In this article you’ll learn what stocks and shares are, and what the difference is between them.
What are stocks and shares?
- Common stocks are shares of ownership of a publicly-traded company.
- Preferred stocks are another type of shares, that usually don’t give shareholders any voting rights.
- The equity of the company is divided into the number of shares, the company has distributed.
Want to learn more about stocks and shares? Read on.
What are stocks and shares in detail?
If a company, has issued a thousand shares, one share represents one-thousandth of the companies equity. The owners of the shares are called shareholders and are co-owners of the company. If a shareholder owns 100 shares in this company, he owns 10% of the shares, of the corporation.
To understand how shares are created, let us look at a fictive company called “Ice Cream Corp”.
Ice Cream Corp has just developed a new product idea and would now like to start producing it. To do this, it has to expand and buy a new factory.
The financing requirement for this new factory is $1 Million. Since Ice Cream Corp does not have $1 Million available on-demand in cash, it has to finance the investment. There are two options for this:
- Financing through debt / external capital: bank loan or issuing bonds
- Financing through equity: issuing new shares
In most cases, companies are financing themselves through both, equity and debt. In our example, the management board of Ice Cream Corp has decided to fully finance the investments by issuing new shares.
The newly issued shares can then either be bought by existing shareholders or by new shareholders.
If we assume that Ice Cream Corp already had $2 million in equity before the new shares were issued, the expansion will add another $1 million. The equity has now risen from $2 million to $3 million. For this purpose, the corporation has now taken new shareholders on board.
If the price of a share at the time of expansion is $100, then Ice Cream Corp previously had $2 million / $100 = 20’000 shares in circulation. Another 10’000 shares are now added, which are also being sold for $100. The new equity of $3 million is therefore divided into 30’000 shares (20’000 old, and 10’000 new).
The company now belongs to the shareholders to the extent to which they participated in the new equity. If you for example owned Ice Cream Corp alone and contributed $0.5 million to the expansion, you own the $2 million of equity before expansion plus the $0.5 million of the new invested capital. The remaining $0.5 million were added by other new shareholders.
Your share has thus decreased from 100% before the expansion to now 83.33% (100 / 3’000’000 * 2’500’000). So you own 83.33% of 30’000 total shares = 24’999 shares (30’000 / 100 * 83.33).
Owning shares is accompanied by various shareholder rights that are regulated by law. These are divided into administrative rights and property rights (which might be different depending on the country).
Administrative rights serve to represent and enforce the interests of shareholders. The shareholders are entitled to vote at the annual general meeting of the company. Every year a publicly-traded company has to convene a general meeting. All shareholders must be invited and informed about important decisions, such as the election of the supervisory board. For each share that a shareholder owns, he usually has one vote. However, some shares have multiple votes or no votes at all.
The property right includes the right of the shareholder to participate in the profit of the company, participation in the liquidation proceeds if the company has to be liquidated, and the right to buy new shares if, as in our example, new shares are issued.
In order to let shareholders participate in the company’s profits, many companies pay out a dividend once a year. If you are a shareholder, this dividend is automatically transferred from the corporation to your deposit account.
Why do companies participate in the stock exchange?
It can be lucrative for companies, to sell their equity to shareholders, and receive money which they can then use to conduct additional investments to grow their business.
How can I earn money with stocks?
In addition to dividends, shareholders can also gain profit through price gains of shares. Since stocks are traded on the stock exchange, they have a price that is based on the buyer’s demand and the seller’s offer. If there is a lot of demand because a lot of people think the company is worth more than its current market value, then the share price rises.
How do I determine the value of my share?
Let’s get back to our example (with different numbers). If Ice Cream Corp’s equity is worth $2 million in total and the company issued a total of 1 million shares, you have to split up the $2 million into 1 million shares. So if we divide the value of $2 million by one million shares ($2’000’000 / 1’000’000), the price per share is $2.
If you own 10,000 shares from Ice Cream Corp, you will own one percent of the total shares in the corporation (10,000 / 1,000,000 = 1%).
The shares of the companies that are listed on the stock exchange are traded daily. So there is an exchange between those who want to become part of the company (buyers) and those who want to sell their shares of the company (sellers). The price of the share then changes depending on how many people are interested in buying or selling.
If there are more investors who want to buy a share than those who want to sell a share, the price rises until an equilibrium is reached and there is a seller for every buyer.
