Have you ever wondered what stock is or why shares of stock even exist? This guide will go far beyond answering the question, "What is stock?" and serve as a great foundation in our Complete Beginner's Guide to Investing in Stock.
Shares of Stock Represent Pieces of a Business
Imagine you wanted to start a retail store with members of your family. You decide you need $100,000 to get the business off the ground so you incorporate a new company. You divide the company into 1,000 pieces, or "shares" of stock. (They are called this because each piece of stock is entitled to a proportional share of the profit or loss). You price each new share of stock at $100. If you can sell all of the shares to your family members, you should have the $100,000 you need (1,000 shares x $100 contributed capital per share = $100,000 cash raised for the company).*
If the store earned $50,000 after taxes during its first year, each share of stock would be entitled to 1/1,000th of the profit. You'd take $50,000 and divide it by 1,000, resulting in $50.00 earnings per share (or EPS as it is often called on Wall Street). You could call a meeting of the company's Board of Directors (these are the people the stockholders elected to watch over their interest since they couldn't run the business) and decide to use the money to pay cash dividends, repurchase stock, or expand the company by reinvesting in the retail store.
At some point, you may decide you want to sell your shares of the family retailer. If the company is large enough, you could trade on a stock exchange. That's what is happening when you buy or sell shares of a company through a stock broker. You are telling the market you are interested in acquiring or selling shares of a certain company and Wall Street matches you up with someone and takes fees and commissions for doing it. Alternatively, shares of stock could be issued to raise millions, or even billions, of dollars for expansion. When Sam Walton formed Wal-Mart Stores, Inc., the initial public offering that resulted from him selling newly created shares of stock in his company gave him enough cash to pay off most of his debt and fund Wal-Mart's nationwide expansion.
Shares of Stock on Wall Street Are No Different
It doesn't matter if you invest in shares of stock of multi-billion dollar conglomerates or tiny publicly traded retailers, when you buy share of stock, you are purchasing a pro-rata piece of a company. For instance, McDonald's Corporation has divided itself into 1,079,186,614 shares of common stock. Over the past twelve months, the company earned net income of $4,176,452,196.18 so management took that profit and divided it by the shares outstanding, resulting in earnings per share of $3.87. Of that, the company's Board of Directors voted to pay $2.20 out in the form of a cash dividend, leaving $1.67 per share for the company to devote to other causes such as expansion, debt reduction, share repurchases, or whatever else it decides is necessary to produce a good return for its owners, the stockholders.
The current stock price of McDonald's is $61.66 per share. The stock market is nothing more than an auction. Individual investors, just like you, are making decisions with their own money in a real-time auction. If someone wants to sell their shares of McDonald's and there are no buyers at $61.66, the price would have to continually fall until someone else stepped in and placed a buy order with their broker. If investors thought McDonald's was going to grow its profits faster than other companies, they would be willing to bid up the price of the stock (which is affected by supply and demand because there are only a fixed amount of shares in existence, in this case 1,079,186,614 shares). Likewise, if a large investor were to dump his or her shares on the market, the supply could temporarily overwhelm the demand and drive the stock price lower.
Keep Perspective on Stocks and Never Forget What They Represent
What happens if you believe McDonald's will generate far higher earnings per share of stock within five years, you buy 1,000 shares at $61.66 (for a total investment of $61,660), and the very next day, the stock falls to $30 per share? Should you be upset?
In this situation, you need to remember that the stock market is an auction. If you still believe the company will generate the earnings per share you calculated several years from now, to be upset that the stock price got cheaper would be, in the words of the legendary Benjamin Graham, to allow yourself to get upset by "other peoples' mistakes in judgment". The share price may move around wildly as millions of investors throughout the world make decisions about how much they are willing to pay, but the ultimate value of your shares will come from the profit the company generates.
If McDonald's did reach, say, $8 in per share earnings within five years, and kept the same dividend policy, your shares would collect $4.55 in cash dividends each year. That means you'd be earning 15.17% in cash dividend yield on the stock you purchased when it fell to $30 per share. This is why you see many successful investors completely unemotional about stock market crashes; they view the events as nothing more than the opportunity to buy a greater stake in businesses they like that generate lots of cash.
More Information About Investing in Stocks
For more information about investing in stocks, read Complete Beginner's Guide to Investing in Stock.
* Footnote: These days, due to changes in state laws, most startups and private businesses are likely to opt to issue units, instead of shares, because they prefer the limited liability company structure.