Frankly put, stock is ownership in a corporation. If you were to buy one share of Microsoft you would obtain a very tiny portion of the corporation, for better or worse. If they have 1 million shares, you own a millionth of the company. That means you own a millionth of every copy machine, every contract, and every trademark in the place. Better still, you own a millionth of every dollar of profit that the corporation earns. Buy more shares and your stake in the company grows.
Most stock buyers don’t think like owners, and they don’t actually have a say in how a company runs its operations. So while owning a share of Microsoft technically makes you Bill Gates’ boss, it doesn’t give you the right to call him up and berate the decisions he makes. It does however give you a millionth of the votes at a shareholder meeting.
If you purchased five hundred thousand more Microsoft shares, you would have obtained a controlling interest in the company and be able to control all areas of Microsoft’s business, like pay fat dividends or merge with your company. Unfortunately, individual investors rarely amass enough stock to exert any tangible influence over a company.
How is stock valued?
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 them from doing so? If Microsoft is successfully sued for a major Xbox glitch, look for its shares to fall. If, however, strong economic numbers forecast improved Xbox 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 market values. Publicly-traded companies are required by law to report their profits quarterly. Investors scrutinize these numbers, 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 stakeholder profits in the future. 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 who had already demonstrated profit. The market won’t tolerate consistently declining earnings or baffling losses. As such, companies that surprise Wall Street with bad quarterly reports nearly always see a significant dip in stock price.
A Word About Risk
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 they are under no obligation to do so. If you own stock in a company that goes bankrupt, you lose the entire value of your investment. Fortunately, such cases are rare.
The best way to minimize your stock risks is to diversify, i.e. 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%. Bonds, on the other hand, have returned just 5.2%.
In conclusion, it’s in your best interest to carefully research management’s competence before purchasing a given company’s stock. An important indicator of aptitude is the company’s ability to deliver consistent earnings over a significant period of time.