What is Stock?
Note: I was inpired to create this section on stocks after my young son asked his grandma “what is stock?” (She was watching some two-bit cable show about investing in stocks.) She explained to him that stock is a piece of paper that you get when you invest money in a company. She then equated investing with gambling. Argh! Enough nonsense. Here is some hopefully helpful info about stocks and
dividends for the new investor, young or old.
What Is a Corporation?
One form of business is a corporation. The ownership of a corporation is divided into
shares of stock, which can be divided among a few or a great many owners. Shares can be transferred from one owner to another without disturbing the other shareholders.
A stockholder need not have any personal acquaintance or contact with the management or with other owners. This permits a corporation to be larger and more flexible and permanent than a proprietorship or partnership can be (more info on other forms of business is
below).
A corporation is a sort of “person” created by law, with an existence separate from its owners, who are “natural persons.” To start a corporation in the United States, the owners must obtain a charter from a state government, or possibly from the Federal Government, and must follow government regulations.
An American business that uses a lot of capital is likely to be a corporation. A company that wants to distribute portions of its ownership among more than a handful of people is practically required to incorporate. All of the business concerns whose stocks or bonds are sold to the public through the stock markets are corporations or the practical equivalent.
A corporation is managed by officers who, technically at least, are selected by a board of directors. The board of directors is selected by a vote of the shareholders. Each share is entitled to one vote. Thus, a stockholder has as many votes as the number of shares he holds.
In practice, the voting right of an ordinary stockholder is of little consequence. When the management needs stockholder approval, each owner receives by mail a proxy, which he is requested to sign and return. His choice is limited to voting “yes” or “no” on the management’s proposals. Even if a small stockholder bothers to attend an annual meeting, voting against the “inside crowd” is useless except on the rare occasions when the opposition is well organized and powerful.
This sounds like a decidedly undemocratic way to run things. But a small stockholder is not powerless. Provided the stock is readily marketable, he is free to express his disapproval of the management by selling shares. Ease of selling shares is something for a cautious investor to check before buying shares. For a corporate shareholder, it is far more important than voting rights.
In the long run, the easiest and safest way for a corporate officer to increase both personal income and prestige is to be in charge of a company that is making money for its stockholders and is growing. The continued success of the company means more to an officer than it does to the average stockholder.
Corporations often need to raise additional capital for expansion. A long time ago they raised capital by selling stock or bonds to wealthy families. But over time, they found it necessary to induce an ever-increasing number of people to become stockholders. With stock exchanges, it became practical and attractive for a small investor to buy and sell shares and become a shareholder.
Theorically, over a long period of time, the interests of corporation heads and of small stockholders are likely to agree. But this does not mean that an investor can trustingly assume that all corporations are well run, or that it does not matter what stock he owns.
Buying and Selling Stock
In the United States there are hundreds of thousands of corporations, ranging in size from baby to giant. The stock of a corporation may be closely held, perhaps with one person owning a majority, and the remaining shares all held in the family. Or maybe shares are sold on a rather personal basis to selected employees. Such shares are privately held and not publicly traded.
When a company sells some of its shares to anyone who will pay for them, normally it arranges for sale of the shares through an organized stock market.
Stock brokers and online stock trading companies handle the buying and selling of stock for individuals. In the past, paper stock certificates were issued in the name of the owner. Now, it is handled electronically.
Who sets the price on a corporation’s stock? An newbie investor may naturally assume that the price is set by the management of the issuing corporation. The price is set mainly by what other buyers (customers) will pay for it, and what price sellers will sell their shares for.
Each share of common stock has the same market value as any other share issued by the same corporation. The price of stock is set by the consensus of opinion of all the people who are either offering or bidding for stock of that company at that time.
Forms of Businesses That Do Not Issue Stock
It might help to understand corporate stock by reviewing other forms of business that do not have shares of stock.
In the simplest type of business organization, one person is the sole owner, proprietor, manager, boss and worker. The occupation may be, for example, a farmer, a plumber or a grocer. Or a professional, such as a physician or a lawyer. Probably he thinks of himself more as a worker than as an owner. But he is in quite a different position from an employee who works for somebody else. Nobody pays the owner a salary or wages.
If his income is not large enough to cover his expenses, including what he takes out for personal and family needs, then he must either cut his expenses or increase his income by finding more customers, or selling more per customer, or raising prices, or else go out of business. When he wants new equipment to do better or more work, he must find the capital to pay for it. These are the responsibilities of an equity owner of any independent, private business, no matter how small or large the organization.
When successful one-person business grows, the owner-manager hires employees, thus becoming an employer. To raise more capital than he is able to furnish, he might borrow money. The lender has no responsibility in the business except that he may interfere if he does not receive payments of interest or principal on time. After payment of all expenses, including interest on the loan, the profit (if any) belongs to the owner. When the gross income is less than expenses, then the loss is the owner’s.
Expansion of a business may go like this: The original owner arranges for one or more people to join as partners. Normally, a partner contributes work, skill and money, but we are concerned here with only the investment aspect. Each partner shares in the profits or losses of the business. But first, the firm must pay all of its expenses. When using borrowed money, it must make the agreed payments to the lender before it pays profit to a partner.
A partnership is an ancient method of organizing business, and is still used extensively. It is a highly personal form of organization. It generally has a better chance of working OK in a business that does not need more than two or three equity owners. A large number of partners is a clumsy arrangement.
Next: What Are Stock Dividends?