However, if there are more interested sellers than buyers, the price will continue to fall until enough buyers are found that are willing to buy the shares from the sellers based on the cheaper price.
What are the risks of buying and owning shares?
If you buy shares of a company, you own a piece of that company, with all its risks and rewards. If the company does well and is able to grow its business, more people will be interested in the stock and buy a share. Therefore if the demand is high, the stock price will climb, which means your shares will be worth more, than they were before. If however, the company does not so good, and sales decline, then a lot of shareholders might sell the stock to a lower price, and the stock price will fall. If the company goes bankrupt, your shares will be worth nothing.
The stock price of a company can be influenced by:
- Media: Reports on how a company is doing. They also report on scandals related to that company.
- Quarterly and Yearly Reports: If a company is able to increase revenue and profit, it usually attracts new buyers and the stock price goes up. If the company missed its target earnings growth, then shareholders might decide to sell their shares, and the stock price falls because there are no new buyers.
- Economic events: Natural disasters (such as earthquakes), pandemics (such as COVID19), politics (such as an election or recession) can influence the stock price.
- Change in Management: If there are changes in management to the good or the bad, it will influence the stock price.
It is important that before purchasing stocks, you get a good understanding of the companies, and especially also the countries they are in!
- Growth: Is the revenue and profit of the company increasing or declining?
- Strategy: How does the company plan to increase revenue and earnings over the next few years?
- Financials: Does the company have a big enough cash cushion to get through bad times? Are revenue and profit growing or declining? Are sales growing or declining?
- Competitors: Are there any competitors that might influence the sales and growth of the company?
- Management: Does the company have managers with skin in the game? (Will the managers lose if the company loses? For example, do the managers own stocks?)
- Location: Where is the company conducting its business? (Are there areas that might have a political, or economic impact?)
- Country: How is the country doing? (If the country is going into a recession, the stock price of all companies will fall)
- Currency: In which currency does the company conduct it’s business, and are there any currency shifts expected?
Companies that are well established, and have been able to grow revenue and profits, are usually less risky, but usually, the share price will also grow slow and steady. Smaller companies that are new on the block, might be more lucrative because the share price can grow exponentially, but the risk that the company won’t succeed and default is higher.
To minimize risks, investors can build up a portfolio of stocks. They usually don’t only own stocks of one company, but own stocks of several companies. Through this, they try to balance, as some companies might take off and be really successful, while others might not be able to achieve the expected growth. If a company defaults, then it’s only one of many companies, the investor owns shares from, while the other investments still do well.
Professional investors such as Warren Buffet have decades of experience in finding good companies, and analyzing the risks. These investors might not diversify that much, but rather take the risk and go all in.
Investors that are however less experienced analyzing companies, might be better off diversifying well with help of ETFs (Exchange Traded Funds) or Mutual Funds. ETF’s and Mutual Funds are used to diversify in a large number of stocks (also available for Bonds, Commodities, and Real Estate). By investing money into a fund, the investor purchases a part of all the assets within it.
How can I buy shares of a company?
Buy stocks through a broker
The most common way to buy stocks is through a broker. Usually, you can differentiate between a discount broker and a full-service broker. A discount broker will purchase and sell shares on your behalf, and will be cheaper but not offer any consulting services. A full-service broker will offer consulting services and might even monitor the stocks actively, calling you if they think amendments are required, due to changing economic environments.
Typical brokers are:
- Insurance Brokers
- Online Brokers
For buying, selling, and managing the stocks for the investor, brokers charge fees. It is important that you understand what this fees are, and compare against other brokers, to limit the costs.
Buy stocks through a company directly
There are companies, that offer direct stock purchase plans (DSPP). The company will issue the stocks through a transfer agent. A transfer agent is a third-party company, that is authorized to handle security transactions, register the ownership, and maintain the records of ownership on behalf of shareholders. Usually using a transfer agent it is also possible to set up automated monthly purchases. This might or might not be a cheaper option, than going through a broker, and it requires more work in order to buy and sell the stocks, so this option is more suited for long-term holders.
Not all companies will offer a direct purchase program, so you will be limited in your choice of buying stocks and thus you might not be able to build up a well enough diversified portfolio.
Below a Youtube Video from Ameritrade, that explains Stocks in a very easy way.