This lesson will provide you with a basic understanding of common stock, why and how companies issue stock, the potential for return on investment when investing, and how to calculate shareholder earnings.
What is Stock?
Are you thinking of investing in the stock market? Are you confused by the different types of stock being offered? Does it all sound like Greek to you? Let's take the mystery out of stock, shall we?
When companies need more money, for things like expansion, they have two primary choices: They can borrow the money, or they can sell stock. Borrowing money requires them to make payments in the future on what they borrowed. Selling stock in the company allows the company to obtain the money it needs without making a payment.
Each stock is worth one share and investors can purchase multiple shares of stock at any given time. The owners of stock are called shareholders. Shareholders basically own a piece of the company whose stock they hold. The more stock they own, the more of the company they own. If one person holds the majority of the stock a company has issued, he is said to have majority ownership.
Common Stock Certificate
Depending on the type of stock the company issues, selling stock can mean other people will be involved in making decisions for the company. There are two kinds of stock, common and preferred. You should consider very carefully which type of stock you purchase as both provide different benefits to the shareholder. Common stock is probably the one you think of most, when someone mentions stock, and is the one most often purchased. Common stock shareholders have a right to vote on how the company is operated, by voting on who will hold positions on the board of directors. The board of directors is responsible for making major decisions for the company. Those who hold preferred stock do not have voting rights, however, they do receive dividend payments before those who hold common stock certificates.
Issuance of Stock
Once a company has decided to offer stock in order to gain an influx of capital (money it can use to expand their facilities or develop new products), it can choose to offer it in private placement. Private placement gives the company control over who can buy the stock. An example of a company that participates in private placement of its stock is Mars Inc.(the candy company responsible for Mars bars as well as M&Ms). Mars Inc. chooses to keep ownership of the company in the family, rather than give it to the public. If a company does not want to offer stock in private placement, it can make what is called an initial public offering (IPO). An IPO marks the first time stock is made available and sold to investors publicly.
New York Stock Exchange (NYSE)
After the IPO, stock can be purchased or traded on the open or secondary market. Two prominent secondary markets in the United States are the NYSE (New York Stock Exchange) and NASDAQ (National Association of Securities Dealers Automated Quotations). Investors will look at the reports from a stock exchange to see how much a company's stock is being sold for. The better a company is doing, the more people are willing to pay for the stock. Stock prices change according to how well the company is doing financially.
Return on Investment
Shareholders receive a return on their investment in the form of dividends. Dividends are the payments companies make to shareholders at the end of their fiscal year. The board of directors generally decides how much of the company's profit (revenues less expenses) they are going to return to their shareholders. They can decide to distribute all of the profit in a given year, none of the profit, or a portion of the profit. Owners of common stock generally receive a higher return on investment (ROI),meaning their dividend payments are typically at a higher rate of return than those who hold preferred stock.
Calculating Shareholder Earnings
So, what about return on investment? How does a shareholder earn money on his investment in a company? At the end of the fiscal year, a company will calculate dividends based on how much money (Income) it has left over (Shareholders Equity) after it pays its bills (Liabilities). Officially it looks like this:
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Net Income - Net Liabilities = Shareholders Equity
So, if a company earned $500,000 in a year and had $450,000 in expenses, shareholders equity is $50,000.
$500,000 - $450,000 = $50,000
The company now knows it has $50,000 to distribute to its shareholders. We want to calculate for common stock shareholders, so the company will have to subtract, from that $50,000, the amount it owes preferred shareholders (remember, preferred shareholders get paid first). It then divides the new total by the number of common stock shares that have been issued:
This is the calculation for our fictional company:
$50,000 - $10,000 / 20,000 = $2 per share
The company has figured that it will pay dividends to common stock shareholders of $2 per share. It now has to calculate the amount each shareholder will receive. If you own one share, you will receive $2 from the company. However, investors typically purchase more than one share.
If John Shareholder owns 100 shares (worth $2 each), then the company will pay him $200.00
If Jane Shareholder owns 10 shares (worth $2 each), then the company will pay her $20.00
At first glance, the stock market appears to be daunting and hard to understand. It doesn't have to be! Just remember, if you hold common stock then you have a say in what decisions the company makes. If you don't care about having a say in the company, and getting paid first is important to you, then preferred stock is the way to go. Not all stock is available to be purchased by the public, as we learned from Mars Inc. and its preference for private placement. That being said, if you want to get started investing in stocks, there are always plenty of options available to you.
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