What are stocks?

A stock, or equity, represents ownership in a fraction of a corporation. Shares are units of stock that entitle the holder to a proportionate share of the corporation's assets and profits.

Stocks are primarily traded on stock exchanges and form the basis of many individual investment portfolios. Stock trades must adhere to government regulations designed to protect investors from fraud.

Understanding Stocks

Corporations issue stock to raise capital for their operations. Stockholders, or shareholders, have a claim to a portion of the company's assets and earnings based on the number of shares they own.

A shareholder is considered an owner of the company, with ownership determined by the proportion of shares they hold relative to the total outstanding shares. For instance, if a company has 1,000 outstanding shares and someone owns 100 shares, that person owns 10% of the company’s assets and earnings.

While stockholders do not directly own the corporation, the law treats corporations as legal persons. This means corporations can file taxes, borrow money, own property, and be sued. The corporation owns its assets, not the shareholders. For example, office furniture belongs to the corporation, not to the individual shareholders.

Corporate property is legally distinct from shareholder property, limiting the liability of both parties. If the corporation goes bankrupt, its assets can be liquidated by a judge, but shareholders' personal assets are not at risk. Similarly, if a major shareholder goes bankrupt, they cannot sell the corporation’s assets to pay their creditors.

What Is Shareholder Ownership?

Shareholders own shares issued by the corporation, while the corporation owns its assets. If you own 33% of a company's shares, it is not accurate to say you own one-third of the company, but rather one-third of its shares. This concept is known as the “separation of ownership and control.”

Owning stock grants you the right to vote at shareholder meetings, receive dividends when distributed, and sell your shares to others.

If you hold a majority of shares, your voting power increases, allowing you to influence the company's direction by appointing the board of directors. This is particularly evident when one company acquires another by purchasing all its outstanding shares.

The board of directors aims to increase the corporation's value, often by hiring professional managers, such as the chief executive officer (CEO). Ordinary shareholders do not manage the company.

The significance of being a shareholder is that you are entitled to a portion of the company's profits, which underpins a stock's value. The more shares you own, the greater your share of the profits. Many stocks do not pay dividends but reinvest profits to grow the company. These retained earnings are still reflected in the stock's value.

How to Compare Common and Preferred Stock

There are two primary types of stock: common and preferred.

Common stock typically grants the owner voting rights at shareholder meetings and eligibility to receive dividends paid by the corporation.

Preferred stockholders generally lack voting rights but have a higher claim on the company’s assets and earnings compared to common stockholders. For instance, preferred stock owners receive dividends before common shareholders and have priority in asset claims if the company goes bankrupt and is liquidated.

Companies can issue new shares to raise additional funds, which dilutes the ownership and rights of existing shareholders unless they purchase some of the new shares. Conversely, corporations can also conduct stock buybacks, benefiting existing shareholders by increasing the value of their shares.

What Is the Difference Between Stocks and Bonds?

Stocks are issued by companies to raise capital for business growth or new projects. It's important to distinguish between buying shares directly from the company in the primary market and purchasing them from another shareholder in the secondary market. When a corporation issues shares, it receives money in return.

Bonds differ from stocks in several key ways. Bondholders are creditors to the corporation and are entitled to regular interest payments as well as the return of the principal amount invested. In the event of bankruptcy, creditors have legal priority over other stakeholders and are repaid first if the company is forced to liquidate its assets.

In contrast, shareholders typically receive nothing in the event of bankruptcy, making stocks inherently riskier investments compared to bonds.

How Do You Buy Stock?

Stocks are primarily bought and sold on stock exchanges like the Nasdaq or the New York Stock Exchange (NYSE). Once a company goes public through an initial public offering (IPO), its stock becomes available for investors to trade on an exchange.

Investors usually use a brokerage account to buy stock on the exchange, which lists the buying price (the bid) and the selling price (the offer). The stock price is influenced by supply and demand in the market, among other factors.

How Can You Earn Income from Owning Stock?

There are two primary ways to earn income from owning stock: dividends and capital appreciation.

Dividends are cash payments distributed from a company's profits. For example, if a company with 1,000 shares outstanding declares a $5,000 dividend, each shareholder will receive $5 per share.

Capital appreciation refers to the increase in the stock's price. If you buy a share for $10 and later sell it for $11, you gain $1 in capital appreciation.

Is It Risky to Own Stock?

All investments carry some level of risk. Stocks, bonds, mutual funds, and exchange-traded funds (ETFs) can lose value if market conditions deteriorate.

When you invest, you make decisions regarding the management of your financial assets. The value of your investment might increase or decrease due to market conditions or corporate actions, such as business expansion or mergers.

Historically, stocks have outperformed most other investments over the long term.

The Bottom Line

A stock represents fractional ownership in a company, differing from a bond, which functions as a loan from creditors to the company in exchange for periodic payments.

Companies issue stock to raise capital from investors for new projects or to expand their operations. The type of stock, whether common or preferred, determines the rights and benefits of ownership for the shareholder.