Steve wrote in with a good question recently:
What does it actually mean to own a stock? Do you own a piece of that company? Are you just gambling that you think a company’s value will go up or down? I guess I don’t really understand the stock market.
Steve asks a good question, so let’s take a simple walk through what exactly a stock is, what owning one means, and why a person would want to own a share of stock in a company.
What is a stock? The word “stock” refers to a share of ownership in a particular company. If you own a stock, you’re an owner of some very small fraction of that company. Take, for example, Exxon. Exxon has 5.28 billion shares of stock outstanding, meaning that they have divided ownership of their company into 5.28 billion pieces. Owning a single share of Exxon stock means that you own 0.0000000189% of Exxon. That’s a very tiny fraction, but Exxon is a huge company, so that little fraction has some value.
How much value does that one share have? Right now, that one share of Exxon stock is worth $90.70 (as of this writing). Shares of Exxon are traded on an open market, meaning buyers and sellers can both make offers and sales only occur when buyer and seller agree on a price, so that $90.70 is literally the dollar amount that someone recently agreed to sell a share of Exxon stock for and someone else agreed to buy it for. In other words, that’s the value that the public estimates a single share of Exxon stock to be worth.
Right now, Exxon‘s stock is worth 90.70 per share, and thus with 5.28 billion shares outstanding, that means Exxon has a market capitalization of $479.23 billion. Market capitalization is the estimate of the total value of the company based on the number of shares out there and the value that the market places on each share.
Why would you want to own a share of Exxon? There are several reasons.
First, stocks pay dividends. Exxon pays an annual dividend of $1.60 per share. A dividend is a piece of the company’s profit that a company pays out to each shareholder. With 5.28 billion shares outstanding, Exxon paid out $8.448 billion in dividends total over the last year, meaning each shareholder got $1.60. That $8.448 billion is Exxon profit that they chose not to reinvest in the company and instead pay out to shareholders.
You also own a piece of whatever would be earned if the company decided to close up shop. Exxon has a book value per share of $23.31. That means if Exxon decided to quit the business and just sell all of their assets, the shareholders would get $23.31 per share. While that wouldn’t recoup the value of the stock purchase (it’s currently $90.70 per share), it is something.
Adding the two together and one can see that a share of stock does have some cash value. It generates dividends for you while the company is in business and has some value when the company goes out of business and sells off their assets.
Larger shareholders also usually gain some voting rights when it comes to making decisions about the company. Obviously, with Exxon, an individual shareholder owns such a small portion of the company that if they allowed each such holder to have voting rights, nothing would get done with the company. Thus, there’s usually some threshold that people have to cross before they have voting rights and get to participate in corporate decision making. With some companies, that comes in the form of special voting shares – only some shares allow you to actually vote. In other companies, if you own a small amount, you vote by proxy – you basically assign someone else to vote on your behalf.
So what does that value add up to? At the moment, $90.70. The stock market is basically a free-for-all of trading where buyers and sellers can quote whatever prices they want. The “value” of a stock is whatever the buyer and seller agree on as a fair price and the $90.70 value is a recently agreed-upon value between an individual buyer and an individual seller. Other buyers and sellers then use this as a thumbnail when deciding the value of the next trade – if Exxon has good news, then it might go up to $92. If something bad happens, it might go down to $88. If things are neutral, it’ll fluctuate a bit, but stay near that value.
The chaos you see on the floor of stock exchanges is basically the chaos of tons of these trades happening at once, with people running around trying to make it happen. Much of the activity happens electronically, too.
Thus, when you buy a stock, you’re buying a piece of a company. That piece pays you dividends and also indicates ownership of a small sliver of the assets of the company. This obviously has a value, and the stronger the company is (or is predicted to become), the more value it has. Ideally, you hope to re-sell it at a higher value than you bought it for – that requires the company to demonstrate that for whatever reason it’s stronger than it was before – but in the interim, you can collect dividends and wait until you’re ready to sell it. That decision point – when to sell – is the topic of countless investment books.
If I want to buy a stock, what’s the process? In its simplest form, you basically state a price you’re willing to buy a stock for and then seek out someone willing to sell it to you at that price – this is called a “limit order.” You can also issue a “market order,” which means you’ll buy the stock at whatever price the market is currently selling it for.
Most individual stock buyers and sellers go through a stockbroker. A stockbroker is an organization that actually participates in those exchanges (it’s rather expensive to get a seat on a stock exchange). An individual, like yourself, goes to a stockbroker and pays them a fee to use their resources to get that stock for you. They might own it themselves and be willing to sell it to you, or they might have to go buy it from someone else. Either way, your fee pays for this service (and their profit margin).
Alternatively, you can buy stocks directly from individual companies. This saves on the broker fees, but it means you deal with only one company at a time and it’s also somewhat difficult to sell the shares back to the company.
In a nutshell, brokers are much more convenient for both buying and selling, but they charge a fee for the service.
So what’s a mutual fund? A mutual fund is just a collection of stocks. A typical mutual fund has their stocks chosen by a fund manager and the fees with that fund go to pay the fund manager’s salary (and the salaries of anyone working for the manager). An index fund is a mutual fund without an active manager – it operates based on a clearly-specified set of rules that do not require active intervention. Thus, the fees for an index fund are much lower. Some people prefer having an actual person manage the fund; as for me, I’ll take the index fund almost every time.
Good luck, Steve. Once you have this basic info in hand, there’s an almost infinite amount of material to learn about the stock market.