Investing Series: Understanding Stocks

Per reader request, I am starting a series on investing. As the blog continues, I will eventually get to more advanced concepts such as buying on margin, how to evaluate an investment, etc. For now, I want to start with the basic building blocks of market investing. The first two weeks will cover stocks and bonds, as those concepts will be referred to throughout the series.

What is a stock?

A stock is a partial ownership in a company. If you own a stock, you are a shareholder of that company. You literally own a small part of the company when you purchase a stock. And when I say small, I mean small. Think 0.000005% levels of small! That number, by the way, represents owning one share of a company that has issued 20 million shares overall. If a company has only issued 1000 shares and you own one of them, you own 0.1% of the company. If they’ve issued 1 million shares and you own 20,000 shares, you own 2% of the company. So on and so forth.

A stock is a general term to refer to partial ownership in any company, or multiple companies. The word “shares” refers to the amount of partial ownership in a particular company. In the examples I’ve used below, I use them essentially interchangeably, because all of my examples are referring to a single fictional company at a time. However, if you are referring to multiple companies you can use the words to differentiate meanings. For instance, you might say “I own 200 stocks, including 100 shares of Coca-Cola and 25 shares each of Caterpillar, Disney, Delta, and Proctor & Gamble.”

Companies that sell stocks to the general public are often referred to as “publicly traded.” Publicly traded companies have financial reporting requirements that private companies are not necessarily required to complete.

Why do companies issue stocks?

If a company issues stock, they are trying to raise money. They are offering equity in the company in exchange for cash in hand now. It’s also a way for the company’s founders and owners to turn the perceived value of the company, which you can’t spend, into paychecks. It allows them to cash out on the work they have put into the company thus far.

However, not all companies want to sell stock publicly. There are lots of companies that do not go public, for various reasons. The first large company that I learned about that refused to “go public” (issue stock) was In-N-Out Burger. If you aren’t familiar with In-N-Out, they are a medium-sized regional fast food burger restaurant. They have chosen to remain privately owned because they don’t want to risk a loss of quality or customer consistency.

But many of the companies you deal with on a given day are publicly traded stock-issuing companies. Staying in the fast food hamburger realm, McDonalds, Burger King, and Wendy’s are all publicly traded.

What are the potential risks and benefits of owning stocks?

Of course, the #1 potential benefit of buying a stock is the possibility of wealth building. Historically, stock prices go up over time. If you look at a short investing timeline for a single stock that isn’t always true, but over decades a diversified portfolio of stocks always goes up. There are lots of arguments about how much money you can expect to earn over the long term, but on average I am confident in saying the price will go up if you are appropriately diversified.

Of course, sometimes individual stock prices don’t go up. Even broadly diversified groups of stocks can lose value. Sometimes, businesses fail. Or you bought when the stock price was too high, and it never gets back to that number. That is the #1 potential risk of owning stocks – you might lose money. This can be mitigated by investing in a wide array of stocks instead of picking one or two individual stocks, but the risk is always there.

How do I earn money with a stock?

There are two ways to profit from a stock. The first is – you guessed it – dividends! You can receive regular payouts from a dividend stock. You can then use those payouts as income, or you could use a Dividend Reinvestment Plan (DRIP) to purchase more stocks. This is a stable, predictable, low-excitement way to earn money from stocks.

The second way to earn money from a stock is through appreciation of the stock price. Unlike dividends, with appreciation (aka capital gains) you don’t actually see any money until you sell the stock. Any earnings you think you have are on paper only until then.  And depending on what method you used to purchase the stock, you may have to pay either short- or long-term capital gains taxes on any profit. Appreciation is the exciting but unpredictable way to earn money from stocks. When you hear somebody say “My stock went up 40%!” they are talking about appreciation of the stock price.

The total return of a stock is the combination of the dividend returns (if it has dividends) and the stock’s appreciation while you’ve owned it. As a very simple example, let’s say you purchased a single stock for $100.00. Every quarter, that stock paid out a $1.00 dividend. Over the course of the year, the dividend return is $4.00, or 4% of the purchase price. At the end of the year, the stock has appreciated in value to $105.00. The capital gain of the stock is $5.00, or 5%. The total return of that stock over the course of the year, then, is $9.00, or 9%.

$4.00  dividend return + $5.00 capital gains = $9.00 total return

$9.00 divided by $100.00 initial cost = 9% total return

What is a stock split?

Occasionally, a company may decide to increase the number of shares issued for the company. With a stock split, the market capitalization (market value of the shares) doesn’t change. For instance, say the market value of a company’s shares are $20 million, and they have 1 million shares. That means the shares are $20 each ($20 million / 1 million = $20). If the company decides to split the stocks at a 2-for-1 rate, there would suddenly be 2 million shares. But the value of the company hasn’t changed as a result of that decision, so the stock price changes too. In this case, a $20 million market capitalization rate company, with 2 million shares, means each share now costs $10 each.

As a shareholder of a company that undergoes a stock split, your number of stocks would increase based on the stock split ratio. For instance, if you owned 20 shares and the stocks split was 2-for-1, you would automatically own 40 shares after the split completes (20 * 2 = 40). If the stock-split was 3-for-2, you would own 30 shares (20 * 3/2 = 30).

A company may decide to split stocks for several reasons, including lowering the price of individual shares. This can have a positive psychological effect on investors, making them see the company as easier to buy into. The important thing to remember, though, is that a stock split doesn’t actually change the value of anything other than the individual stock. The overall market value of the company stays exactly the same. So a stock split does not necessarily mean anything good or bad for the company, though people often correlate it with positive results by the company. One of the most famous stocks, Berkshire Hathaway (BRK.A) has never had a stock split. That doesn’t mean BRK.A is a bad stock. I’d love to get my hands on some! And that is coming from someone who rarely-if-ever recommends buying individual stocks.

Should I buy a stock?

At all? Probably. Historically, stocks enjoy higher earnings than most other types of investments (such as bonds).

Should you buy a particular stock? That’s where the answer gets more tricky. If you are willing to do the research required to find out about a company’s financials, it’s projected earnings, etc, maybe the purchase is a good one. If you don’t want to do that research, a better bet for you is likely going to be one of several types of funds. We’ll get into the details on investment funds in the coming weeks.

Do you own stocks? Do you have a favorite individual stock?