Stocks (also known as shares or equities) are an integral part of many investors’ plans to build wealth. They come in many different varieties, each with unique characteristics and benefits. But even for those who have a brokerage account, stocks can be complex to understand. This article will help clarify some of the more important points about this type of investment and its terminology.
A share of a company’s stock represents a proportional claim on the company’s net assets and future earnings. The market sets a price for the stock that reflects the current perception of its value and its potential for future growth. The price discovery process is a key benefit of the market, which helps allocate capital to the most promising companies and industries. The market also serves as a mechanism to reduce risks by diversifying portfolios across companies and industries.
There are two main ways that people make money from owning stock: dividends and capital appreciation. Dividends are payments made by companies to shareholders, usually a portion of the current year’s net income. Special dividends – funded by retained earnings or asset sales – are occasionally made as well. Capital appreciation is the increase in the value of a stock since its purchase. This increase can be a result of either a positive change in the business’s financial condition or simply the perception that the stock is an excellent long-term investment.
The other main function of the market is to allow businesses to raise money through share offerings. Companies use the cash from these offers to finance projects that they can’t or don’t want to finance with new debt or from other sources. Often, companies use the money from these offerings to grow their businesses and expand their operations. The goal is that the value of a company will go up over time, and shareholders will be able to sell their shares for more than they paid for them.
While investing in stocks can be a great way to achieve financial goals, it is important to remember that not all stocks have the same return potential. Some stocks have historically had very high returns, while others have experienced losses. As a result, careful investors avoid establishing highly concentrated positions in any one or two stocks and instead build diversified portfolios that include a broad range of industries and regions.
There are a number of tools that can be used to evaluate stocks, including financial ratios such as price-to-earnings, price-to-book, and price-to-sales. Using these tools can help investors understand the intrinsic value of a stock, which is its true worth in terms of cash flow. Ultimately, the amount of cash flow a company is likely to earn over its lifetime is what determines its value, and that figure can be discounted for inflation in order to arrive at a fair valuation. In addition, investors can look at a company’s historic returns and compare them to benchmarks, such as market or sector indices.
