Beginners Introduction: What Are Stocks?
Answering the most common questions about buying and selling shares in the stock market.
In this post, we’ll take a look at:
🧭 Key Takeaways
Company shares represent a single unit of ownership in a company. They can be bought and sold on a stock exchange. A common shareholder will be eligible to receive dividends. The stock’s price is primarily based on the expected future earnings and the current underlying value.
Knowledge about company shares is fundamental to understanding the stock market. They determine the ownership of companies and can be bought and sold on stock exchanges. This beginner-friendly guide aims to explain the basic concept of company shares as well as other knowledge related to owning and trading company shares.
What Is A Company Share?
A share (also known as a stock) is a single unit of ownership in a company which can belong to both a public or a private company. Company shares can be traded at fluctuating prices due to factors like market demand and the valuation of the company. A person who owns shares of a company is called a shareholder.
Some brokers, such as Trading 212 or Interactive Brokers, also allow their investors to purchase fractional shares. In this case the brokerage will own the full share and multiple investors will hold a fractional ownership of this full share.
While common shares generally give their shareholders voting rights there may be different classes of shares available. These classes are generally designated as class A, class B etc. For example a company might have class A shares which give the shareholders one vote per share while class B shares might give the shareholders five votes per share.
What Is The Shareholders Equity?
The equity, also called shareholders equity, is the current value a shareholder would receive per owned share if all assets were sold and all liabilities were paid off. However investors will usually not only consider the expected future earnings the company will receive.
What Is The Market Capitalization Of A Stock?
The market capitalization of a company is simply the current share price multiplied by the number of outstanding shares. For example, if a company has 100 outstanding shares at a current share price of 10€ the market capitalization would be 1000€.
What Is The Difference Between Stocks And Shares?
Nowadays the distinction between the terms stock and share are blurry and both are being used interchangeably to refer to investors who own shares of stock in a company. While the term share is more specific than stock both refer to the partial ownership of equity in a public company.
The term stock is generally being used to describe the ownership of publicly traded shares in one or more companies. For example an investor might buy different stocks on an exchange. Shares, on the other hand, refer to the actual partial ownership of a company.
Why Do Investors Buy Stocks?
The goal of an investor is profit from the capital appreciation of their investment. They attempt to buy the share at a cheap price and sell after it at a profit by following an investing strategy, such as value investing, growth investing or dividend investing. This allows them to value how much one share of a company should be worth. Based on this estimation they can determine whether a share might be a good purchase.
Another benefit of stock ownership is that investors will often be eligible to receive dividends. However this is often dependent on the dividend policy of the company. Generally more mature companies tend to pay out dividends while younger or small companies reinvest their earnings to achieve higher growth.
What Is The Difference Between Common Stock And Preferred Stock?
Common stock represent an ownership in a company. Common shareholders have the right to vote in shareholder meetings. In addition they are eligible to receive dividend payments in case the board of directors votes to pay dividends to the company’s shareholders. However in reality retail investors holding small amounts of shares have relatively little influence on the company.
Preferred stock, on the other hand, are more similar to fixed income securities. They entitle their shareholders to fixed dividend payments in regular intervals. These preferred dividends will be prioritized over the common stock dividend. However in return the preferred shareholders does not receive voting rights.
The value of common shares is determined by the expected future earnings growth. Contrary, the value of preferred stock is primarily based on the dividend yield. This is because preferred stock works more like fixed income securities, such as bonds.
What Is A Stock Exchange?
A stock exchange is a public marketplace where investors can buy or sell stocks and other securities like exchange-traded funds (ETFs). They are also sometimes referred to as the secondary market or simply the stock market.
Buyers and sellers of shares are being connected through an intermediary stock broker. These brokers are offering their service in exchange for a small commission as well as other fees.
Companies which can be bought via an exchange are called public companies. Public companies first have to be listed on the exchange through an initial public offering or a direct listing. Private companies are not listed on an exchange and their shares can only be traded by purchasing directly from existing shareholders.
As there is only a fixed set of shares issued a purchase or sale might not go through immediately. First the broker has to find a suitable buyer or seller who is willing to take the opposite side of a stock order. As a result the liquidity of the market dictates the availability of shares for purchase.
What Types Of Stock Exchanges Exist?
There are two types of exchanges. In an auction-based exchange buyers and sellers come together through physical communication by matching them based on their bids and offers. The largest auction-based exchange is the New York Stock Exchange (NYSE).
