Investing 101: What are stocks?
This is part 3 of the Investing 101 series. If you haven’t already, I strongly recommend reading Part 1: What is investing? and Part 2: Why invest? first.
Remember that from Part 1, one of the two basic ways to invest is to purchase assets which grow, generate profits, or both. And the most common example of this type of asset class is a business. But if you don’t know how to run a business, don’t worry. Even without any business acumen whatsoever, you can still be the owner of some of the largest and most profitable companies in the world. You can do this buy purchasing shares of stocks.
What are stocks?
Stock represents ownership of a company. A company’s total ownership is divided into a number of “shares”, and this collective group of shares is known as the company’s “stock”. Ownership of a share of stock equals fractional ownership of the company in proportion to the total number of shares. Stocks are also referred to as equities, because stockholders, also known as shareholders, have an equity stake in the company. The shareholder is then entitled to the company’s profits, assets, and voting power in proportion to their ownership stake. Colloquially, the words stock and share are often used interchangeably, although technically a company only has one stock, which in turn is divided into numerous shares.
Ownership of stock grants voting power. Here, my brokerage Fidelity informs me that I can vote in Corsair’s annual shareholder meeting.
Why would any business owner offer a piece of their business for sale? As it turns out, offering shares of stock for purchase is a common way for companies to raise capital. If a company needs money, it can basically sell a small portion of its equity in exchange for funding. If you ever watch the TV show “Shark Tank”, you’ll see an example of this basic concept. Public companies can offer their shares for sale to the general public, so anyone can invest in the company and become an owner. Private companies can also raise funds this way, although there is no open market for their shares. Some private companies are also too new or too risky for the general public to invest in. Instead, private companies tend to look towards a selective group of wealthier investors to provide the funding that they need.
In addition to raising capital, another common reason for companies to offer shares to the public is to provide liquidity to existing shareholders. It can be difficult for an investor in a private company to “cash out” their investment if they wanted to do something else with their money. Going public allows existing shareholders to sell their ownership stake to the public on the open market.
For example, Microsoft (MSFT) is a public company. At some point in the past (in 1986), Microsoft offered shares of its stock for purchase by the public. This process is usually called an initial public offering, or IPO (although there are other ways for a company to go public). Currently, however, Microsoft is not issuing any new shares, so you cannot purchase shares directly from Microsoft. But there are billions of existing shares of Microsoft stock in possession by shareholders, many of whom are willing to sell on the open market. So you can still purchase a share of Microsoft stock from another shareholder on the open market and become an owner (of a very small fraction) of Microsoft.
On the other hand, IKEA is an example of a private company. It has never sold any shares of stock to the public, and you cannot purchase any fraction of ownership in IKEA, no matter how small.
Historically, proof of share ownership came in the form of physical stock certificates. These are physical documents which resemble diplomas, issued by the company in question, containing information about the shareholder’s identity and how many shares they own. Nowadays, electronic ownership registration has all but replaced paper stock certificates.
Some of the largest and most profitable companies in the world are public companies. This means that regular people like you and me can easily become (fractional) owners of companies such as Microsoft, Google, Apple, Amazon, and Walmart, just by buying shares of their stock.
Stock exchanges and brokerages
Stock exchanges are marketplaces where people can buy, sell, and exchange shares of stocks with others, with the aid of a broker. To continue with our example above, if you wanted to buy a share of Microsoft today, you are actually buying it from another shareholder, not from Microsoft directly. This is because Microsoft went public a long time ago and is not currently issuing more shares of its stock. Shareholders naturally congregated at centralized marketplaces to meet other shareholders and buy, sell, and exchange stocks. These marketplaces eventually became stock exchanges that we know of today.
The New York Stock Exchange (NYSE) and the Nasdaq are both stock exchanges. In fact, they are the two largest stock exchanges in the world. Almost all publicly traded companies in the United States of any significant size are listed on either the NYSE or the Nasdaq. Together, these companies make up most of the total US stock market.
A broker is a third party who facilitates a stock transaction between two interested parties for a commission. A broker’s main job is to play matchmaker in order to connect an interested buyer and seller of a particular stock at an agreed-upon price. The broker also handles the process of ownership transfer. Remember that after you agree to buy a share of Microsoft from another shareholder, they have to inform Microsoft that the ownership of the share was transferred to you. The formal transfer of ownership is known as the settlement, which doesn’t occur until several days after the initial transaction. Because this process takes time as well as good faith on the part of both seller and buyer, the broker steps in to mediate to make sure that the seller gets paid and the buyer gets the ownership.
