We’re pretty sure you’ve heard the terms “stock” and “share” before. Well, aside from being a cooking ingredient or a virtue, that is. These two terms are used interchangeably and it’s important to keep this in mind to avoid confusion.
As an investor, these terms are probably one of the first things you’ll hear as you start your investing venture. Let’s break down what stocks are and what you need to know about them.
A corporation issues stocks when it wants to raise capital which it is not obliged to pay within a specified period of time, unlike debt. Of course, like what your parents told you, there’s no such thing as free money, right?
Companies and individuals who want to provide capital to corporations are given a parcel of ownership in the company in exchange for the consideration, usually cash, given by them. This piece of ownership is signified by stocks, which are intangible representations of ownership. These stocks entitle their holders a claim or part in the corporation’s assets and earnings.
So, there are two types of stocks – common and preferred. Each of these types have their own pros and cons. Common stocks entitle their holders voting rights. Important business decisions are usually decided upon by voting among the owners of the corporation. Holders of common stocks have the right to participate in this voting.
Preferred stock generally cost higher than common stock. However, generally, these stocks do not entitle their holder voting rights. You might be thinking – what’s in it for them? Well, a lot!
When corporations are doing well and generating income, dividends – usually in the form of cash – are paid to the company owners. Holders of preferred stock get higher dividends. In addition, in the event of bankruptcy, holders of preferred stock get their money back first before those of common stock.
Stocks are issued by the corporation and owned by the company or individuals who purchased them. Stock owners are referred to as “stockholders” or “shareholders”.
Stocks are issued for the first time by corporations through an initial public offering (IPO). An IPO is generally a milestone for the company. Corporations usually don’t offer all of their stocks in an IPO. So, for instance, a company registered that on the aggregate, it has 10,000 stocks. During an IPO, they can decide to only offer 5,000 stocks, and save the rest for next time.
Those who have purchased the stocks in an IPO can subsequently retain ownership of the stocks or decide to sell them.
Stocks are traded in – where else? The stock market, of course! What is a stock market? The stock market is a broad term. Specifically, stocks are issued and traded in stock exchanges, where buyers and sellers of stocks and other financial securities gather.
Corporations issue stocks if they need to raise capital which they can retain for the longer term. In the most basic sense, a company’s assets are attributable to two parties – their debtors and their shareholders. Debt, however, is more demanding than stock in the sense that it needs to be repaid in a specified time with interest. Stocks don’t need to be repaid, in fact, shareholders must not get repaid unless the company buys back shares, goes bankrupt or undergoes liquidation.
A shareholder’s claim can be measured based on the proportion of stocks owned vis-à-vis the “outstanding” stocks. So let’s say a corporation has 10,000 stocks but have issued only 5,000 of them. Only 5,000 stocks can be considered outstanding. A shareholder with a 1,000 stocks has a 20% (1,000 divided by 5,000) claim in the corporation.
An investor earns in two ways – dividends or capital appreciation. As previously mentioned, corporations issue dividends to the stockholders when business performance is good. On the other hand, investors may also opt to trade these stocks for a profit as the price rises.