Personal Finance 101: What Exactly Does It Mean to Own a Stock?

Understanding the Basics of Stock Ownership

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.

pf 101Steve 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.

1. 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.

2.You 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.

3. 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.

4. Larger shareholders can 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.

What does the total 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.

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  1. James says:

    Great posting, are you going do to one defining mutual funds?

  2. Andy says:

    That is a great summary. Don’t forget that the stock price is also hypothetically the present value of all expected future dividends…well, I think that is right. I heard something like that before.

  3. Frugal Dad says:

    Excellent response to “what is a stock.” Sometimes it is hard to boil something so complex down to its simplest form, but that’s exactly what you did here.

    These are the kinds of lessons administrators should allow educators to teach in the classroom, instead of archaic forms of algebraic expressions no one will use in their day-to-day lives.

  4. Saving Freak says:

    Great synopsis of all things stock. Now if we can just get that nasty P/E ration into people’s minds.

  5. Tom Angstadt says:

    Good piece, but one small but important detail was left out. If Exxon (the example) were to go out of business (take under or an enron like scandal) common shareholders would likely get zero as BOND holders have their bond value tied to the company’s hard assets. This is because the stock issuance is bascially the company raising capital based on future grown, you are not getting any assets tied to the stock, you are simply buying a share of future earnings (even though they don’t have to pay them out to you) So when the ships, storage facilities, and buildings are sold, lawyers and bond holders get it all. Some class A shareholders may receive some money, but it is unlikley common stock owners would get anything. Wall Street is just a Casino without flashy lights.

  6. K says:

    “The little book that beats the market” has a good illustration of the stock market in child-like terms.

  7. Pinyo says:

    Excellent and informative primer.

  8. Simon says:

    Thanks for this incredibly useful breakdown. I’m with @saving freak – we need one like this for P/E, P/B, etc…

  9. Shawn says:

    Trent,

    You made an important error here: “You also own a piece of whatever would be earned if the company decided to close up shop”

    Common shareholders are the LAST group to be compensated when a company closes up shop for any reason. Bond and secured loan holders, then preferred shares, and lastly common holders. The first two groups usually get something. Typically, common holders get peanuts or bubkus! Just ask United Airlines employees that held stock in the last bankruptcy, and the ESOP before that. Is there yet another BR coming? Ask the Enron common holders how they made out.

    Other than this error, it is a very good post. I hope that this shows some readers they can begin with little $$, save, learn, develop saving discipline, rinse, and repeat for 40 years and retire a millionaire.

  10. I prefer to own shares that pay dividends. Then I roll them back into the stock.

    Also, Exchange traded Funds may be something to look at.(ETFs)- You trade them just like stocks but they are collections of stocks, and a little safer.

    Best,
    Lisa

  11. David says:

    Great post! This really helped me get a grasp of things!

  12. Dave says:

    Here’s something I’ve never understood. If you are Joe Smith and place a stock order over the phone or computer based on what you believe is the current price (say, $10 per share), how is it possible that by the time your request to purchase that stock makes it to some guy in the mess of activity on the stock floor many states away, the stock price is still $10? For that matter, how is there any guarantee, given the flux of incoming stock trade requests I imagine these people deal with, that a guy on the floor will even have time to get to “your” purchase request?

    To me it’s unbelievable that any one person gets any attention in the process, or, is able to buy and sell at prices they think are “current”.

    Excellent article. I love articles that explain things to adults that are not dumb about common things, but just haven’t been paying attention to them. This is the trend in web based eduction IMHO. :)

    — Dave

  13. SophG says:

    Shawn: actually Trent got it right about the value of a share when a company is wound up. Book value of a company takes into account all the other claims against the company’s assets. So he is right to say there is value in that situation. The reason we think of companies that are wound up having no value for common stockholders is because most companies that wind up are in big trouble, usually having overstated their assets and undervalued their liabilities significantly.

    Trent there was one thing that I disagreed with you on. Unless you have specifically purchased non-voting stock, you do have a vote for every share, no matter how small your holding. And when you appoint a proxy you can tell them how to vote, rather than letting the proxy make the decisions. Other than that, this is a good post.