A brokerage is just an institution that provides the aforementioned broker services. With the advent of the internet and electronic trading, the process of trading stocks has been greatly simplified. You no longer need to go to a stock exchange, nor do you need a personal broker on speed dial. Instead, you can simply open an account at a brokerage to utilize broker services, much in the same way that a bank provides you banking services. All of this can now be done online, from the comfort of your home.
Investors have many choices when it comes to which brokerage to use. I recently wrote an article comparing Fidelity, Vanguard, and Charles Schwab, three of the most popular retail brokerages.
What determines a stock’s price?
A company’s overall valuation, divided by the total number of shares of stock, determines the price of one share. If a company is worth $100 and has 10 shares of stock, then each share represents 10% of the company and is worth $10. For a real-life example, on March 19, 2021, there were 7.56 billion shares of Microsoft stock outstanding, and Microsoft’s valuation was 1.74 trillion dollars. Therefore, each share of Microsoft stock was worth $230.72 on that date and represents 1/7.56 billionth of Microsoft ownership.
This valuation is also known as the company’s market capitalization. Simply put:
market capitalization = total shares of stock * price per share
therefore
price per share = market capitalization / total shares of stock
You might notice that this line of reasoning seems somewhat circular, because a company’s share price defines its valuation, and a company’s valuation also dictates its share price. For example, few weeks prior to our example above, on February 12, 2021, a share of Microsoft stock was actually trading at $244 and Microsoft had the same number of total shares. Therefore, Microsoft was, by definition, worth 1.84 trillion dollars at that time. Which valuation of Microsoft ($1.84 trillion on February 12 vs. $1.74 trillion on March 19) is correct? Or did Microsoft somehow “lose” $100 billion in 1 month?
So what determines a company’s valuation?
The answer is complicated. Remember from Part 2: Why invest? that money has a time value. Therefore, a dollar on February 12, 2021 does not have the same value as a dollar on March 19, 2021, so valuations on different dates are not apples-to-apples comparisons.
Even so, it is obvious that the valuation of Microsoft fluctuated beyond what time value of money alone can explain. As it turns out, the value of Microsoft fluctuates because nobody knows for certain what Microsoft is worth. The question of how to properly value a company is the fundamental question of financial theory. Over the years, many different methods have been devised in an attempt to answer this question.
A popular and logical way to value a company is through a technique known as fundamental analysis and and calculating net present value by discounting future cash flows. In simple terms, a company’s present valuation is expressed as a combination of its book value (current assets minus debts) plus a projection of its future earnings, with a present-day discount applied. Again, because money has time value, a discount must be applied to future profits. If a company has $100 of book assets today and will earn another $10 in profits next year, its value today (present value) is slightly less than $110 because $10 next year is not as valuable as $10 today. So the formula for valuing companies with fundamental analysis looks something like this:
present value = book value (current assets - debt) + year 1 discounted profits + year 2 discounted profits + year 3 discounted profits +….
in other words,
present value of company = book value + all future profits with present-day discount applied
In the formula above, the bold parts are known, and the italic parts are unknown. A company’s book value is easy enough to discern from a company’s financial statements. A company’s future profits, however, is not known. By looking at the trajectory of past profits, you might try to guess future profits. But even if you could correctly guess a company’s profits next year or the year after, the company’s longevity is also unknown. The correct discount rate to use can also be debated. To accurately estimate the totality of all of a company’s future profits over the company’s lifetime and apply the appropriate present-day discount to each year’s profits is basically an impossible task. So because the future is unknowable, the present valuation of a company under fundamental analysis is never known with certainty.
All over the world, there are thousands of securities analysts whose full-time jobs involve analyzing the fundamentals of companies and projecting their future growth and earnings. They then compare their own analysis with the current market valuation of the company to see if a company is being overvalued or undervalued. Fundamental analysis also gives rise to ratios known as multiples, such as price-to-earnings ratio (P/E) and earnings-per-share (EPS). In our previous example, a company was valued at $100 with 10 shares of stock outstanding worth $10 each. If the company earns a profit of $10 at the end of the year, the company has an EPS of 1 (each share earned $1), and it has a P/E ratio of 10 (the price of a share divided by the EPS). If, on the other hand, the company earns a profit of only $5 on the year, it has an EPS of 0.5 and a P/E of 20. And when a company releases its earnings data to the public (as they are required to do), their earnings might either beat or miss prior expectations. All of these concepts arise from fundamental analysis.
