Understanding the stock market can be a daunting task for any new investor. Not only are there many concepts and technical terms to decipher, but nearly everybody will try to give you conflicting pieces of advice. For example, if a stock in your portfolio falls in price, should you be accumulating additional shares at a lower price or should you be strategically cutting your losses? Some experts will tell you one thing, while others will tell you precisely the opposite.
To help you navigate through the minefield that is the stock market, here is a list of terms used in the stock market:
In the financial market, shares are a unit of capital that depicts the ownership relationship between the shareholder and the company. In such transactions, investors buy or sell shares through a stockbroker who acts as the middleman. The market value of the shares you buy is determined by the performance of the company and other economic factors such as wars, elections, and new economic policies. In addition to this, dividends are the income you earn from shares.
Bonds are an interesting alternative to dividend investments. Bonds are defined as fixed income structures that represent a loan made by an individual investor to a borrower. Most times, the borrower is the government or a corporation. Fixed or variable interests rates are attached to these loans, and the end date is fixed for the payment of the principal to the bond owners. Some investors prefer bonds since they are seen as safe, and can be easily traded with other investors or brokers. Companies or other entities issue bonds to investors when they need to raise money for a new project or re-finance existing debt. They issue bonds that contain the terms and conditions, the time at which the loan (principal) must be paid back, and the interest rates that will be paid. The interest rate is a fixed income that bond owners earn for buying bonds. You should know that the face value or value of bonds differs. In addition to this, you don't have to wait for the bond to expire before you can sell it off.
In the financial market, the term equity has various definitions. Generally, these definitions revolve around the concept that equity is the difference between the value of assets and liabilities. You can think of equity as the degree of ownership in any asset, once we subtract the cost of the debt associated with it. Here's an example to simplify this term. Imagine you had a car that was worth $15,000, but you owed $5,000 worth of debt against the car. In this case, your equity for the car (asset) was $10,000. Furthermore, equity becomes negative when the cost of liabilities exceeds assets. In terms of shareholder equity or capital, this represents the total number of assets subtracted from liabilities, as divided between shareholders.
You become a shareholder when you own shares of stock in a corporation. Shareholders are the owners of a company since each share of stock they possess entitles them to have a say in the way a corporation operates. However, just because you are a shareholder doesn't mean you can barge in and start firing workers. There are laws in place that protect the company from such actions. Shareholders have the power to elect a board of directors to make major decisions in the company, such as the number of shares to be sold to the public. Besides this, some long-standing corporations pay out dividends to their shareholders.
Initial Public Offering (IPO)
This is a term used to describe the process of a company selling its share of stocks on the stock market for the first time. This is when you hear terms like: "the company is going public”. In IPOs, the company's shares are sold to institutional or retail investors, who later sell the investors to others via brokers [WU1]. Investment banks who act as underwriters calculate and establish the value of the company's share, and a detailed overview of the public offering is given to initial investors in the form of a lengthy document known as a prospectus.
Earnings per Share
This is the total profit of the company divided by the number of shares. This is an important factor you must consider before investing in a company. Each part of a company’s shares can be likened to pieces of a pie. The larger your share in the corporation, the bigger your pie slices. To know the earnings per share, the investors calculate how much income after-tax each share will receive. Therefore, if a company generates more and more profits annually, but only a little profit makes its way to the shareholders on a per-share basis, then it is considered a terrible investment.
Ticker symbols are used to represent corporations listed on the stock market. They are usually a short group of letters. For instance, Johnson & Johnson has a ticker symbol of JNJ and Coca-Cola has a ticker symbol of KO.
This is the total asset of a company that’s useful to shareholders. It determines what a shareholder will get in case of liquidation. The book value of a company is calculated as the total asset of a company, excluding the liabilities and intangible assets like patents. Investors can use a corporation’s book value to gauge if their stocks are overpriced or undervalued.
Here's a term that you will come across countless times in this book - corporations are different from businesses. How? Well, any business that sells shares of stocks to investors needs to first become a corporation. A business must undergo a legal process known as incorporation before it becomes a corporation. It’s important to understand that a corporation is different from a sole proprietorship or partnership. In fact, it is a virtual person in the eyes of the law. It is registered with the government and has a federal tax number.
More so, a corporation can sue, make contracts, and own properties. There are certain laws put in place to ensure uniformity in the way a corporation operates, and how the public and shareholders are protected. For instance, it is compulsory for every corporation to have a board of directors. The shareholders hold yearly meetings to decide who gets to sit on the board. Shareholders also use corporations as shields against liquidity in case the corporation goes bankrupt.
What Are Stocks?
Also referred to as equities, stocks are issued by companies in a bid to raise capital in order to expand their business operations or take on new projects. To shareholders, stocks represent a claim of ownership on the company's assets or earnings. Your ownership stake becomes higher as you acquire more stocks. You should know, however, that owning stocks does not give you control over the properties of the corporation, as it is protected under laws of ownership. Now that we’ve got that out of the way, let's take an in-depth look at the different types of stocks companies issue to investors.
Types of Stocks
Companies issue two main types of stocks that get listed on the stock market to their investors. It is important to know the type of stock that you are dealing with since each type of stock comes with its own benefits and setbacks. So, let’s get right to it!
When you hear people talking about stocks, it’s very likely that they are referring to common stocks. In fact, common stocks make up a large percentage of the total number of stocks traded on the stock market. A common stock confers voting rights on investors and gives them a client on profits or dividends [WU2]. With common stocks, investors often get one vote per share to elect a board of directors to oversee operations. What's more, these types of stocks come with higher returns than corporate bonds. However, this high return comes with many risks. If a company goes out of business, you stand to lose your entire life's investment (one of the reasons why you need to diversify). If a company goes out of business (bankrupt) and liquidates, common shareholders will not receive their money until bondholders, preferred stockholders, and creditors have been paid.
Preferred stocks have a similar bill function to bonds, and don't usually come with voting rights. Sometimes, some companies offer voting rights with their preferred stocks. With preferred stocks, investors will get a fixed income in the form of dividends. The dividends are guaranteed, unlike common stocks which have variable dividends that are never guaranteed. In fact, many companies don't pay out dividends to common stockholders. Also, in the case of liquidation, preferred shareholders are paid first, before common shareholders. The company settles creditors and bondholders before getting to preferred stockholders.
What's more? Companies can buy back preferred stocks from shareholders at any time. Therefore, you can consider preferred stocks as a blend of the features of bonds and common stocks. Aside from common stocks and preferred stocks, companies can also create classes of shares in a bid to fit the needs of investors. Companies create classes of stocks when they want to keep power concentrated in a certain group of shareholders.