Stocks
Stock is an ownership interest, or equity stake, in a company-and it is one of the primary securities that individuals invest in. When you own a company's stock, you are a part owner, or shareholder, in the company, and you have claim to your share of the company's earnings. You also have the right to vote on certain business decisions.
Companies issue stock to raise capital. With equity financing, as opposed to debt financing, companies do not have to pay back the money or pay interest on it. Instead, managers work to increase the value of the company for the shareholders. But as a shareholder, there is no guarantee on your investment. Stocks yield a higher return than most investments because of the greater risk involved in owning them.
When a company issues stock to the public for the first time, the process is called an initial public offering (IPO). The company stock then becomes "publicly traded." Shareholders used to receive a stock certificate as proof of their ownership. While some people still do get these documents when they buy stock, shareholders usually own their stock in what is called "street name," which means the brokerage firm you bought the stock through holds the stock for you electronically. Owning stocks in street name makes them easier to trade.
What is a stock exchange?
When you buy and sell stock, you usually do so through a broker. But the actual transaction takes place on a stock exchange.
A stock exchange is the marketplace where buyers and sellers trade stocks. Some exchanges are physical locations where stocks are bought and sold on a trading floor through open outcry. Others are electronic networks where stocks are traded through computers. Each exchange has its own requirements for stocks to be listed.
Every publicly traded stock is bought and sold on an exchange. The major exchanges include:
- New York Stock Exchange. To be listed on the NYSE, the market value of a company's public shares must be worth at least $100 million.
- American Stock Exchange. Companies whose stocks trade on Amex are usually small- and mid-cap companies. Options and other derivatives are also traded on Amex.
- Regional Exchanges. The Boston Stock Exchange, the Chicago Stock Exchange, the Pacific Exchange and the Philadelphia Stock Exchange.
- Nasdaq. The National Association of Securities Dealers Automated Quotation system has grown in prominence as companies such as Microsoft®, Intel and Cisco have chosen to list on this exchange instead of the NYSE.
Over-the-counter (OTC) markets usually list small, riskier companies. In many cases, stocks end up on the OTC market because they were de-listed from another exchange.
What is "market capitalization"?
Market capitalization, or "market cap," refers to a company's size. It is the total value of a company's shares of stock, calculated by multiplying the price of a stock by its total number of outstanding shares. All companies are categorized according to their market cap as large cap, mid cap, small cap and micro cap. The ranges for these categories vary, depending on how the market as a whole is performing. Companies with different market caps have different levels of risk/return and react differently to market conditions.
How do I know if a stock is cheap or expensive?
Stock prices move based on supply and demand. If more investors are buying than selling, the stock price moves up. But stock price alone does not determine the stock's value. The company's earnings must also be considered. If profits consistently increase, that is a good indication of the company's future prospects, which is what you are betting your money on by owning the stock.
There are many ways to determine a stock's valuation, but the "price-to-earnings ratio" (P/E) is the most common. The P/E, or multiple, is calculated by dividing the stock price by the last four quarters of earnings. Some analysts calculate forward P/E by using the next four quarters of earnings estimates. Companies often provide "guidance" to investors as part of their quarterly earnings statements. Guidance is some indication of future earnings potential for the company.
You can compare the P/E of one stock to the P/E of another stock to determine its value relative to its peers. (It is only meaningful to compare companies in the same industry.) Or you can compare the P/E of a stock to its own valuation history to see if it traded at a higher or lower multiple in the past. A high P/E might indicate the stock is overvalued; a low P/E might indicate the stock is undervalued.
Other common valuation ratios include "price-to-sales" and "price-to-book" value.
What are "dividends"?
In addition to stock price appreciation, shareholders can receive a return on their investment through dividends. Some companies distribute a portion of their earnings to shareholders in the form of a cash payment on a quarterly basis. The board of directors decides what percentage of profits to pay out.