Fundamental analysis is not the only way to value companies. There are times when a company’s valuation doesn’t seem to make sense. See my GameStop article for a recent example of a company whose valuation which was seemingly “divorced” from its fundamentals. GameStop is a company that lost money last year, and therefore has a negative EPS and undefined P/E. Another example would be Tesla, which has a P/E ratio of over 1,000 whereas most companies have a P/E ratio between 15 to 30.
We’ll reduce the numbers by some orders of magnitude but keep the proportions the same to provide some more clarity. In GameStop’s case, if I had a company that lost $3 last year, you would be unlikely to offer me $12 for my company today, unless you were confident that I could turn my company around. And in Tesla’s case, if I had a company that made $1 in profit last year, you would be unlikely to offer me $1,000 for my company today, because although I am profitable, you’re unlikely to recoup your investment in a reasonable amount of time, unless I can grow my future profits exponentially. So in this sense, the current valuations of both GameStop and Tesla don’t make much sense under fundamental analysis.
Most people believe, however, that in the long-run, valuations are derived from fundamental analysis and that speculative valuations will return to what the fundamentals actually support. But even with fundamental analysis, future earnings are still projections, so there is always some room for disagreement and speculation.
This is why the valuation of companies fluctuate on a day-to-day or even minute-to-minute basis, as reflected by the price of their stock. So Microsoft’s valuations of $1.84 billion on February 12 and $1.74 billion on March 19 are both “correct”. But as you can see, stock prices are not completely arbitrary, although they might appear so to casual observers. As I discussed in my article Can the stock market go to zero?, as long as a company has either positive book value or any expectation of future profit, it will have a non-zero valuation. One of the beauties of being a publicly traded company in a free market is that the general public gets to decide on what the value of the company is through buying and selling shares of its stock. This is a process known as “price discovery”. At the end of the day, no governing entity or higher power determines a public company’s valuation. It instead reflects the consensus reached by millions of buyers and sellers on the open market.
How do I get a return on my investment from stocks?
Ultimately, all companies must be profitable, or they cannot survive. Ownership of these companies through stocks provide return on investment in two main ways. The first occurs when the stock price goes up. When a company uses its profits to grow and its valuation increases, the price of each share increases as well.
Let’s go back to the example of a small company which is valued at $100, and its ownership is divided into 10 shares of stock. Each share represents 10% of ownership stake and is therefore worth $10. Several years later, the company has grown and is valued at $200. Each share of stock is worth $20 at that point.
The second way occurs when companies pay dividends. When a company makes a profit and has excess cash left over, it must decide what to do with its cash. The company can choose to reinvest the cash into itself (for example, by buying more factories or hiring more employees) and help itself grow, as in the previous example. On the other hand, the company can decide to pass the extra profits down to shareholders in the form of a dividend. Many, but not all, companies pay dividends to their shareholders.
For example, the company previously valued at $100 makes $10 of profit in a year. Instead of reinvesting to grow the business, the company decides to pay the $10 as a dividend to shareholders. Since the company’s stock is divided into 10 shares, each shareholder will receive $1 in a dividend payment that year.
Note that if the company reinvested the $10 of profit into itself instead of a dividend payment, the outcome is the same. The company is now worth $110, and since the company has 10 shares of stock, each share is now worth $11. Either way, each shareholder received a 10% return for the year.
A look at real stocks
These days, you can find all the basic information you need about any company’s stock from any number of sources, including online and through your brokerage. Taking all of the information above, let’s look at some real companies. We’ll keep using Microsoft as our first example. The picture below shows Microsoft stock, as viewed through the iOS stocks app, on April 19, 2021.
From this screenshot, we can already determine a few things. Every company has an abbreviated ticker name under which it is listed on a stock exchange. This usually ranges from 1 to 5 letters. Microsoft Corporation’s ticker is MSFT. As you can see, on April 19, 2021, a share of Microsoft ranged in price from $257.82 to $261.48, ultimately closing (U.S. stock markets close at 3:30pm ET) at a price of $258.74. Volume indicates the number of shares that exchanged hands on that day: 21 million. Market Cap indicates the total valuation of Microsoft, based on the total number of shares of Microsoft stock (about 7.56 billion, not shown in this app) multiplied by the price per share.
