What are stocks?
In this section, we will explain what stocks are and how they work.
The concept is simple! A share of stock (or stock) is essentially a contract that grants you (the buyer) partial ownership of a company. To clarify what this means, we will go over an example: Laura had an amazing idea for a business that sells organic, low-calorie pies. So she created SmartPies Company.
Her business has been doing well but she wants to grow into other markets and broaden her reach. To grow as much as she wants, she needs more funds to buy machines, buildings and hire more people. Currently, she has $100,000 to grow her business, but she needs $100,000 more to achieve her goals.
Current amount: $ 100,000
+ Needed amount: $ 100,000
Total needed to grow: $ 200,000
She decides to raise funds by offering partial ownership to the public (an IPO, or Initial Public Offering) in exchange for money (this is called the primary market: where investors buy shares directly from the company). Five people gave Laura $20,000 each to grow her company; in return, she gave 10% ownership to each one. Let’s look at the two sides of the solution to her problem:
- Money: she can raise the money she needs to take her business to the next level.
Laura: $100,000 invested
Public: $20,000 invested x 5 people = $100,000 (which is the amount she needed to grow)
- Ownership: the catch is that she had to give up part of her company to other people.
Laura: $100,000 invested / $200,000 Total Value of Company = 50% of Ownership in SmartPies Co. –> 5 Shares
Public: ( $20,000 invested x 5 people ) = $100,000 invested by the public
$100,000 invested by the public / $200,000 Total Value of Company = 50% of Ownership in SmartPies Co. –> 5 Shares
Partial ownership is formally known as a share of stock, or stock (for short); it is also commonly known as a share, ownership, or equity. All these words refer to the same concept, which is owning part of a company.
But what does partial ownership really mean?
If you own part of a company, have stock in it, you technically:
- Own part of that company’s assets (buildings, machinery, materials, products, etc.)
- Own part of its earnings (the income that they generate from selling their products or services), which is distributed to the shareholders (you) in the form of dividend or it is reinvested in the company
- Have a voice in the decisions that management take to run the company, you have a voting right
Following Laura’s example, the five investors (who have stock in SmartPies Co.) will be entitled to a part of the company’s earnings, which we will explain later. Also, SmartPies stockholders can sell their stock to other people at any time if they please; if they see that future growth is limited or are unhappy with the way the company is managed. This is called the secondary market: investors buy shares from other investors.
The Reality of Stocks
A typical public company, which is traded in the stock market, has millions of stocks owned by shareholders (or shares outstanding). Typically startup companies have about 10 to 15 Million shares outstanding, and as they grow, their number of shares may increase significantly. For instance, Microsoft currently has 7.7 Billion shares outstanding.
Thousands and thousands of stocks are bought and sold every second through exchanges all over the world. Stock exchanges are physical or online centers dedicated to putting buyers (people or companies that have money to invest) and sellers (people or companies that need money and have stocks) together to trade their stocks for money, and vice-versa. An average of 6.43 Billion stocks were traded every day in 2017. The internet has made it possible for these transactions to be made instantaneously from anywhere in the world with WiFi connectivity.
In the next section, we will see the basics of how to make money with stocks and then we will dive into the world of bonds.