All about Stock (business) 
and Investment
| I | | INTRODUCTION |
Stock (business), in business and finance, a share of ownership in a corporation. Shares in a corporation can be bought and sold, usually on a public stock exchange. Consequently, the owner of shares can realize a profit or capital gain if the stock is sold at a price above what the owner originally paid for it.
Some companies enable stockholders to share in the profits of the company. These payments of corporate profits to stockholders are called dividends. In addition to having a claim on company profits, stockholders are entitled to share in the sale of the company if it is dissolved. They may also vote in person or by proxy on a variety of corporate matters, including the most important matter of who should run the corporation. When the company issues new stock, stockholders have priority to buy a certain number of shares before they are offered for public sale. Stockholders also receive periodic reports, usually quarterly, that provide information regarding the corporation’s business performance. Stocks generally are negotiable, which means stockholders have the right to assign or transfer their shares to another individual.
A stockholder is considered a business owner and has the protection of limited liability under
| II | | WHY CORPORATIONS ISSUE STOCK |
Corporations issue stock in order to finance their business activities. This method of raising funds is only available to business firms organized as corporations; it is not available to sole proprietorships and partnerships. The corporation can use the proceeds of a stock offering in a variety of ways. Depending on the type of company, this might involve increasing research and development operations, purchasing new equipment, opening new facilities or improving old ones, or hiring new employees.
An alternative to stock financing is debt financing or the sale of bonds, an interest-bearing loan. This alternative is also available to sole proprietorships and partnerships. With the issuance of a bond a company typically promises to make periodic interest payments to the lender or bondholder as well as pay back the amount of the bond when the term of the bond expires. Thus bonds are evidence of loans while stocks are evidence of ownership. Stocks and bonds are collectively known as securities.
When a corporation first makes stock available for public purchase, it works with an investment banking firm to arrange an initial public offering (IPO). The investment bank acquires the first issue of stocks from the corporation at a negotiated price, and then makes the shares available for sale to its clients and other investors. Corporations that have IPOs are usually young companies in need of large amounts of capital.
A corporation can only have one IPO—the first time it makes stock available to the public. After its IPO, a company is said to be public. Public corporations that need additional financing for further business development may choose to issue more stock at a later time. This is called a subsequent, or follow-on, offering.
Some corporations may choose not to go public. In this case it is said to be a privately held corporation. A corporation may elect to remain private because it does not want to share its profits, or it may not want to relinquish control to shareholders.
Most of the information reported in the daily news media about the buying and selling of stock refers to transactions involving previously issued stock. The daily buying and selling of stock rarely involves IPOs. Almost all stock transactions are “second-hand transactions.” The corporation that initially issued the stock is not directly involved.
A corporation’s capitalized value refers to the market value of the stock that it has issued and that remains outstanding—that is, available for sale or purchase. A corporation’s capitalized value may be greater or less than its book value. Book value is the value of the corporation’s assets as reflected in its accounting statements—that is, on its books. Capitalized value may also be greater or less than the corporation’s replacement value, the amount that it would take to replace all of the corporation’s assets.
Corporations will sometimes split their stock. This means the corporation replaces outstanding shares with new shares on some multiple basis, such as a two-for-one or three-for-one split. When a corporation splits its stock, it does not obtain any new funding. Splits usually occur when the market price of shares is deemed too high by corporate management. With a split the price of shares falls, making purchase by smaller investors more affordable. Keeping a stock relatively affordable for smaller investors makes it easier for a corporation to raise money with a follow-on stock offering.
| III | | WHY PEOPLE BUY STOCK |
Economic gain represents the primary motive for the purchase of stock. The gain or return from stock consists of two parts: dividends, the periodic payments made from profits, and appreciation, the capital gain realized from selling a stock for more than its purchase price.