Digital exchanges on the other hand work by trading electronically without physical interaction. This enables faster trades and removes the requirement of a physical exchange. One of the best known electronic exchange is Nasdaq.
How Is The Company’s Stock Price Of A Share Determined?
A company sets the initial price per share when it is selling shares and goes public in an initial public offering (IPO). The initial company’s stock price is based on the expected future earnings of the company. In addition investors will analyze the current underlying value based on the company’s financial statements.
Once a share is available for trading on the stock market the share price is based on what investors are willing to pay for it. Therefore supply and demand are the major factors which push the share price up or down.
It is important to understand that not only fundamental, objective facts influence the supply and demand but also subjective factors which are often based on emotions like greed or fear. Factors influencing the share price are analyst estimates, financial reports, news about the company or other events which might have an impact on the company.
What Is The Difference Between Outstanding, Authorized And Issued Shares?
The number of shares which are currently being available for trading are called outstanding shares. As an outstanding share is still available it can be bought or sold in the stock market.
However outstanding shares don’t necessarily have to equal the amount of shares a company’s board of directors is authorized to issue. The company’s shareholders are able to authorize more shares than are currently outstanding. By selling these additional shares the company can acquire new equity at a later date.
Similarly the amount of shares actually issued can deviate from the amount of outstanding shares. For example, a company might have bought back shares from shareholders in a share buyback. In this case the number of issued shares is higher than the number of outstanding shares as the it had been reduced in the buyback.
What Are American Depositary Receipts?
There is one special type of share called an American depositary receipt (ADR). It allows investors to buy and sell foreign stock which would otherwise not be available on an American exchange. At the same time it reduces the complexities of dealing with foreign companies.
The difference between regular shares and ADRs is that the shareholder does not directly own a share in the foreign company. Instead they own a certificate issued by a U.S. bank which represents the shares owned in the foreign stock.
What Is Share Dilution?
The distribution of company shares determines the total ownership of a company. As a result if an investor of a company which issued 100 shares owns 25 shares the investor owns 25% of the company. Dilution occurs when the proportion of shares owned by shareholders is changed. This can happen when a company issues new shares, for example to raise new capital or pay for acquisitions or services, or when it buys back existing ones. As Dilution changes the proportionate ownership of the company it causes a potential loss of value for shareholders..
What Is A Rights Issue?
When a company has to raise more capital it may issue new shares to on the secondary market. In this case a company may offer existing shareholders the right, but not the obligation, to buy additional shares at a preferential price by a given date. This practice is meant to reduce dilution for existing shareholders who accept the offer.
Shareholders can usually choose between three actions when they receive a rights offering:
- They can accept the rights offering and purchase the offered shares at the preferential price.
- They can refuse the offer and sell them on an exchange for a price which is determined by the market instead.
- If they take no action the rights offer will expire and the shareholders will be diluted. Many banks and brokerages will sell the rights automatically and pay out the proceeds to the owner rather than letting them expire.
What Is A Stock Split?
Contrary to a rights offering the proportionate ownership of a company is not being changed in a stock split which is being decided by a company’s board of directors. Rather the amount of owned shares increases while the value per share decreases. However as neither the overall valuation of the company nor of each shareholders owned shares change there is no dilution happening.
For example in a 2-for-1 stock split the company would double the amount of outstanding shares. In return the value of each share is cut in half. If a company previously issued 100 shares and each share is worth 2 Euros there would be 200 shares after a 2-for-1 stock split with a value of 1 Euro each. As a result an investor who owned 10 shares would own 20 shares afterwards which will have the same value.
Stock split can be attractive opportunities for investors as the new lower price makes share more accessible to smaller investors and therefore provides more opportunities to grow the share price.
What Is A Reverse Stock Split?
A reverse stock split is the opposite procedure than a stock split. In a reverse stock split rather than increasing the amount of issued shares the amount is being decreased. Like with a regular stock split the value of the overall stake of each shareholder is preserved and only the amount of shares owned changes. For example in a 2-for-1 reverse stock split an investor owning 10 shares worth 1 Euro each would end up with 5 shares worth 2 Euros each.
What Is A Share Buyback?
A share buyback happens when the board of directors of a company decides to buy back outstanding shares from existing shareholders. The bought back shares are then reflected as treasury stock on the balance sheet of the company and is treated like a liability agains the company itself. Share buybacks are highly popular amongst investors as the amount of outstanding shares decreases and therefore the value of the remaining outstanding shares increases.
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