What is a stock?
A company's operations are financed in one of two ways. The
first way is by loans from major lending institutions such as banks and credit
agencies or though sales of bonds. The other way for a company to raise money
to fund its operations is through sales shares of stock or equity. Shareholders
are essentially owners of small pieces of the company, because that's what a
share of stock is. Therefore, the management of the company is responsible to
the shareholders, because they are essentially owners of the company that they
are managing.
Why Invest in Stocks?
So why invest in stocks? They are volatile, risky, and the
investor could lose if the market crashes. The answer is actually quite simple.
Stocks allow the investor to own successful companies, and stocks tend to be
the best investments over time. And, if the investor is not a speculator and
does his or her due diligence and research, stocks can really pay off.
Table 1 below shows the average total return of stocks measured
by the S&P 500 Index and AAA Corporate Bonds shown by Moody's Seasoned AAA
Corporate Bond Yield Index over five decades.
Table 1- Percentage Return
Compiled Using Data from FRED and Yahoo Finance
It's easy to see that every 10 year period, stocks have
outperformed bonds, and by quite a lot. Even during the 1980s when one of the
great recessions happened and the 1990s when the dot com bubble burst, stocks
on average seemed to provide a way better return than bonds.
Types of Shares
However, not all shares of stock are created equal. There are
two types of stock offered by the company in order to finance its operations.
Even though most beginners will deal with common stock, it is necessary to
understand both types:
Preferred Stock
The first type of stock is preferred stock. If the company
goes bankrupt and after all the creditors get paid off, the holders of
preferred shares get first claim on whatever is left over, followed by the
holders of common stock. Preferred stockholders usually get paid dividends, and
if there's still money left over after paying dividends to the preferred
stockholders, the corporation will issue a dividend to pay the common
stockholders. Furthermore, preferred stock shares usually do not have voting
rights.
The exact definition and rights of preferred stock vary from
company to company, but the best way to think of this of preferred stock is a
financial instrument that is similar to a bond (fixed dividends) and equity
(stock price appreciation).
Common Stock
The stock that is most often traded on the markets is common
stock. Corporations usually issue a lot more shares of common stock than they
do preferred. Holders of these shares maintain control of the company through a
board of directors, and have voting rights on corporate policy. However, they
are on the bottom of the list if the company goes bankrupt and gets liquidated,
right after the creditors, bondholders and preferred stockholders. However,
common shares most often outperform preferred shares in the long run.
Making money in stocks
So how can stocks return gains on the money Tony invests in
them? There are several ways:
Capital Appreciation
The first is capital appreciation, or when the price of the
stock goes up. Therefore, the capital that Tony has invested into the security
has increased in value, because the value of his shares has increased. The
capital appreciations part of the investment includes all of the market value
exceeding the original investment or cost basis.
Dividend
The other way to make money is by holding stocks that pay
dividends. Dividends are a distribution of a portion of a company's earnings to
a class of its shareholders. The distribution of dividends and how much is
decided by the company's board of directors. It's most often quoted in the
terms of the dollar amount per share such as $.50 per share. For example, if
Tony is the owner of 10 shares of Disney, and they decide to issue a dividend
of $.50 a share, he will receive a total dividend of $5 for the shares that he
is holding. Not all companies pay dividends, but generally the well
established, slow growth companies. High growth companies usually reinvest
their dividends in order to maintain high levels of growth and don't pay out
their investors.
Declaration Date
This is the date on which the next dividend payment is announced
by the board of directors. This announcement will include the dividend size,
ex-dividend date and payment date. Once this announcement has been made, the
dividend becomes a declared dividend and it is now the company's legal
liability to pay it. Ex-Dividend Date
This is the date on which the security becomes traded without
a previously declared dividend. After this date, the seller, and not the buyer
of the stock will be entitled to the announced dividend. It is usually two
business days before the record date.
Record Date
This is the date on which the shareholder must be holding the
security in order to receive the declared dividend. On this date, the company
records who the holders on record are and makes sure that they receive the
dividend. Even if the shareholder sells the stock after this date, he or she
will still receive the dividend. Payment Date
This is the date on which the dividend payment is finally
made. Only the shareholder who bought the stock before the ex-dividend date and
were still holding it during the record date will receive the dividend
distribution.
Extra dividends
These are a non-recurring distribution of the assets of a
company, determined by the board of directors to shareholders. These are
unusually large in size and are not on the usual payout date. These dividends
are often declared following strong earnings results as a way for a company to
distribute the really good profits of the fiscal cycle to the shareholders.
Stock Splits
A stock split is a corporate action where existing shares are
divided into two or more shares. Even though the number of shares increases,
the value of each share decreases proportionally. This is in order to keep the
company's market capitalization (explained further) the same, since no real
value has been added because of the split. For example if Google is currently
trading at $580 a share, and has 33.74 Million shares outstanding. The company
decides to do a 2:1 split. The stock price becomes $290 a share and they now
have 67.48 Million shares outstanding. In each case, 290 * 67.48Million and
580*33.74 million provides the same number for market capitalization. In
addition, if an investor is the owner of 100 shares before the stock split, he
or she is the owner of 200 shares after. Companies may do this in order to
decrease their per share price so that different kinds of investors would
invest in it. For example, since Tony only has $10000 to invest, he can only
buy 16 shares of Google, and if the stock goes up by $100, he will only make
$1600. However, if he buys after a 2:1 split for Google, he can buy 32 shares,
and if those shares increase by $100 a share, he or she will make $3200.
Therefore, in order to attract smaller investors, companies may want to perform
a stock split.
Stock splits also go the other way. A company can also reduce
the number of shares trading on the market by doing a reverse stock split. This
can be done to increase the company's Earnings per share, even though nothing
has really changed. It's usually a bad sign if the company has to reverse stock
split as they may do so to make their shares look more valuable or even to
avoid being delisted.
