Understanding Stocks — minus the maths

Understanding Stocks — minus the maths

Stocks? What comes to your mind when you hear the word “stocks”?

To me, it means part ownership in a company.

Here comes the big jargon: Stocks also known as equity is a security that represents fractional ownership in a corporation or company. A unit of stock is called a share.

A share is to stock what metre is to length.

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A simplified explanation would be a pizza, when you and nine of your friends contribute equally to buy a pizza. The pizza arrives, so everyone has a piece of the pizza — say the pizza has 10 parts. That is the same way stocks are, the more shares of a corporation you buy, the more of the corporation you own.

This is a very simplified example, stocks are a bit more complex than that.

Stock is security —a negotiable financial instrument (most times paper) that holds monetary value, here the value of the stocks is in the value of the company, i.e the more valuable the company is the more valuable the stock is.

WHY STOCKS?

When companies want to get funds for any reason, there are two major ways they do so. They can either borrow which is called debt financing or issue ownership (equity) in exchange for money, this is called equity financing.

Let say I own a bakery and I sell all my goods there, no deliveries or pick up. Some years down the line I decide I want to open up another branch some miles away, but I don’t have enough money for that. What do I do?

  • Option A: I give up and not expand
  • Option B: I borrow money from bank, friends or a relative
  • Option C: I collect money from people and give them ownership of the bakery — proportional to the money they give me.

Well, A is definitely not an option if I truly want to expand. Option B is what debt financing looks like, I have an obligation to pay back the money I borrowed. Option C is equity financing, we become owners of the bakery.

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However, because we are owners of the bakery does not mean owners can come and take a loaf of bread for free, or come to take my oven or any asset(machine, tool, or ingredient as the case may be). Owners can only have a share of the profit we make — when we distribute the profit.

Another point to understand is that because you are part of the owners of the bakery, you do not have control i.e you do not have a say on the day-to-day running of the bakery. You don’t dictate the number of pieces of bread to be produced or the flavor to be used. The board of directors or the heads of the bakery have the say. As a part-owner, you only get the chance to elect members of the board, your voting power is proportional to the number of shares you own of the bakery, so the larger your shares, the larger your voting power hence you can influence how the bakery runs.

WHERE TO BUY STOCKS

Stocks are traded (bought and sold) on exchanges. Exchanges are simply markets. Different countries have exchanges where companies are traded. The major world exchanges or stock market if you wish are

  • New York Stock Exchange NYSE
  • NASDAQ
  • London Stock Exchange LSE
  • Tokyo Stock Exchange
  • Shanghai Stock Exchange
  • Hong Kong Stock Exchange

With the advent of the internet, you can buy and sell from anywhere in the world. There are apps such as Robinhood, Acorns, TD Ameritrade, Bamboo, Chaka, Trove etc.where you can trade.

BUYING STOCKS

There are two ways to purchase stocks: Using a brokerage and through DIPs.

  • Using a brokerage: This is the most common method. The brokerages are intermediaries between the purchasers and the sellers. They execute orders to buy and sell stocks for other people. Brokerage comes in two forms full-service and discount.
  • DIPs: Direct investment plans, are plans that the company offers that allows shareholders to purchase directly from the company usually at a minimum price.

A person who has shares in a company is referred to as a shareholder of the company.

Initial public offer (IPO) is when a company first issues shares to the public. When a person buys shares when a company issues them, it is referred to as buying in the primary market. When a person buys shares from another individual instead of buying directly from the company, the person buys from the secondary market.

The first common stock ever issued was by the Dutch East India Company in 1602.

HOW DO YOU MAKE MONEY

When you buy a stock of any corporation, you buy it to make money(profit). There are two ways to go about it:

  • Capital gains: This simply means an increase in the price of the share. Say you bought a company’s stock at $10.99 then after a period its price increase to $15.00. That is a profit of $4.01. The profit is referred to as capital gain.
  • Dividends: Remember the bakery story? So let’s say the bakery makes a profit, the board of directors can decide to share part of the profit to part-owners periodically (quarterly, biannually, or annually).

Companies are not obligated to paid dividends.

TYPES OF STOCKS

There are two main types of stock: common and preferred. Common stock — sometimes referred to as ordinary shares usually entitle the owner to vote at shareholders’ meetings and to receive any dividends paid out by the corporation. Preferred stockholders generally do not have voting rights, though they have a higher claim on assets and earnings than the common stockholders. Owners of preferred receive dividends before common shareholders and have priority in the event that a company goes bankrupt and is liquidated.

WHAT CAUSES THE FLUCTUATION OF PRICES

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In an efficient market, prices of goods and services are determined by the forces of demand and supply. Similarly, in the stock market stock prices are determined by forces of demand and supply, however, while this is easy to understand, what is quite difficult to understand is why people like a stock or why they dislike a stock.

The stock price of a company does not necessarily reflect the value of the company, instead, it is a reflection of what investors think the company is worth.

Another factor is the earnings of a company. Earnings are the profit a company makes. In essence, a company without profit would, in the long run, would collapse. An increase or anticipated increase in earnings makes the price to increase. Company earnings are reported every quarter.

HOW TO CHOOSE A STOCK

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When one decides to buy shares of a company, there are many reasons to select certain companies from the exhaustive list of companies in the stock exchange market. Most reasons are personal but in the end, it is to make money or profit from it. There are ways of selecting stocks based on what an individual wants the major ways are:

  • Technical analysis: This is evaluating investments and identifying trading opportunities in price trends and patterns seen on charts. Technical analysts believe past trading activity and price changes of security can be valuable indicators of the security’s future price movements.
  • Fundamental analysis: Fundamental analysis is a method of determining a stock’s real or “fair market” value also called intrinsic value. Fundamental analysts search for stocks that are currently trading at prices that are higher or lower than their real value.

Past performance do not guaranty future performance

  • Qualitative analysis: Qualitative analysis uses subjective judgment based on “soft” or non-quantifiable data such as the expertise of the management, the labour relations, the industry’s cycle, etc. Qualitative analysis deals with intangible and inexact information that can be difficult to collect and measure.

Qualitative analysis is more like “listening to your gut”

  • Quantitative analysis: This is a technique that seeks to understand behaviour by using mathematical and statistical modeling, measurement, and research. Quantitative analysts aim to represent a given reality in terms of a numerical value.

To get a better picture of a company’s performance, analysts also evaluate information that is not easily quantifiable or reduced to numeric values, such as reputation or employee morale

WHY BUY STOCKS

As discussed in my earlier post here, there is a need to beat inflation. Historically, return on stocks has beaten inflation and has given one of the highest returns in the financial sector. Look at the graph below

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Graph showing the compounded annual return of a dollar from 1926–2013

From the graph, a dollar put into stocks would have returned almost a thousand dollars a return of 8.1% against inflation at 3.0%.

CONCLUSION

In this piece I try to write about stock for beginners — like real beginners, no numbers and I try to limit the lingo to the minimal. Here is a summary:

  • Stocks are a security that shows ownership in the underlying assets of a company.
  • Stocks are a good way to beat inflation with returns gotten from either capital gains and or dividends paid.
  • There are different ways to pick stocks based on individual needs.

Last piece of advice:

Read more and shun the news.