In this article, I will explain what investing in stocks really means and how to do it, for people that are new to investing. This site aims at both educating people that are new to investing, and supplying stock analysis for people that are active investors, so I’m building up a collection of definition and explanation articles.
What is a stock?
Stock is the collection of shares of a corporation, and each share is a piece of that business. Consider an example:
Over the past several years, you have founded and built up a successful and profitable gym. You earn $100,000 in net profit each year from this business, but you are looking to retire and sell your gym. There are a couple of options available. You can look for a buyer, and potentially have them pay hundreds of thousands or even a million or more dollars for this gym, but that might be difficult because only a few people have this kind of money. Another option would be to break the ownership of your gym up into pieces, or “shares”, and then sell the gym to more than one person. In this scenario, you’d be selling stock.
Let’s say that your gym, with an annual profit of $100,000, is valued at $1 million. You decide to break it up into 20 shares, valued at $50,000 each, and sell them to 20 people. Each of those shareholders is now a partial owner of the gym, and you’ve retired with a nice $1 million. Since the total profit is $100,000, and there are 20 shares, the profit per share (or “earnings per share” as it’s called), is $5,000.
Those shareholders now want to continue running the gym, and profiting from it. So, the 20 of them get together and decide on someone to manage and run the gym for them. This could be one of the 20 shareholders, or it could be someone else that they choose to pay to do the job. The gym continues to grow and make money. In this scenario, part of the profit earned each year is reinvested back into the gym for expansion- perhaps for increased advertising or for opening new gym locations. Another part of the profit is distributed to each shareholder, and these distributed profits are called dividends. Shareholders can sell their shares at any time as long as they can find a buyer and agree on a price, much like negotiating a deal on a car or a house.
That’s how a public company works, except public companies are typically worth hundreds of millions or even billions of dollars, and are typically broken down into several million shares (instead of just 20, like with our example), with share prices usually being low enough for anyone to buy. When you own shares, you have voting rights in the company as an owner of that business.
How to buy stock
A stock exchange, like the NASDAQ or the New York Stock Exchange, is a collection of buyers and sellers of shares of companies. A public company is “listed” on one of these exchanges so there is a central place to buy shares. Share prices go up and down every day because people that want to buy them make deals with sellers on what price they will pay, and this can change often. Because shares are generally low in price compared to another asset like a house, they are sold in large quantities each day and tend to fluctuate in price quite dramatically.
To buy shares from a stock exchange, you have to go through a brokerage. A brokerage is a firm that does the buying and selling for you on a stock exchange. If you see a company for which the shares seem attractive to you, you can ask your brokerage to buy those shares and keep them in an account for you (for a small purchase fee). Some popular budget brokerages are Sharebuilder, Scottrade, and Charles Schwab.
With these budget brokers, you simply log into your online account, deposit money, and then can choose what you want to invest in and manage your account. Typical investments include index funds, mutual funds, individual stocks, bonds, options, and other investments.
Should I buy stock?
Ultimately, whether you invest or not is up to you, though if you’re serious about building wealth, then investing in the stock market is something you’ll want to look into. Usually the price of the shares of a company will go up over time since businesses primary goals are to make money and to increase earnings and revenue. As a company earns profits, it will reinvest those profits into growing, so that it can raise larger profits each year. As the profits increase over time, the share price usually follows.
Consider the gym as an example again. The company was worth $1 million when the company was sold to 20 shareholders, so each share was worth $50,000. The annual earnings were $100,000, so that was $5,000 in earnings per share. Let’s say that over time, the company managed to grow its annual earnings to $200,000. Since the company is still divided into 20 shares, the earnings per share are now $10,000. Each share might be worth $100,000 now, compared to the $50,000 that the shareholders paid for their shares. If a shareholder decides to sell his or her share, they’ll be able to sell it for a lot more than they paid for it. Or, they can simply hold onto their shares and collect larger and larger dividends each year.
What are the risks?
Investing is often looked upon as a risky activity, and it is true that just like with everything else, there is a degree of risk, but with careful analysis, you can buy very healthy and profitable businesses. The stock market definitely isn’t the roulette table that most people imagine it to be.
If a company goes bankrupt, your shares will drop in price to about $0, since there is no longer profit being made. Alternatively, a less extreme example might be that a company runs into a few problems, and stays in business, but has lower profits. This will generally trigger a drop in share price, since people will pay less for those shares.
A good investor carefully analyzes companies and their shares to determine good investments for the long-term. They look for increasing earnings, low debt, a good price, and various other factors to determine the potential worth of an investment. Some companies like Coca Cola, Becton Dickinson, and Exxon Mobile have been steadily increasing profits and dividends for decades, providing shareholders with massive returns.
Let me know if this was helpful to you in the comment section below.
Full disclosure: Long BDX, KO
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