Investing 101

What Happens When You Buy Stock In A Company?

To make a long story short, when you buy stock, or shares, you own a slice of the company. Stock is what is referred to as an equity investment and stocks are shares of a particular company that are traded on the market both privately and publicly. By buying a shares in a company, you are technically a part owner, albeit a probably very small part. These shares (or stocks, as these two terms are synonymous) are traded publicly. By having shares in a company, you are entitled to share in the profits the company makes. You also have the right to vote on certain company decisions made in stockholder meetings.. You can buy stocks either from a stock exchange or over-the counter. Over-the-counter stocks (OTC) are those that do not meet the regulations required to be on a more centralized exchange market; this includes stock in smaller companies unable to meet listing requirements.

Why do people buy stocks?

Most of the time, people buy stocks for one of the following two reasons:

• They expect the stock to increase in value over time (growth, or capital appreciation): a hoped-for increase from the share’s purchase price to the actual market price somewhere in the future)
• They expect the corporation to pay them dividends, which is a portion of its profits (income): dividends are important, as they pay shareholders profits earned from an investment.

In fact, many stocks offer the best of both worlds, and that is both growth and income.

When a corporation issues stock, the company receives the proceeds from that initial sale. After that, shares of the stock are traded, or bought and sold among investors, but the corporation gets no income from these trades. the price of the stock moves up and down depending on how much investors are willing to pay for it at a particular time.

The value of a stock is determined by a number of factors. As a rule, stocks tend to be well ahead of inflation, bonds, and other investment vehicles when it comes to return on investment, and that makes them the best option for long term investing. What it costs to purchase a stock does not tell you what its earning potential is, and various ratios have been developed to assess whether a stock is overvalued or undervalued.

Common Stock

Most stock that is issued for sale by corporations is common stock. Shareholders can vote on any issues that may affect the corporation; one vote per share is allowed. Owning it entitles the buyer to collect dividends if the company pays them, and you can sell shares at a profit if its price increases. The catch is that stock prices are pretty volatile, so you have to understand that your shares could lose value, especially in the short term. By “volatile”, we mean that stock prices may increase or decrease rapidly. One of the ways to protect yourself against this volatility is through diversification. In that same line of thought, it’s usually recommended to consider the benefits and risks of investing abroad and put some money out of the US market to benefit from growth in other countries.

If the company goes bankrupt, common shareholders only receive what remains after creditors, bond holders and preferred stock holders have been paid. This makes common stock more risky to own than bonds and preferred shares, but common stocks frequently rewards investors with higher returns over the long run.

Preferred Stock

Some companies issue preferred stock in addition to common stock. These equity investments (they do, after all, also represent ownership in a corporation), which also trade in the secondary market, are listed separately from the company’s common stock and trade at a different price. Preferred stock dividends are paid before common stock dividends and are often guaranteed, unlike those on common stock. Preferred shareholders are also more likely to recover some of their investment if the company fails. Conversely, preferred stock owners do not have voting rights.

The prices of preferred stock tend to change little over time, which means they pose less risk. But the dividends typically aren’t increased if the company’s earnings increase, which limits potential gains. Preferred stocks are a stable investment vehicle, pretty much guaranteeing a timely dividend. The combination of these various characteristics help explain why preferred shares are sometimes described as hybrid investments – a combination of fixed income and equity.

Preferred stocks can be exchanges for common stock, and the issuer has the right to redeem the investment at all times. The difference between preferred stock and common stock are the voting rights and a fixed income.

Classes Of Stock

Companies may issue different classes of stock, label them differently, and list them separately on a stock market. Sometimes a class is indicative of ownership in a specific division or subsidiary of the company. Other times it indicates that shares that sell at different market prices, have different dividend policies, or impose voting and/or sales restrictions on ownership.

Stock Splits

A stock split occurs when a company creates more shares of their company by splitting the amount of shares they have, doubling, tripling, the amount of shares, or more.

So why do stocks split? Well there are many reasons why the management of a company might decide to split its stock. It might for instance they may want to make it more affordable for the average man. If the stock is trading at a very high price, let’s say $200, then a lot of people will be unable to buy the stock, so it will be overlooked. Corporations have come up with a way to make their shares more accessible, by splitting the cost to lower the price, with the expectation that it will stimulate trading. When a stock is split, there are more shares available, but the total market value of the company remains the same.

Say a company’s stock is trading at $200 a share. If the company declares a four-for-one stock split, it gives you four shares for each one you own. At the same time, the price drops to $50 a share. If you owned 300 shares selling at $200, after the split you now own 1,200 shares selling at $50. The value of your investment in that company remains the same: $60,000.

The initial effect of a stock split is no different from getting coins in exchange for a dollar bill. But the price may move up toward the pre-split price, increasing the value of your stock.

Stocks can split three-for-one, three-for-two, ten-for-one, or any other combination.

Reverse Stock Splits

In a reverse split, the corporation reduces the number of shares outstanding (say ten shares for five) and the price increases accordingly. Again, if you owned $60,000 worth of stock before the reverse split, you will own $60,000 worth of stock after the reverse split too. Typically the motive is to boost the price so that it meets a stock market’s minimum listing requirement or makes the stock attractive to institutional investors, including mutual funds and pension funds, which may not buy very low-priced stocks.