Stocks
TLDR
Stocks are simply the ownership shares in a company. This represents a percentage the stockholder owns of a company and how much they share in the company's profit/loss.
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| IMAGE:Drew Angerer/Getty Images |
What are they and what is their purpose?
Stocks are a type of tradeable security that provides stockholders with a share of ownership in their chosen company. Stocks should be viewed as actual ownership of a business. All of the business' gains and losses are reflected in the stock price. The stock market is where these assets predominantly change hands. Owning these types of assets is unique to other investments because the public can readily access them and the market provides a reasonably high level of liquidity.
How are profits distributed?
The two major ways a company redistributes profits to shareholders are through dividends and stock buybacks.
Dividends are cash handed back to the shareholders based on their ownership of the company, not requiring them to sell any of their shares to get compensation from the business' profits. Dividends can be used to either reinvest into the market or simply used as the investor's income, it is purely their choice.
Stock buybacks, on the other hand, are where a company will purchase its own shares from any that are outstanding in the stock market. The purchase is typically done at a premium versus the current share price, which benefits all shareholders. Understandably, share buybacks can be confusing, and an easy way to understand this is from a quick illustration:
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| IMAGE:CFI |
This example showcases a company that decided to purchase 20% of the outstanding shares. At $10 this would cost the company $200,000 (20,000 shares x $10), which is being subtracted from the business' profit. Doing this would reduce the overall number of shares available to the public by 20% while increasing the earned amount per share by 25% (EPS went from 10 to 12.5) assuming the company earned $1 million on the next earnings report. This massive increase happened because the overall profit available to shareholders remained the same, but the reduced number of shares raised the value of the ones remaining. This is a fantastic way for a company to give back to its shareholders and increase their return. Among the many advantages share repurchasing has, it primarily shows investors that the company believes itself to be undervalued and that the market should load up on these cheap prices (CFI, 2022).
What determines the price of a stock?
The price of a stock can fluctuate greatly and may not reflect its true underlying value. The market is not always efficient, and just like a grocery store, can go on sale occasionally even though the product has remained the same.
These deals occur due to a variety of circumstances, primarily from emotional buying and selling. Investing through greed or fear is the main reason retail investors purchase securities around market highs and sell around market lows. When all hope is seemingly lost, or the investor believes the stock will climb indefinitely, investors are tempted to react emotionally. These partial thoughts will hurt them in the long run (Zuccchi, 2022). Conviction in the underlying asset and knowing its worth is what separates amateurs from professionals. Remember, whenever stock transactions take place, there are two parties necessary to complete the trade. Whenever you are selling a stock, there is someone else buying it believing it to be favorable to them through their analysis.
Overall, stock ownership has been proven to be the best vehicle for long-term investing, as long as individuals have the emotional control to hold through periods of short-term volatility (Siegel, 2021). This will take time to master, but if done effectively will increase the investor's returns tremendously.
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