Stocks and Equities as an Investment

Let's start our discussion of stocks by defining the term and providing some background information. When you buy a company's stock, you are buying a piece, or a share, of that company. In essence, you have become one of the owners of that company, no matter how small your piece of the pie may be. This is the reason stocks are considered equity investments--through your investment you own a piece of a company.

To represent your ownership, stock certificates are issued for your shares in the corporation. Most investors don't actually receive physical possession of their stock certificates. If you purchase stock through a brokerage firm, you receive statements that document your stock transactions. When companies decide to offer shares for sale to the public ("go public") for the first time, it is called an initial public offering (IPO). When companies decide to go public, it is mainly to get the needed funds for expansion.

Buying and selling stocks. Stocks are bought and sold through a network--the stock market. The stock market is a network made up of companies and the investors who purchase their shares. The main stock exchanges in the United States are the New York Stock Exchange (NYSE) and the National Association of Securities Dealers Automated Quotations (NASDAQ). The NYSE is the oldest and most prestigious exchange, and is made up of larger, wealthier, well-established corporations. The NASDAQ, known as the electronic or over-the-counter market, is primarily made up of smaller, newer companies, and is referred to most often for its listings of the technology industry.

Many individual investors buy and sell securities (including bonds) through brokerage firms that are registered with the former National Association of Securities Dealers (NASD), now called the Financial Industry Regulatory Authority (FINRA). This allows registered stockbrokers to buy and sell stocks through traders in the appropriate stock exchange.

Investors also may purchase interests in mutual funds and other types of managed asset accounts. The idea is to delegate responsibility for individual investment decisions to professionals who manage large portfolios for numerous investors. The performance of such funds is usually measured against the performance of stock indexes. A stock index is the aggregate performance of a group of stocks, rather than the performance of individual stocks.

Several federal agencies are involved in the operations of the stock market. The Securities and Exchange Commission (SEC) is the federal agency that regulates stock trading. Minimal regulatory enforcement has been the policy of previous administrations but, since the meltdown of 2008, more vigorous enforcement and more regulations will be the policy for the forseeable future. Among the SEC's requirements are that a company's shares be registered with the government, and that a description of a company and its financial conditions be given to investors interested in purchasing the company's stock.

Stock market investors also have the protection of the Securities Investor Protection Corporation (SIPC), an insurance fund established to reimburse investors if their brokerage firm (which must be registered with FINRA) goes out of business. The SEC website offers much valuable information on companies as well as on brokers and advisors. Go to the SEC website, and you will be directed to the area you are interested in.

Why do companies sell stocks? When investors purchase stock in a company, the company can raise the capital it needs to get started or to expand. This may not be possible otherwise. As a matter of fact, one of the reasons many businesses operate as corporations is so that they can sell stock to investors.

Your ownership in a company allows you to vote on certain issues involving the company, including the election of the company's board of directors. If you own stock in a company, you may also be eligible to receive regular payments (dividends) based on the company's profits. Whether you receive dividends depends on the type of stock you own, and the type of company whose stock you own.

Stock splits. Sometimes investors buy a certain amount of shares of stock and end up owning more through what's known as a stock split. What happens is that the company you've invested in changes the amount of shares it has outstanding and must then adjust each share's price accordingly. Two-for-one stock splits are the most common. Read through the following examples to see how this process works.

Example Nancy buys 20 shares of Sugar Blast Soda Corporation on April 1 for $200 ($10 per share). On June 1, Sugar Blast announces that it's splitting its stock two for one as of July 1. As of July 1, Nancy will own 40 shares of Sugar Blast stock rather than 20 shares. Assuming that the stock is still trading on the market for $10 per share as of June 30, on July 30 each share will be trading for $5 per share. Therefore, Nancy still owns $200 worth of Sugar Blast stock (40 shares x $5 per share = $200) even though she now owns 40 shares rather than 20 shares. Clydesdale Industries' stock has fallen to 50 cents per share. It announces a "reverse stock split," under which a shareholder receives one share for every 10 they own. This reduces the number of shares and increases the share price proportionately. Thus, after the split, each share of stock is worth $5. Companies often split their stock when they think the stock price is too low to attract investors to buy their stock. One consequence of some reverse stock is that small shareholders are "cashed out" so that they no longer own the company's shares.

What's the point of issuing a stock split? If a company's stock is doing well, its price is usually skyrocketing, making it harder for many investors to choose it for their portfolio. Increasing the number of shares and therefore reducing the price of each individual share makes it easier for people to invest in the company and the company's stock can trade more easily. The company hasn't given up anything, and has a chance to sell more shares and raise money. In addition, investors that already own a company's stock greet stock splits with pleasure that the company is doing well and the hope that the stock price will rise as they now own more shares.

Stock Value and Dividends

How does the process of making or losing money from stock investments work? This is a two-tiered process that involves increases in a stock's value and earnings that produce dividends.

Stock value. What factor determines whether a stock goes up or down in value? While one factor alone usually can't be held responsible for a stock's rise or fall, a catch-22 situation is at work here. A corporation with high earnings and the potential for growth creates a good market for its stock. As more and more investors choose the stock, its value goes up, so the price that investors will pay for the stock goes up, and the circle begins. When a company has losses or lower than expected earnings, investors will not be as eager to buy stock in the corporation. Therefore, the price of the stock drops. In the worst-case scenario, stock may become worthless if a company folds.

When you sell stock and make money, you may have what is know in the world of income tax as a capital gain. If you sell stock and lose money, you may have a capital loss. Therefore, it's important to consider the impact for tax purposes as one of the factors of whether you should sell stock and when you should sell it.

Dividends. Dividends are the payments that a corporation makes to its stockholders. Dividends are based on a corporation's earnings and profits. The higher the company's profits, the higher the dividends paid. The amount of the dividend paid is also based on the type of stock you own. If you own common stock in a slow-growth company or preferred stock, chances are good that you will be receiving steady dividends. If you own common stock in a growth company--a company that needs to reinvest its profits in the company--you probably will not be receiving dividends.

Dividends that are paid to you may be considered income for tax purposes.

Warning It's important to remember the major role the state of the economy plays in the value of companies and their stocks. While the stock of each company should be evaluated individually, the economy can positively or negatively affect specific industries or the stock market as a whole.

Read on for information about the different classes and types of stock available, and how to go about choosing your investments in the stock market:

• Common Stock
• Preferred Stock
• Stock Options
• Choosing a Stock

© 2024 Wolters Kluwer. All Rights Reserved.