Companies that pay a dividend tend to be mature, stable firms, whose stock price does not appreciate much. Newer companies that are rapidly growing usually do not pay a dividend because they are reinvesting their earnings to fuel further growth. But in general, a company's ability to pay regular dividends and increase them over time is a good indication of its financial strength.
A stock's dividend yield is calculated by dividing the annual dividend income per share by the current stock price. Dividend yield plus price appreciation is the stock's total return-that is, what you, the investor, earn at the end of the day.
What are "dividend reinvestment plans" (DRIPs)?
If a stock pays a dividend and you do not need the current income it provides, you may consider reinvesting those dividends to buy more shares of stock. Many companies provide investors with an easy mechanism for doing that. Dividend reinvestment plans, or DRIPs, automatically purchase more shares for an investor, directly from the company, on the dividend payment date.
You can establish a company DRIP with a very small amount of money. To become eligible, you usually only need to own one share of company stock. DRIPs charge low or no fees and no commissions when stock is purchased.
What is a "stock split"?
When a stock's price has gone up considerably, the company sometimes decides to split the stock. A split increases the number of outstanding shares by dividing each share, which decreases the stock price. The most common stock splits are 3-for-2, 2-for-1 and 3-for-1.
For example, in a 2-for-1 stock split, two shares equal the value of one previous share. Each shareholder receives an additional share for each share they already own, but those shares are worth half what they once were.
Companies do this primarily to combat a perception problem. If the stock price gets too high, the stock may seem too expensive to investors. But you do not get more value, just more shares. Still, a stock split is usually a good indication a company is doing well because their stock price increased so much.
How do I buy on margin?
Buying on margin involves borrowing money from your broker to buy stock and using the investments you already own as collateral for the loan. You can typically borrow up to 50 percent of the value of your brokerage account. Buying on margin dramatically magnifies the risk of investing in stocks and is not appropriate for most investors.
If the stock you buy with the borrowed money goes up, you can pay back the amount you borrowed to the broker and profit from the gain. But if the stock you buy goes down and the value of your account drops below a certain threshold, the broker will issue what is called a "margin call." At that time, you either have to come up with the money to pay back the loan, or the broker will take the amount out of the investments you used as collateral. You also must pay interest on the loan.
What is "short selling"?
Short selling involves selling a stock you do not own but rather, borrowed from a broker. When you sell that borrowed stock with the expectation that the stock price will fall, you are shorting that stock. Since you do not own the stock, you have to buy back the shares and return them to the broker. If the price declines, as you believe it will, you can buy back the shares at a lower price and profit from the difference. Short selling is a very risky strategy and not advised for beginners.
How do I invest in foreign stocks?
Foreign stocks trade in their countries of origin, but investing in foreign markets is very complex and costly. However, many large international companies also trade on U.S. exchanges as American Depositary Receipts, or ADRs. An ADR represents a share of an underlying foreign stock. ADRs can be bought and sold just like U.S. stocks. ADRs are priced in U.S. dollars and pay dividends in U.S. dollars. ADRs must also follow all U.S. securities regulations.
What are "penny stocks"?
Penny stocks, which sell for less than $1 to $5 a share and trade on the OTC markets, are very risky investments. Few, if any, analysts cover these stocks. Some are not required to file with the SEC. Information about them can be scarce. Most of these companies are extremely small. Many are newly formed or near bankruptcy.
These stocks are sometimes manipulated in "pump-and-dump" schemes, where dishonest promoters try to pump up the stock price before dumping their shares. Innocent investors are the victims of this fraudulent practice.
There are some good quality penny stocks, but investors should use caution when considering them.
What is "preferred stock"?
When people talk about stock, they are usually referring to common stock. But there is a class of ownership called preferred stock that is higher in the debt structure than common stock but lower than bonds. If a company declares bankruptcy, and its assets are liquidated, preferred shareholders must be paid before common shareholders but after bondholders. Preferred stocks yield dividends, have call provisions and are rated like bonds.