If you were to buy one share of Microsoft Corporation you would own a very tiny portion of the company, for better or for worse. If there are 1 million shares, you own one-millionth of the company. That is stock.
Most stock buyers don’t think like owners, and they don’t actually have a say in how a company runs its operations. Owning shares of Microsoft does, however, give you a portion of the votes at a shareholder meeting. In this scenario, if you purchased 500,000 more Microsoft shares, you would have a controlling interest in the company. Unfortunately, individual investors rarely amass enough stock to be able to exert any tangible influence over a company.
The stock market itself is basically a daily financial analysis, or valuation, of the companies that trade there. Traders keep a close eye on the news, including potentially troubling lawsuits and hot product releases that may lead to greater market shares for their respective companies.
For the purposes of stock value, the day’s news is distilled down to a single simple question: Will it help Company XYZ make money in the future, or will it prevent it from doing so? If Microsoft is successfully sued, look for its shares to fall. If, however, strong economic numbers forecast improved sales, traders will buy with a vengeance and the price of Microsoft stock will rise.
Earnings, also known as profits, are the highest measure of value as far as the market is concerned. Publicly traded companies are required by law to report their profits quarterly. Investors scrutinize these numbers, which are expressed as earnings per share, in an attempt to gauge each company’s present health and future potential.
The market rewards two types of earnings growth: fast and stable. Stock traders are even keen to invest in money-losing companies that promise significant future stakeholder profits. This was the case in the late ‘90s with the explosion in Internet stocks. In hindsight such investors would have been better off investing in companies already showing a profit. Two things the market won’t tolerate are consistently declining earnings and baffling losses. As such, companies that surprise Wall Street with bad quarterly reports nearly always see a significant dip in stock price.
Unlike bonds, which promise regular interest payments and payout after set periods of time, there are no assured returns from stock. Many well-established companies pay regular shareholder dividends but are under no obligation to do so. If you own stock in a company that eventually goes bankrupt you would lose the entire value of your investment. Fortunately such cases are rare.
The best approach toward minimizing the risk of owning stocks is to diversify, that is, to own a variety of stocks. Doing so prevents any single company from wiping out your investment savings. That said, as an investor you can be well compensated for taking a chance on stocks, which historically have obtained a long-term return of about 11 percent. Bonds on the other hand have returned just 5.2 percent.
It’s in your best interest to carefully research management’s competence before purchasing a given company’s stock. And an important indicator of that is the company’s ability to deliver consistent earnings over a significant period of time.