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What is a stock? Thumbnail

What is a stock?

Education

What is a stock?

by Jim Steel, CFA, CFP

A stock is another name for a share and represents ownership and control of a company. The terms equity, stock, stock certificate, share and share certificate are all synonymous. 

If someone (founder) has an idea for a business, they incorporate a new company by filing paperwork with a government agency. As part of this process, the founder is issued company share certificates (i.e. stock). These share certificates represent private ownership. They also represent control over the new company because they carry voting rights.  Most companies grant stockholders one vote per share, thus giving those shareholders with a greater investment in the company a greater say in corporate decision making. Usually a founder will issue a small number of shares at the outset, but reserve the right to issue an unlimited number of shares in the future as the business grows. 

At this point, the founder has a privately held incorporated company, owns all the shares, has full control over the company, and has the ability to issue more shares. However,  the shares have no value yet because the company has not started selling a product or service.  

As the company starts selling its product or service and the business grows, it is now worth something. Keep in mind that the shares represent ownership and are worth money. Think of the share certificate as a deed to a house. Your house is worth money, but the deed is where the money is represented.  

Bankers now approach the founder offering to bring the private company public through an initial public offering (IPO). This means listing the company on a public stock exchange such as the Toronto Stock Exchange. When companies trade on a public stock exchange, their shares typically sell for much higher valuations than if they continued to be held privately.  

To go public, the founder would exercise their control and issue a large number of shares. With the help of the bankers, some of these shares are sold to investors in exchange for cash. The bankers then arrange for the shares to be traded on a public stock exchange  where they  can be bought and sold. 

The founder is now left with a smaller percentage of shares but has received cash in exchange for the shares that were sold. As long as the founder keeps enough shares, they retain control of the company.  

However, if the founder had sold more than a certain percentage of the shares, it would be possible for all the new shareholders to band together, combine their voting rights and take over control of the company. If this happened, the founder would still have the shares they owned (and their inherent value), but would lose control of the company.  

So how is the value of the company and its share price determined? A company's worth, or its total market value is  its market capitalization, or market cap, which is  the stock price multiplied by the number of shares issued. So while we can express the value of a company as an entity, most investors think about the value of a share, which is what we will do here.  

Various metrics help determine the value of a share. Generally, these metrics compare the share’s current price to performance indicators such as earnings, sales, cash flow, dividends and book value. In addition, the outlook for the industry in which the company operates plays a role. If the company’s main industry is fossil fuels, the forecast may not be as rosy as it would be for electric cars.  

Much like any market, the stock market is driven by supply and demand. When a stock is sold, a buyer and seller exchange money for share ownership. The price for which the stock is bought becomes the new market price. When a second share is sold, this price becomes the newest market price, and so on. Therefore,  the market ultimately decides the value of the share.  

Purchasing shares of a company on a stock exchange allows everyday investors the opportunity to participate in the growth of publicly traded companies. Over time these types of investments tend to deliver higher rates of return versus keeping money in less volatile securities such as guaranteed investment certificates or bonds. However, as with any opportunity, there is also risk. The value of a company’s shares can fall as quickly as they rise. That’s why it is  important for investors to adopt a long-term horizon with stocks, and to diversify by holding stocks in many different companies. But that is a subject for another day.