Stocks are among the most talked about and most popular investment opportunities available. But although virtually everyone has heard about stocks, many people don’t understand the basic concepts underlying them. Indeed, the starting point for any investor interested in investing in stocks should be to understand what shares of stock actually represent and why there is a market for them.
Simply put, shares of stock represent partial ownership in a company. That is to say, when you own a share of stock, you actually own a part of the company, not just a fancy sheet of paper. This means that you have a say in how the company is run and that you have a claim on the company’s profits if and when they are paid out in the form of dividends. The more shares of the company that you own, the more say you have in how the company is run and the greater your claim on the company’s dividends. Ownership in the company is determined by the number of shares you own divided by the total number of shares outstanding. So, for example, if a company has 100 shares of stock outstanding and you own 50 of them, then you own 50% of the company (of course, most companies have millions of shares outstanding.)
That, in essence, is what it means to own stock. In reality, of course, there is much more to it, starting with the reasons why companies have stock in the first place. In fact, not all companies have stock. Only a certain type of company called a corporation has stock; other types of companies such as sole proprietorships and limited partnerships do not issue stock. What distinguishes a corporation from these other businesses is the structure of its ownership. A corporation is in itself its own entity and is owned by shareholders, whereas in a sole proprietorship or limited partnership the company is directly owned by the sole proprietor or partners, respectively. The owners of the corporation own it through the ownership of shares of stock.
There are many reasons why a company might choose to become a corporation. First of all, incorporation gives the company separate legal standing from the owners and protects the owners of the company from being personally sued in the event that the company does injury or harm to another person or corporation. This concept is known as “limited liability” and it protects the owners of a corporation from being held personally liable in the event that the company is the subject of a lawsuit. Incorporation also provides companies with a more flexible way to manage their ownership structure. In addition, there are different tax implications for corporations (although these can be both advantageous and disadvantageous).
So how does one obtain stock ownership in a corporation? For many companies, shares of stock are limited to the founders of the company and/or their employees. These companies are called “private” companies because their stock is owned privately; that is to say, it is not possible for the public to buy shares in the company. All corporations start out private; after all, the founders of the company usually want to maintain control over the company and its profits. However, after a company has grown for a while, the private owners will sometimes decide to sell shares of stock in the company to the public. This is what is called “going public” or performing an “initial public offering” . Companies choose to sell shares of their stock to the public in order to raise money for the company. They might need this money in order to expand their operations, pay off existing debt, develop a new product, or for any number of other reasons. So for a certain price the corporation decides to sell its rights of ownership to the public.
Once a company has sold shares of its stock to the public, those shares can then be resold by the initial buyers to other investors. This buying and reselling of stock is done on what is called an exchange, which is essentially just a marketplace for stock . As the demand for a stock rises and falls on the exchange (which can be due to a number of different reasons), the price for the stock will also fluctuate. Price fluctuations, in turn, create another opportunity for investors to make money through stock, namely through capital gains. Capital gains are those profits that an investor makes when he or she buys a stock for one price and then later sells that stock for a higher price. Capital losses, the opposite of capital gains, occur when the investor sells the stock for a lower price than he or she originally paid.
So, companies sell stock in order to raise money and investors buy stock in order to make money. But, as economists are forever reminding us, there’s no such thing as a free lunch. Each side must give something up in order to have the opportunity to make money. As mentioned, corporations, when selling their stock, give up some control as to how the company is run and what is done with the profits. In return, they get an influx of capital for the business. On the flip side of the equation, individuals give up their money in order to buy the stock (and become “shareholders“); in return, they gain control over the corporation and the right to future profits. There is, however, the chance that there won’t be any future profits, that the profits will be much lower than what the investor anticipated, or that the company will go out of business entirely. That means that the investor takes on a certain amount of risk when investing in a company’s stock, If any of these things happen, the investor could lose most or all of the money that he or she paid for the stock in the first place. That means that there is a certain amount of risk associated with investing in stocks.
Of course, most of the above is a vast simplification of what is actually involved in investing in stocks. Deciding how much a stock is worth, evaluating the risks associated in investing in them, and trading them are all very complicated processes that are discussed in detail elsewhere in this section.