What comes to your mind when you hear a conversation about investing in stocks?
Do you think about gambling, or Wall Street, or stock brokers, or the most recent financial crisis? Perhaps you’ve heard the media use all of these terms interchangeably, creating more confusion about stock ownership.
Instead of relying on loosely defined financial jargon, this article will explain what stocks represent, and why you might be interested in owning them.
What are Stocks?
Stocks represent ownership interest in a company. When you purchase the stock of a particular company, you become a “shareholder” in that business. Stocks are often called equities because the shareholders legally own the net assets of a company, which is also known as equity.
Companies issue stock to raise investment capital that is needed to grow the business or create new projects. If a company decides to raise capital through a public stock offering, the stock shares can then be bought and sold by investors on the stock exchange where the company is listed.
There are two main types of stock, called common stock and preferred stock.
The majority of publicly issued (and traded) stock is common stock, which is what most people think about when discussing “stocks.”
The remainder of this article will focus on common stock, but feel free to also visit my guide to preferred stock if you are interested.
Why Do Investors Choose Stocks?
Stock ownership provides several benefits that attract investors.
1) Share in the company’s profits
When you purchase the stock of a publicly traded company, you are entitled to a portion of the company’s financial gains.
Company profits are the foundation of any stock’s value, and profits depend on earnings. For this reason, stocks are often valued in relation to earnings. For example, a stock’s price will often fall if a company misses their estimated quarterly earnings. Similarly, the stock price will increase following positive earnings news.
As a shareholder, you can share in a company’s profits in the following ways:
Dividends – A dividend is a payment to shareholders as a distribution of profits. Dividends are typically paid to shareholders quarterly (four times per year), but companies may issue special dividends at any time. Not every company issues dividends and a company may increase, decrease, or eliminate future dividend payments, depending on the performance of the business. The most common type of dividend is a cash payment to shareholders, although firms can issue dividends in the form of more stock.
Capital Appreciation – Instead of paying dividends, a company might decide to retain earnings. It can reinvest the earnings into future growth by creating more products, hiring more employees, increasing advertising, or any number of capital expenditures that are expected to increase earnings over time.
By creating additional earnings, the company becomes more valuable, which increases the stock price per share. When the value of your stock increases over time, you can sell the shares to another investor and realize a profit (known as a capital gain).
You may be wondering if dividends are a magical source of free money. The answer is no.