  14. Kevin says:

    Very nice suymmary. However, you got the facts on voting wrong. Every owner of common shares has voting rights, one vote per share (see http://www.investopedia.com/terms/c/common_shareholder.asp). So even if you only own 1 share, you get 1 vote. Of course, 1 vote out of 5.28 billion (for Exxon) doesn’t give the individual much power. That’s why company founders, institutional investors like big pension funds or mutual funds, or rich investors, who all tend to have millions of shares, wield a lot of voting power.

  15. David says:

    Hi Trent,

    Good overview. Just last week I had to make a very similar summary on this subject when an acquaintance asked me to explain how the stock market works, starting with the question, “what is a stock?”

    It was good timing, because I had recently gone back to try and test my own basic understanding of this issue.

    Shawn @ 11:17 is right to note that a common stockholder’s claim on company assets and earnings come after a bondholder’s or preferred shareholders claim on those same assets.

    Here is an excerpt from another helpful link, explaining the common stock.

    “First, what is a common stock? It can be said to. constitute the basic ownership of a company. It has no preference over any other stock, bond, or claim against the company, but after such preferred claims have been settled, then common represents the entire remaining interest in both assets and earnings.”

    http://www.oldandsold.com/articles09/wallstreet-16.shtml

  16. Christopher Smith says:

    I wanted to echo the point Kevin made, that every single share carries with it appropriate voting rights. Now while it’s certainly true that a small shareholder can’t individually determine company policy, sometimes smaller shareholders do band together to force through changes in the company.

    As for the problem with getting things done, corporations have three levels of supervision: shareholders, the board of directors, and the officers (CEO, president, and similar). While shareholders could theoretically make any decision, generally only the most important decisions are voted on directly, while the board makes policy and major operational decisions, and the officers actually handle the day-to-day running of the company.

  17. Jeremy says:

    “Price is what you pay, value is what you get.”

    – Warren Buffett

  18. petervcook says:

    It should be noted that not all stocks pay dividends

  19. Shawn says:

    SophG: Respectfully, you are not correct. I responded to Trent’s writing, ““You also own a piece of whatever would be earned if the company decided to close up shop” Common share holders are, in fact, the last to own anything in a liquidation. While investing in common-class shares is the most common method, and perfectly fine for the vast majority of investments, you are, in effect, buying the very last seat at the feeding trough. If the farmer stops putting feed into the trough, you are going to get a big zero to eat.

    My initial comment did not address, as you did however, what book value means. Book value is an accounting term. While it “should” reflect what assets could be sold for, it rarely does. Liquidation value is the real money that would be distributed: First to bond and secured note holders, then Preferred stock, lastly, all others, to include common share holders. For clarification regarding the accounting “book value” and how that is not relevant here: What valuation were assets carried on Enron’s books prior to the liquidation? And, what actual value was obtained by the common shareholders through the process? It was pennies on the dollar, if anything.

  20. Michelle says:

    Great summarization. I do question Exxon as an example, though haha.

  21. Nancy says:

    How about discussing buying short and on the margin – what do they mean? Good discussion of the basics.

  22. Robert says:

    Nancy: To answer your question…

    “Selling short” is when someone makes a contract to sell shares (usually ones they do not yet own) at a fixed price to another person on a certain date. The seller is effectively betting the share prices will go down before then so they can buy the shares to cover the deal at below the amount agreed upon. They buyer is betting the opposite, that the stock will be worth more than the agreed price so they would be getting their shares at a discount. Both are in effect making a bet with each other, and the one who guesses right about the future trend (hence “stock futures”) makes money, while the one who guessed wrong usually loses money (there are some scenarios where both can make money on the deal, but they are rare).

    When people talk about the “long” vs. the “short” interest in a stock, the “longs” are people that actually own a stock in anticipation of it rising in value, while “shorts” are the people who have sold “borrowed” shares in the belief the stock will drop before they have to cover the shares they borrowed.

