Stocks

What is a Stock?

A stock is a financial asset that represents a fraction of the ownership of a company. When purchasing a company's stock, you own a small piece of this company called a share. The owned company can either be private or public (listed on stock exchanges).

Owning stock gives you the right to vote in shareholders' meetings of the company (even though non-voting shares exist) and receive dividends if the company chooses to distribute them. Those voting rights and dividends are proportional to the number of shares you own.

Stocks are one of the most important building blocks of modern investing. They allow individuals to participate in the growth of businesses and the broader economy. Over the long term, stocks have historically been one of the best-performing asset classes, outpacing bonds, savings accounts, and inflation.

How Do Stocks Work?

When a company wants to raise capital, it can issue stock to the public through an initial public offering (IPO). Once the IPO is complete, the stock trades on a stock exchange where buyers and sellers determine the price based on supply and demand.

The price of a stock is influenced by many factors, including the company's earnings, revenue growth, industry trends, economic conditions, and investor sentiment. Investors use financial ratios like the PE ratio, return on equity, and free cash flow to evaluate whether a stock is fairly priced.

A stock's market capitalization (share price multiplied by total shares outstanding) determines its classification as a large-cap, mid-cap, or small-cap stock, which helps investors assess the level of risk and potential return.

How to Buy a Stock

There are a number of ways you can buy stocks, such as through a direct stock purchase plan or through an online broker. When purchasing through an online broker, you can place an order to buy stocks, which will be filled when the price of the stock reaches the desired amount.

You can also invest in stocks through a mutual fund or an ETF, a type of investment vehicle that pools money from individual investors in order to invest in multiple stocks with the goal of diversifying risk. This can be a great way to start investing in the stock market while still limiting potential losses.

The most common order types when buying stocks include:

• Market order: Buys the stock immediately at the current market price.
• Limit order: Sets a maximum price you are willing to pay. The order only executes if the stock reaches that price or lower.
• Stop-loss order: Automatically sells a stock when it drops below a specified price, helping to limit losses.

Common Stock and Preferred Stock

The most common type of stock is common stock, but there are other, less common types such as preferred stock and restricted stock.

• Common stock: When you buy common stock, you become an owner of the issuing business. You get the right to vote in shareholder meetings and can receive split dividends depending on the performance of the company.
• Preferred stock: Preferred stock is a type of stock that gives investors priority over common stockholders when it comes to receiving dividends, and also provides the right to vote in shareholders' meetings. These stocks have a much more reliable dividend rate than common stock, but their price tends to be higher.
• Restricted stock: This type of stock offers special tax benefits to their holders. Restricted stocks are usually allocated to employees as a part of their benefits package, and they cannot be sold on the public stock market except under certain conditions.

Stock Valuation Methods

Investors use various methods to determine whether a stock is undervalued, fairly valued, or overvalued:

• Price-to-Earnings Ratio (PE): The PE ratio compares the stock price to the company's earnings per share. A lower PE relative to industry peers may indicate the stock is undervalued.
• Discounted Cash Flow (DCF): DCF analysis estimates the intrinsic value of a stock based on projected future cash flows, discounted back to present value.
• Price-to-Earnings-to-Growth (PEG): The PEG ratio adjusts the PE ratio for expected earnings growth, helping investors identify growth stocks that are reasonably priced.
• Enterprise Value: Enterprise value provides a more complete measure of a company's total value by including debt and subtracting cash.

Value investors seek stocks trading below their intrinsic value, providing a margin of safety against potential losses.

What is the Difference Between Stocks and Bonds?

Bonds are a different type of financial instrument than stocks. Stocks represent ownership in a company, while bonds represent debt to the issuing organization. The holder of the stock is an owner, and the holder of the bond is a creditor.

Stock holders are generally entitled to voting rights, whereas bondholders are not. Additionally, stock holders are entitled to dividends as long as the corporation generates a profit, while bondholders are generally only guaranteed a fixed rate of return.

Finally, the price of stocks is more variable than the price of bonds, and the scarcity of a given stock affects the price more than scarcity of a bond. Over long time periods, stocks have historically delivered higher returns than bonds, but with greater volatility.

What Are Share Buybacks?

Share buybacks are when a company purchases shares of their own stock in order to reduce the number of shares outstanding. This in turn often leads to a rise in the stock price, as there will now be fewer shares of the company to go around. Share buybacks are usually done to reduce the amount of debt on the balance sheet or simply to return some of the funds to shareholders.

Share buybacks are not without risks. They reduce the amount of liquidity available to investors, and if the price of the stock falls, then the buyback can be viewed as a failed investment. Thus, it is important to do your own research and understand the risks before investing in a stock with the expectation of it being bought back.

What is Dilution?

Dilution is when a company issues new shares of stock to existing shareholders or to the public, thus reducing the existing shareholders' percentage of ownership in the company. A company can issue new shares for a variety of reasons, such as to fund acquisitions or for adjustments to employee compensation.

Dilution can cause frustration among existing shareholders, as it reduces the value of each stock they hold. It is important to understand the pros and cons of a particular company's dilution strategy before investing.

What Are the Risks of Investing in Stocks?

Like any other form of investing, there are risks associated with investing in stocks:

• Market risk: Stock prices move up or down in response to fluctuations in the economy, interest rates, and investor sentiment.
• Company-specific risk: The company may experience losses due to poor performance, bad management, competitive pressure, or regulatory issues.
• Liquidity risk: Some stocks, particularly penny stocks, have low trading volumes and can be hard to sell quickly at a fair price.
• Volatility risk: Stocks can experience sharp price swings in the short term, which can be unsettling for investors with a short time horizon.
• Inflation risk: If stock returns do not outpace inflation, the real purchasing power of your investment decreases.

The best way to manage these risks is through diversification — holding a mix of stocks across different industries and market capitalizations, along with other asset classes like bonds and ETFs. A long-term investment approach and a solid understanding of financial statements also help investors make informed decisions.