. These are paid before any dividends are paid to the common stock holders. Preferred stock holders do not have voting privileges.
Valuation of Common Stock
Valuing a common stock is an inexact science. In the short term, the stock prices are often driven by the demand and supply of the shares in the market. In the longer term, stock prices approximate the actual value of the business assets adjusted for debt and other liabilities. Investors often pay a multiple of the business value which varies according to the future expected growth of the profits at the company. Since expectations vary from one investor to another and each investor has different appetite for risk, there are buyers and sellers at most price points for any given stock. This is how a market is created in the stock.
Value investors emphasize tangible assets over future expectations to arrive at a more conservative value of a stock. Growth investors on the other hand look for fast growing companies that have the potential to generate rapidly increasing profits and may choose to pay higher prices for a stock for a share of future profits.
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