    Buying on margin means you are taking out a loan to buy a stock, on the assumption the stock will increase in value or pay enough of a dividend, to cover the loan’s principle and interest by the time you have to pay it back. It’s basically another form of betting (for the borrower). It was huge amounts of margin buying, with no requirements for a certain minimum ratio of asset values to debt, that led to the 1929 stock market crash and the eventual formation of the SEC (Securities and Exchange Commission). In the years leading up to the crash, investors bought large amounts of stock on margin, fueling a major stock bubble. When the stock prices started to drop the investors didn’t have the money to repay their debts causing them to have to sell off at any price to repay at least some of what they owed, thus fueling a huge crash in prices because there were few buyers with enough liquid assets (cash) to buy all of the stock that suddenly went up for sale! Today investors are required to have a minimum percentage of assets to cover most of their debt before they can buy on margin (I believe the law states you can have no more than 20% of your portfolio’s value in margin debt).

  23. Robert says:

    Oh, and I wanted to point out that my “history lesson” about the 1929 stock market crash is a very good example of the stock price bubbles that seem to happen fairly regularly int he markets. In the 1929 bubble, the stocks du jour were “Radio” related, radio being the new technological wonder of the day. Prior to the Depression, there were literally hundreds of stocks related to radio (either companies making the units, or companies owning radio stations, etc.) Today the exactly one of those stocks is still around, Radio Corporation of America (RCA), which is pretty much completely uninvolved with Radio! At one point prior to the crash, there were radio stocks selling for hundreds of dollars whose companies made little to no profit… Anyone thinking about Yahoo! or Google when you read that sentence? :)

    Bubbles are sadly far more common than most Americans realise. Investors tend to play a game of “Follow the leader” and invest most of their money in certain types of stocks (or other assets in the case of the recent housing bubble). Initially this works since the surge in buyers for a given type of stock/asset pushes the prices up rapidly, but unless you get out of the market before the prices get too high and correct downward (i.e. crash) you are likely to lose a lot when the demand to buy fizzles out, and a lot of people are suddenly looking to sell at the same time.

    This is why most good financial advisors tell you over and over to NOT try to “time the market”. It’s nearly impossible to tell exactly when irrational buying that fuels a price surge is going to switch to frantic selling and fuel a correction (polite term for a crash). A few lucky people manage to both get in and out early enough to make huge profits, but most get in late and then lose a lot when their $500 shares of Yahoo! drop to $50 six months later. Often they cling to these falling shares for too long because they “know” the price will go back up… After all, it had been doing so before, right?

  24. James says:

    Good article!

    Shawn: Actually, book value does not normally (nor should it) reflect what the net assets could be sold for – it is often quite a bit less. A voluntary liquidation should yield more for equity holders (common shareholders) than the book value. Of course, a distressed or forced liquidation may not and in the case of wrongful accounting (e.g. Enron) then book value is misstated anyway.

    At any rate, it all depends on what the assets are – some assets (like licences and rights) have less value if separated from the rest of the business.

  25. kevin pickell says:

    The stockholders get all the assets minus the debt if the company goes into liquidation. Stockholders own the equity on the book. Equity is simply value of all assets minus the debt. Often the debt will wipe out equity completely in a bankruptcy reorganization. However, there have been many instances when a company closes shop, sells assets, and returns capital to shareholders. On occasion those shareholders have made much more money than the principle cash they put up to by the stock in the first place. Sometimes a stock price will fall below a book value. This creates a margin of safety in the purchase price and often presents a great ‘value’ opportunity. But that can be a topic for another day.

    Also, shareholders do have same voting rights. You get one vote per share. If you want more votes then buy more shares. It’s only reasonable to expect those owning the most shares get the most votes. This is simple and rational.

    The value of one share is a complex subject matter. You have to consider many things to conclude what value is. You must consider the price of the stock, the value of the assets, the debt, the intrinsic value of future earnings and cash flows, the goodwill value of things like the brand(like Coca Cola, Budweiser etc…where just the name alone is worth an awful lot of money), and then also consider the number of shares outstanding, and the dilution of those shares thru options, warrants, etc.

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