The primary reason people invest is to earn a return that allows them to grow their wealth over time and achieve financial goals like retirement or homeownership. That’s why stocks typically make up a large portion of an investment portfolio.
A stock is a security that represents partial ownership in a publicly traded company. Each share represents a fraction of the company’s total value, and when bought and sold in the market, the investor can earn a profit when the shares increase in value. Stock prices can be volatile, and the value of a single share will fluctuate up and down throughout the course of a trading day.
When companies want to grow, they often need additional capital to pay for expenses such as designing new products, hiring more employees and expanding into new markets. To raise this money, they issue new shares of stock. When these new shares are purchased, the owners of the stock receive profits if the company’s value grows. This process is known as ‘equity financing’.
The price of a stock is determined by supply and demand in the marketplace. The lower the amount of available shares in circulation, the lower the share price will be. If there is more demand than supply, the price will climb as investors try to outbid one another for the remaining shares in circulation. The market value of a share of stock is also called its market capitalization.
For a long time, the average person couldn’t easily buy and sell shares of a publicly traded company. In fact, the stock market didn’t exist until 1602 when the Dutch East India Company launched what was essentially the first joint-stock company.
Investing in stocks can help you build your wealth and generate a return that is higher than savings or other asset classes like real estate and cash. However, a significant risk is that you could lose money on the stocks you hold if they decline in value.
The value of stocks is calculated using various methodologies, including discounted cash flow analysis. This approach tries to figure out what a fair value is for a company’s stock, given the foreseeable future profits it can bring in and its current assets.
The simplest way to understand the ‘fair value’ of a stock is to compare its price-earnings ratio with the ratio for other companies in its industry. The lower the P/E, the less it is expected to grow and the more affordable it is. The opposite is true for high P/E stocks. Nonetheless, it’s important to remember that value and price are not the same thing. A company’s share price can go up a lot, and it may still be expensive even after the price has gone up. This is because the outlook for a company’s profitability can change, and that can have a major effect on its stock price. The share price can then fall again. This can be frustrating for some investors.