An investor really has only two choices in acquiring the financial assets of a corporation—buying stocks or bonds. As a financial claim against a company, bonds take precedence over all types of stock. Thus, they are a safer investment than stocks, especially in times of deflation (a period when the prices of goods and services are generally falling). Stocks, however, are usually the better investment during periods of inflation (a period when the prices of goods and services are generally rising) because they represent ownership of assets that will probably rise in value as fast as or faster than prices in general. Because the dollar value of bonds is fixed, they cannot serve as a hedge or protection against inflation as do common stocks. See also Inflation and Deflation.
| IV | | THE LANGUAGE OF STOCKS |
People who invest in stocks or follow the progress of the stock market encounter a wide variety of terms unique to these investments. These terms include price-to-earnings ratio, earnings per share, market capitalization, mutual fund, bull market, bear market, and day trading, among others. Understanding this vocabulary helps explain many of the workings of the market in stocks.
| A | | Price-to-Earnings Ratio and Earnings Per Share |
Investors use several techniques to determine whether a particular stock should be purchased. Some investors examine a stock’s fundamentals such as its earnings per share or its price-to-earnings ratio. Earnings per share is calculated by dividing the corporation’s total earnings or income by the number of shares the corporation has outstanding. A corporation’s price-earnings ratio is calculated by dividing the current price of a share of the company’s stock by its earnings per share. These calculations represent fundamentals in the sense that they reflect the effectiveness of a company’s business operation (earnings per share) and the market’s current assessment of the company’s worth in relation to its earnings (price-earnings ratio).
In making a decision to buy or sell a particular stock, expectations are formed regarding future fundamentals. If expectations about the corporation’s operations improve and investors expect higher earnings per share, then the price of the stock is likely to rise. Investors expect that more people will want to buy shares to participate in the increased profitability. If, however, expectations turn pessimistic and shareholders anticipate lower earnings per share, then holders of the stock will try to sell their shares, reducing the stock’s price.
| B | | Mutual Fund |
Investors can own stock in two different ways. The first is direct ownership, in which investors add a corporation’s stock to their personal portfolio or account. The second type of ownership is indirect and involves participation in a mutual fund. A mutual fund is operated by a management-investment company that combines the money of its shareholders and invests that money in a wide variety of stocks. A mutual fund is thought to be safer because it is diversified. Diversification means that shareholders are less likely to lose their investment because the risk is spread among the stocks of many corporations rather than just a few. Investors add the stock of the mutual fund to their personal accounts. However, the mutual fund has direct ownership of the corporations’ stocks.
| C | | Bull Market, Bear Market |
Bear Market
Traders on the floor of the New York Stock Exchange cringe as they watch the market go into a free fall on
Henny Ray Abrams/AFP
Bull market is a term applied to a period when stock prices on average experience a sustained increase. During a bull market investors are optimistic about future business conditions and expect corporate profits to rise. So they will want to acquire stock to participate in the expected higher profits. A bear market describes the opposite situation, when stock prices on average experience a sustained decrease. Pessimism regarding the economic future dominates investor thinking during a bear market.
The most recent bull market extended from 1990 to early 2000 when the market value of the outstanding shares of domestically issued stock rose from $3.5 trillion to $19.6 trillion. During the bear market that followed, the market value of these stocks fell from their
| D | | Dealers and Brokers |
Investors typically employ the services of dealers and brokers to execute the purchase and sale of securities. Some of these brokers are considered full-service brokers. Full-service brokers provide a wide variety of services for the investor, including the provision of investment advice. Other firms are considered discount brokers. Discount brokers basically provide the single service of executing the buy and sell orders of investors. For mutual fund transactions the investor can deal directly with the mutual fund. Thus, the investor need not use the services of a broker or a dealer for these types of transactions. Even in these instances, however, an investor may seek the advice of a financial adviser to determine which mutual fund to buy or whether to sell fund shares.
| E | | Day Traders |
Some investors are known as day traders. These are individuals who sit at computer terminals continuously monitoring stock prices for profit opportunities. They typically own stocks for very short periods of time, usually for less than a day. Day trading became popular with the development of computer technology and with the bull market of the 1990s. But day trading became significantly less popular with the advent of the bear market in 2000.
| V | | WHO OWNS STOCKS? |
For a long time only the wealthy were likely to own stocks. Middle-class and working-class Americans generally did not participate in the stock market. Recent estimates, however, have shown significant growth in stock ownership. In 1989, 31.6 percent of American families had either direct or indirect stock ownership. By 2001 that percentage had grown to more than half at 51.9 percent. Most families held stock in retirement accounts. Only 21.3 percent of families owned stock directly in 2001. The median value of the direct and indirect stockholdings among families holding stock was $34,300, up from $27,200 in 1998 and $10,800 in 1989. This means that half the families holding stock owned more than $34,300 worth, and half owned less than $34,300. For families holding stocks, the value of their stockholdings increased from 28 percent of all their financial assets in 1989 to about 54 percent in 1998. Financial assets include checking accounts, certificates of deposit, savings bonds, bonds, stocks, mutual funds, retirement accounts, cash value of life insurance, and the like.
