What exactly is a stock?
So I know this may be on the top of many of your minds. You know investing is a good and right thing to do, but what exactly is a stock?
I'm glad you asked – let's dig in and find out! If you hunt online, some of the definitions for "stock" are difficult to understand. I will explain what a stock is by using a hypothetical example.
Getting Started – What Exactly Is a Stock?
Let's say you are living in the mid 1800's and you are interested in starting up your own buggy whip manufacturing business. There are four basic options available to you to get your company the funding it needs:
-Have a rich uncle.
-Use your own money to startup operations.
-Take out a loan from the bank or other creditors.
-Find partners that are willing to invest in your business venture by selling them a stake in your business.
If you come from a wealthy family, then choice #1 or #2 may be a viable option for you to get your enterprise off the ground. In this hypothetical case, you are not rich – sorry! Now, let's move onto option #3 and explore this possibility. You could take out a loan from the bank if you are able to persuade the bankers that you are not a credit risk. Bad news again – in this hypothetical case, you cannot find a bank that is willing to take the risk and lend you the money – dangnabbit! It seems that the only option that will work for your potential buggy whip company is option is #4.
Selling a Stake in the Business?
So, option #4 it is! Now let's say you decide to take your yet uncreated company and split it up into 1,000 small little pieces. We call these 1,000 pieces shares of stock (equity). If you are able to persuade your friends, family, and other investors to buy a share of stock, they will now own a small piece of your new company. We call these owners of some of the equity in your new company "stockholders" or "shareholders." These stockholders are small owners of the company.
Why would anyone want to purchase equity shares of stock in your company?
Well, let's suppose that your buggy whip manufacturing company is wildly successful. Congratulations – I always knew you were destined for success! The buggy whip manufacturing firm can take three actions with its profits:
Sell off all or part of the company (assets) and return the money to the owners (stockholders/shareholders)
Reinvest the money to expand business and increase revenues (purchase assets)
Pay out the profits to owners (stockholders) and continue operations.
Of course, every company can undertake any number of combinations of these three actions. In this case, because things are going so well, the business will plan to reinvest half of the profits to expand operations. The buggy whip business will take the other half of the profits and distribute them out to stock shareholders (owners).
Stocks and Dividends
This payment to shareholders is known as a dividend. Out of the total pot of money allocated for a dividend, each shareholder will receive a dividend payment in proportion to the amount of stock they own out of the total amount of stock issued. In this case, after reinvestment in the company, let us assume that there were profits of $500,000 that will be paid out as a dividend to shareholders. Because there were 1,000 shares of company stock issued and sold to investors, each investor will receive $500 per stock share that they purchased.
Why Do Investors Purchase Shares of Stock in the First Place?
All investors purchase a company's stock with the expectations that eventually they will be compensated. These investors are taking a risk by purchasing company shares in the hope that the company will eventually generate a profit. If profits are continually generated, eventually there will be a dividend once the company grows to its desired size or the company will buy-back shares and reduce the total amount of stock in circulation thereby increasing the value of each stock remaining investors hold.
All long-term investors are ultimately after a dividend. Long-term investors base the amount of money they are willing to pay for a stock on an estimate of how much money the company will eventually earn and pay out as a dividend. I will cover concepts behind this method of stock valuation in greater detail in a future post.
Stocks and Risk – All Your Eggs in 3 Baskets?
In the example above, I discussed the stock of a single company – the buggy whip manufacturing company. You can see that if investors are working to limit their investment risk, they understand the wisdom of investing in 25 or 30 companies. If investors had most of their money in just two or three companies, any one company could go bust causing them to lose a substantial portion of their investment.
What Exactly Is a Stock? – Final Thoughts
Historically, investors motivated to purchase stock in many companies (25-30 or more) had to pay large fees known as trading commission. Brokers loved this, but as far as the investors were concerned – not so much... If only there were "stocks" that combined the stock of several companies into a single investment. If such a thing existed, then this "bucket" of stocks would certainly make things easier for us. There would be no need to purchase and track 25 or 30 separate stocks concurrently... We are speaking, or course, of a market index fund.
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