Stock: Understanding Stocks And Bonds

What Is a Stock, Exactly?

A stock (also called equity) is a financial instrument that represents ownership of a portion of a company. This entitles the stockholder to a share of the corporation’s assets and profits proportional to the amount of stock they own. “Shares” are the units of stock.

Stocks are the foundation of many individual investors’ portfolios and are bought and sold primarily on stock exchanges, though private sales are possible. These transactions must comply with government regulations designed to protect investors from deceptive practices. They have historically outperformed most other investments over time. The majority of online stock brokers sell these investments.

Stocks: An Introduction

Stock is issued (sold) by corporations to raise funds to operate their businesses. The stockholder (shareholder) has now purchased a piece of the corporation and may be entitled to a portion of its assets and earnings, depending on the type of shares held. To put it another way, a shareholder has become a shareholder of the issuing company. The number of shares a person owns in relation to the number of outstanding shares determines ownership. For example, if a company has 1,000 outstanding shares of stock and one person owns 100 of them, that person owns and has a claim to 10% of the company’s assets and earnings.

Stockholders do not own corporations; rather, they own shares issued by corporations. Corporations, on the other hand, are a special type of organization because the law treats them as legal persons. In other words, corporations pay taxes, can borrow money, own property, and can be sued. The concept of a corporation being a “person” implies that the corporation owns its own assets. A corporate office with chairs and tables is owned by the corporation, not the shareholders.

This distinction is significant because corporate property is legally distinct from shareholder property, limiting the liability of both the corporation and the shareholder. If the corporation declares bankruptcy, a judge may order the sale of all of its assets, but your personal assets are not at risk. The court cannot even order you to sell your stock, even if the value of your stock has plummeted dramatically. Similarly, if a major shareholder declares bankruptcy, she will be unable to sell the company’s assets to satisfy her creditors.

Equity ownership and stockholders

The shares issued by the corporation are what shareholders actually own, and the corporation owns the assets held by a firm. So, if you own 33% of a company’s shares, it is incorrect to say you own one-third of the company; instead, you should say you own 100% of one-third of the company’s shares. Shareholders are not free to do whatever they want with a corporation or its assets. A shareholder cannot walk away with a chair because the corporation, not the shareholder, owns the chair. This is referred to as “separation of ownership and control.”

Owning stock gives you the right to vote in shareholder meetings, receive dividends (the company’s profits) when and if they are distributed, and sell your shares to someone else.

If you own a majority of the shares, your voting power increases, allowing you to indirectly control a company’s direction by appointing its board of directors. This is most obvious when one company buys another: the acquiring company does not go around buying up the building, the chairs, and the employees; instead, it buys up all the shares. The board of directors is in charge of increasing the value of the corporation, which is often accomplished by hiring professional managers or officers, such as the Chief Executive Officer, or CEO.

Not being able to manage the company isn’t a big deal for most ordinary shareholders. The significance of being a shareholder is that you are entitled to a portion of the company’s profits, which, as we will see, form the basis of a stock’s value. The greater your stake in the company, the greater your share of the profits. Many stocks, on the other hand, do not pay dividends and instead reinvest profits in the company’s growth. However, these retained earnings are still reflected in the value of a stock.

Preferred Stock vs. Common Stock

Stock is classified into two types: common and preferred. Common stock typically entitles the owner to vote at shareholder meetings as well as to receive any dividends paid out by the corporation. Preferred stockholders typically do not have voting rights, but they do have a greater claim on assets and earnings than common stockholders. For example, preferred stockholders (such as Larry Page) receive dividends before common stockholders and have priority if a company goes bankrupt and is liquidated.

Fast Fact: The Dutch East India Company issued the first common stock in 1602.

When a company needs to raise funds, it can issue new shares. This procedure dilutes existing shareholders’ ownership and rights (provided they do not buy any of the new offerings). Corporations can also engage in stock buybacks, which would benefit existing shareholders by increasing the value of their shares.

Bonds vs. stocks

Companies issue stocks to raise capital, either paid-up or share capital, in order to expand the business or embark on new projects. There are important distinctions between buying shares directly from the company when it is issued (in the primary market) and buying them from another shareholder (on the secondary market). When a corporation issues stock, it does so in exchange for money.

Bonds differ fundamentally from stocks in a number of ways. First, bondholders are creditors of the corporation, and they are entitled to interest as well as principal repayment. In the event of a bankruptcy, creditors have legal priority over other stakeholders and will be made whole first if a company is forced to sell assets to repay them. Shareholders, on the other hand, are often the last in line and receive nothing or only pennies on the dollar in the event of bankruptcy. This means that stocks are inherently riskier than bonds.

Questions and Answers

What exactly is a stock?

A stock is a type of security that gives the holder a portion of a company’s ownership. The holder of this stock may be granted a portion of a company’s earnings, which are distributed as dividends. In general, there are two types of stocks: common and preferred. Common stockholders are entitled to dividends and the right to vote at shareholder meetings, whereas preferred stockholders have limited or no voting rights. Preferred stockholders typically receive higher dividend payouts and a greater claim on assets in the event of a liquidation than common stockholders.

How do you purchase a stock?

Stock exchanges, such as the Nasdaq or the New York Stock Exchange (NYSE), are where most stocks are bought and sold . Following a company’s initial public offering (IPO), its stock becomes available for investors to buy and sell on an exchange. Typically, investors will use a brokerage account to purchase stock on the exchange, which will display the purchasing price (the bid) or selling price (the ask) (the offer). The stock price is influenced by market supply and demand factors, among other things.

What’s the distinction between a stock and a bond?

When a company raises capital by issuing stock, the holder receives a portion of the company’s ownership. When a company raises funds for its operations by selling bonds, the bonds represent loans from bondholders to the company. Bond terms require the company or entity to repay the principal as well as interest rates in exchange for this loan. Furthermore, bondholders have priority over stockholders in the event of a bankruptcy, whereas stockholders are typically last in line for asset claims.

For Further Reading:

What Is a Mortgage and How Does It Work?

 

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