Because Microsoft is a mature and successful company, it earned profits in 2020. How do we know this at a glance without delving into Microsoft’s financial statements? Because Microsoft has a positive EPS (earnings per share) and a real P/E (price-to-earnings) ratio. In 2020, Microsoft earned around $50 billion in total profits. Its total profits, divided by its total number of shares outstanding (again, around 7.56 billion) yields an EPS (earnings per share) of $6.71. Finally, Microsoft’s share price of around $258 divided by each share’s earnings ($6.71) gives the P/E ratio of around 38. All of these numbers will fluctuate constantly as Microsoft’s share price fluctuates. Finally, Microsoft doesn’t invest all of its profits back into itself. It pays some of it directly to the shareholder in the form of a dividend, which can be seen as the dividend yield. Note that because the current year is still ongoing, many of these calculations are presented as the previous fiscal year’s numbers.
Not every company is profitable! Many start-up companies and declining companies are not profitable and lose money instead. AMC is an example of a company that was not profitable in 2020, due to theaters shutting down from the COVID-19 pandemic:
As you can see, AMC does not have a defined P/E ratio, and it has a negative EPS. Prior to the COVID-19 pandemic, AMC was earning around $100 million in profits every year. In 2020, however, most of its theaters were closed, and it could no longer generate much revenue. It still incurred expenses because it has to pay its employees, rent, maintenance and upkeep, etc. Therefore, instead of earning a net profit in 2020, AMC posted a massive net loss of - $4.59 billion. This leads to a negative EPS and an undefined share price-to-earnings ratio (as there are no earnings). AMC also does not pay a dividend to shareholders (as it does not have profits to do so with), so the yield is undefined.
Companies can still survive despite losing money, as long as they still have money to burn. When a company runs out of money, however, it faces bankruptcy unless it can either raise additional capital through investment or through loans. AMC did exactly this and remains in business, for now. A company can only lose money for so long, however, before no one is willing to invest in it or lend it money anymore.
At this point, I invite you to look up some companies that you’ve heard of and discover some basic information about them, just by looking at their stock ticker. Try to find an example of each of the following:
A massive company (above $1 trillion in market capitalization)
Any profitable company (had a positive EPS in 2020)
A profitable company (positive EPS in 2020) that doesn’t pay any dividends
An unprofitable company (negative EPS in 2020) that paid dividends in 2020
Have fun! There are multiple companies that fit each of these descriptions, so feel free to leave your answers in the comments! I’ll reveal some of my picks in the next Investing 101 article.
How do you know which stocks to buy?!
All of this might sound great in theory, but how do you pick which stocks to buy? Obviously, not all companies follow the same trajectory. Some go on to bankruptcy, while others become hugely successful household names.
The short answer is that I actually don’t know which stocks to buy, but I also don’t need to know. Instead, I buy something called index funds. Simply put, I don’t try to pick and choose the best stocks. I just buy them all.
In Part 2: Why invest?, we saw that the S&P 500 (which is a collection of stocks representing the US stock market) returned more than 10% per year over the past 35 years. Over the past hundred years or so, the United States became an economic superpower and in aggregate, American companies have provided tremendous returns to their shareholders. Instead of trying to invest in individual companies, I just invest in every company.
This is not the only way to invest, but perhaps somewhat counter-intuitively, it works incredibly well. It also requires very little expertise. This type of strategy is generally referred to as passive investing. On the other hand, I suppose you could learn to read financial statements and do your own fundamental analysis on companies. You could also rely on the analysis of others (for example, you could hire someone to professionally manage your investments). Strategies where you pick and choose specific investments are generally referred to as active investing. There are merits to both strategies; I recently wrote an in-depth comparison of active versus passive investing,
Putting it all together
This article became much longer than I originally intended. So let’s summarize the key points.
Businesses are the most common type of asset class that generate returns
Shares of stock represent ownership stake in a business or company
A public company means anyone can purchase shares of their stock
Companies go public to raise capital or to offer liquidity to existing investors
The total valuation of the company, divided by number of shares, is the price per share
Stock prices, and therefore company valuations, are not arbitrary, but they do fluctuate because the future is unknown
Fundamental analysis is one popular method of calculating valuation, but the free market decides in the end
Ultimately, every company must be profitable; if they are not, they will eventually go bankrupt.
The shareholder is rewarded when the company’s valuation increases from reinvesting profits, or when it pays its profits as dividends
I don’t know which stocks to buy, but I invest in aggregate through index funds.
This is a good place to end. Now that you know some basics about stocks and the stock market, it’s time to explore Part 4: Market Indices and the S&P 500. Happy investing!
