02 - Stock Basics: What Are Stocks?

The Definition
Ownership in a corporation represented by shares that are a claim on the company's assets and earnings.

Plain and simple, stock is ownership in part of a company. The more stock you own the great your ownsership stake in the company becomes. Stocks are also sometimes referred to as shares, securities or equity.

Being an Owner
Holding a company's stock means that you are one of the many owners (shareholders) of a company, and as such, have a claim (albeit usually very small) to everything the company owns. Yes, this means that technically you own a tiny sliver of every piece of furniture, every trademark, and every contract of the company. As an owner you are entitled to your share of the company's earnings, as well as any voting rights attached to the stock.

A stock is represented by a stock certificate. This is a fancy piece of paper that is proof of your ownership. In today's computer age you won't actually get to see this document because records are kept electronically at your brokerage. Also known as holding shares "in street name." The reason this is done is to make it easier to trade the shares. It used to be that if you wanted to sell your shares you'd have to physically take the certificates down to the brokerage. Trading with a click of the mouse or a phone call makes life easier for everybody.

Being a shareholder of a public company does not mean you have a say in the day-to-day running of the business. You get 1 vote per share to elect the board of directors at annual meetings. This is the extent to which you have your say in the company. For example, being a Microsoft shareholder doesn't mean you can call up Bill Gates and tell him how you think the company should be run. In the same line of thinking, being a shareholder of Anheuser Busch doesn't mean you can walk into the factory and grab a free case of Bud Light!

The management of the company is supposed to increase the value of the firm for shareholders. If this doesn't happen, the shareholders can vote to have the management removed - this is the theory anyway. In reality, individual investors like you and I don't own enough shares to have a material influence on the company. It's really the big boys like large institutional investors and billionaire entrepreneurs who make the decisions.

Not being able to manage the company isn't too big a deal. After all, the idea is that you don't want to have to work to make money, right? The importance of being a shareholder is that you are entitled to a portion of the company's profits and have a claim on assets. Profits are sometimes paid out in the form of dividends. The more shares you own, the larger portion of the profits you get. The claim on assets is really only relevant if a company goes bankrupt. In case of liquidation, you'll receive what's left after all the creditors have been paid.

This last point is worth repeating:

The importance of stock ownership is the claim on assets and earnings; without this, the stock wouldn't be worth the paper it's printed on.

One other feature of stock that is extremely important is limited liability. This is a legal term which means that you will not be personally liable in the case where a company cannot pay its debts. Other companies, such as partnerships, are set up so that if the partnership goes bankrupt the creditors can come after partners (shareholders) personally and sell of their house, car, furniture, etc. With stock, no matter what, the maximum value you can lose is the value of your investment. Even if a company you are a shareholder in goes bankrupt you can never lose your personal assets.

Debt vs. Equity
Why would a company would want to issue stock? Why would the founders share the profits with thousands of people when they could keep profits to themselves? The reason is that at some point every company needs to raise money. To do this, companies can either borrow it from somebody or raise it by selling part of the company, known as issuing stock. Borrowing can be done from a bank or by issuing bonds. Both methods fit under the umbrella of "debt financing." On the other hand, issuing shares of stock is called "equity financing." Issuing stock is advantageous compared to debt because a company does not have to pay the money back or make interest payments along the way. All you get in return for your money is the hope that the shares will be worth more some day.

The distinction between debt and equity financing is important. With a debt investment such as bonds, the return of your money (the principal) is guaranteed along with promised interest payments along the way. This isn't the case with an equity investment. By becoming an owner you assume the risk of whether the company will be successful or not. Just as a small business owner isn't guaranteed a return, neither are the shareholders. Also, by being an owner you have a lower claim on assets than creditors do. This means if a company goes bankrupt and liquidates you don't get any money as a shareholder until the banks and bondholders have been paid out, we call this absolute priority. Shareholders have a greater upside if a company is successful, but they also stand a greater chance of losing their entire investment.

Risk
It must be emphasized that there are no guarantees when it comes to individual stocks. Some companies pay out dividends, but many others do not. And there is no obligation to pay out dividends even for those firms that have traditionally had them. Without dividends the only way an investor can make money on a stock is through appreciation in the open market. On the downside, any stock may go bankrupt in which case our investment is worth nothing.

Although risk might sound all negative, there is also an upside. Taking on greater risk demands greater returns on your investment. We can see this happen over the long-term as stocks have historically outperformed other investments such as bonds or savings accounts with an average return of around 10%-12%. A great example of the power of owning equities is General Electric. If you owned 1 share in 1928, it would be worth $65,000 today!