The stock market has become more popular than ever but what exactly is a stock and how do they work?
What is a Stock?
When you buy stock, you are actually buying a small portion of the company and becoming a partial owner or shareholder.
This means you have a claim on the company’s assets and earnings based on the number of shares you own. You also have the right to vote at board meetings.
The price of a stock is different for each company but is largely based on supply and demand. The more demand for a stock the higher prices will be and vice versa.
Private companies issue stock or shares to the public through an Initial Public Offering after meeting specific guidelines set by the Securities and Exchange Committee.
There are thousands of companies that trade publicly in the US market alone.
However, they generally offer only two different types of stocks: common stock and preferred stock.
Common stock is what you usually trade in the open market and is what most companies offer to the public.
Most active traders and investors purchase common stock for a few reasons:
- Common stock is more liquid, meaning more shares available to trade and smaller spreads
- You have voting rights, rights to receive dividends and a claim on company assets
Preferred stocks are much less common but have some perks over common stocks:
- Have a higher claim on the company’s assets and earnings over common stock
- Receive dividends before common stock shareholders
- Have priority on a company’s assets over common shareholders
Preferred stocks trade on the open market as well but have a different ticker symbol and can vary depending on your broker.
Trading Stocks Example
Buying stock means you are purchasing shares in the open market and becoming a shareholder of that company.
The amount of shares that are available to trade in the open market is called the float but there may be more shares that are held by insiders and employees that are restricted from trading. Companies can reduce or increase the amount of shares available through stock splits.
For example, a company that issues a 2-1 stock split will increase the amount of shares available by two, resulting in the share price being reduced by half. So if Microsoft had 1,000,000 shares outstanding with a stock price of $50 and they issue a 2-1 stock split, they would then have 2,000,000 shares outstanding with a share price of $25.
The reason companies usually do this is to reduce the price of the stock because it has become more expensive than other companies in its sector and less attractive for investors.
One share equals one unit of ownership in a company. So the more shares you own, the more you own of the company. If you own 1,000 shares of XYZ stock and they have 100,000 shares outstanding, then you own 1% of that company.
Generally companies will issue shares to the public so that they can raise money to further business operations or pay down debt, and in return they will work hard to make the business more valuable, resulting in your shares being worth more money.