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EDUCATION: ARTICLES
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Lesson 3 : What Are Stocks?
Understanding Stocks, What They Are and How They Work
What Are Stocks?
Stocks represent ownership in a company, making you a shareholder or part-owner of that company. When a company needs to raise capital, it may issue shares of stock, which are sold to the public through a process called an Initial Public Offering (IPO). Once stocks are issued, they can be bought and sold on stock exchanges like the New York Stock Exchange (NYSE) or NASDAQ. The price of a stock fluctuates based on various factors such as company performance, investor sentiment, and broader market conditions.
By purchasing a stock, an investor is entitled to a portion of the company’s profits, either through capital appreciation (when the stock price increases) or dividends (periodic payments to shareholders). Stock ownership comes with varying degrees of risk and reward, with the potential for high returns but also the possibility of losses if the company underperforms. There are two main types of stocks: common stocks and preferred stocks.
Types of Stocks:
- Common Stocks:
Common stockholders are the most typical type of shareholders and have voting rights at shareholder meetings, such as in the election of the board of directors. In addition to voting, common stockholders are entitled to receive dividends, which are payments made from company profits, although these are not guaranteed. Common stockholders are last in line to be paid in the event of a company's liquidation, after bondholders and preferred stockholders.
- Preferred Stocks: Preferred stockholders do not have voting rights, but they have a higher claim on the company’s earnings and assets. For example, they are paid dividends before common stockholders, and in case of liquidation, they are given priority. Preferred stocks often provide more stable dividends, which makes them attractive to income-focused investors, but they typically do not benefit as much from stock price appreciation compared to common stocks.
How Do Stocks Work?
Stocks represent a fraction of ownership in a company. As a stockholder, you benefit when the company performs well and its stock price increases. On the flip side, if the company faces financial difficulties, the value of its stock may fall, and you may lose money. The value of a stock is influenced by supply and demand in the market, which is, in turn, driven by factors such as:
- Company Fundamentals:
This includes the company's financial health, earnings, revenue growth, and future growth potential.
- Economic Conditions:
Broader economic trends, such as interest rates, inflation, and GDP growth, can impact stock prices.
- Market Sentiment:
Investor sentiment, driven by news, rumors, or general market trends, can cause stock prices to fluctuate.
- Industry Performance:
If the sector or industry the company operates in is thriving, the company’s stock price may rise.
- Political or Global Events: Political decisions, regulatory changes, or global events (like pandemics or natural disasters) can have significant effects on stock prices.
Advanced Concepts in Stocks:
- Stock Valuation: One of the critical aspects of investing in stocks is determining the value of a stock. Investors use several methods to assess whether a stock is overvalued or undervalued. Common valuation techniques include:
- Price-to-Earnings (P/E) Ratio:
This ratio compares the company’s stock price to its earnings per share (EPS). A high P/E ratio might indicate that the stock is overvalued, while a low P/E might suggest the stock is undervalued.
- Discounted Cash Flow (DCF):
This method calculates the present value of a company’s future cash flows, helping investors determine the intrinsic value of the company.
- Price-to-Book (P/B) Ratio:
This ratio compares the market value of a company to its book value (assets minus liabilities). A lower P/B ratio may indicate a stock is undervalued.
- Stock Splits:
A stock split occurs when a company increases the number of its outstanding shares by issuing more shares to existing shareholders, usually in a ratio like 2-for-1. While this does not change the overall value of the investment, it reduces the stock price, making the shares more accessible to investors. A reverse stock split is the opposite, where the company consolidates its shares into fewer shares at a higher price.
- Dividends:
Dividends are a portion of a company’s profits paid out to shareholders, usually on a quarterly basis. Companies with strong earnings and stable cash flow often issue dividends to provide income to investors. Dividend yield is calculated by dividing the annual dividend payment by the stock’s current price. High dividend yields can be attractive to income-focused investors, while growth-oriented investors might prefer companies that reinvest their profits into expansion rather than paying dividends.
- Stock Buybacks:
In a stock buyback program, a company repurchases its own shares from the open market, reducing the number of outstanding shares. This often leads to an increase in the stock price as it can make remaining shares more valuable. Buybacks are often seen as a signal that the company believes its stock is undervalued.
- Short Selling:
Short selling is an advanced strategy where investors borrow shares of a stock and sell them, hoping the price will drop. If the stock price falls, they can repurchase the shares at a lower price, return them to the lender, and pocket the difference. However, short selling carries significant risk because, theoretically, there is no limit to how high a stock’s price can rise.
- Algorithmic Trading:
In conjunction with standard trading is the use of algorithmic trading, ie: automated electronic trading. The majority of these systems operate on bots and standalone systems, and nodes. Modern days allows for any individual to setup automated trading and algorithms.
Market Orders vs. Limit Orders
Market Orders:
A market order is an order to buy or sell a stock at the best available price. It ensures that the order will be filled quickly but doesn’t guarantee the exact price.
Limit Orders: A limit order sets a specific price at which an investor is willing to buy or sell a stock. The order will only be executed if the stock reaches the desired price or better.
Stock Market Indices
Stock indices are used to measure and track the performance of a specific group of stocks or the overall market. These indices represent the performance of a basket of stocks and provide a snapshot of market trends.