| VI | | TYPES OF STOCK |
The rights and benefits of a stockholder vary according to the type of stock held. There are two main categories of stock, common and preferred.
| A | | Common Stock |
Financial loss or gain can be greater with common stock than with preferred stock. Holders of common stock have residual equity in a corporation. This means they have the last claim on the earnings and assets of a company, and they may receive dividends only at the discretion of the company’s board of directors and after all other claims on profits have been satisfied. For example, if the company is dissolved, stockholders share in what is left only after all other claims have been settled. Because dividends and equity do not have fixed dollar values, holders of common stock can reap greater benefits when a company is prosperous or lose more when a company is doing poorly than holders of preferred stocks.
| B | | Preferred Stock |
Holders of preferred stock take precedence over holders of common stock. Preferred stock shareholders are usually entitled to receive a fixed dividend before any payments are made to common stockholders. Holders of preferred stock typically receive a share of the proceeds from the dissolution of a company before holders of nonpreferred stock. Some stocks have both preferred dividends and preferred assets. Stock with first preference in the distribution of dividends or assets is called first preferred or, sometimes, preferred A; the next is called second preferred or preferred B, and so on.
Although holders of preferred stock may have to forego a dividend during a period of little or no profit, this is not true for two types of preferred stock. One is cumulative preferred stock, which entitles the owner to cumulative past-due and unpaid dividends. Another type is protected preferred stock, which the corporation issues after paying the preferred-stock dividends and placing a specified portion of its earnings into a reserve, or sinking, fund in order to guarantee payment of preferred-stock dividends.
Two other categories of preferred stock are redeemable stock and convertible stock. Redeemable stock is issued with the stipulation that the corporation has the right to repurchase it. Convertible stock provides the stockholder with the option of exchanging preferred stock for common stock under specific conditions, such as when the common stock reaches a certain price or when the preferred stock has been held for a particular time.
| C | | Voting, Nonvoting, and Vetoing Stock |
Although most stockholders have the right to vote at their meetings, thus participating in corporate management, some stocks specifically prohibit this. Such nonvoting stock may be common or preferred stock. However, at least one kind of stock issued by a corporation must be endowed with the voting privilege. This type of stock is called voting stock, and it may not be changed to nonvoting stock without the stockholder’s consent. Another type of stock is vetoing stock. Holders of vetoing stock may vote only on specific questions. Voting at stockholder meetings can be done by proxy—that is, a stockholder who will not be present at the meeting can authorize someone who will be at the meeting to cast their vote. Each share of stock is worth one vote. Before voting by proxy was permitted, independent stockholders had a greater chance of influencing the management of a company. After voting by proxy was authorized, however, company managers and directors holding a stock minority usually obtained enough proxies from absentee stockholders to outvote any opposition, thus perpetuating their control.
While stockholder voting is typically limited to the determination of the company’s board of directors and other specific corporate matters, there are instances where social concerns lead stockholders to force a change in business operations. For example, during the 1970s and 1980s the stockholders of a number of corporations required their companies to terminate or modify their business operations with
SHAREHOLDERS` RIGHTS
Owners of shares in mutual funds receive investment income dividends derived from dividends and interest earned on securities in the portfolio. Capital gains distributions are made when and if long-term gains are realized on the sale of securities in the portfolio. Income dividends are paid quarterly or semiannually; capital gains distributions are usually made annually, toward the end of the fiscal year of the fund.
A variety of services are offered to shareholders by mutual funds. Most funds provide accumulation plans, in which investors may buy shares at regular intervals, have dividends reinvested automatically, and accept capital gains distributions in additional shares. A few mutual funds offer contractual plans wherein the shareholder agrees to invest a certain amount each month. Many financial institutions offer a so-called family of open-end mutual funds, allowing investors to divide their savings among funds with varying objectives but managed by the same sponsor and to switch from one fund to another at little or no cost. A number of funds also offer withdrawal plans, under which shareholders may receive payments from their investment at regular intervals while income dividends and capital gains are routinely reinvested.
Mutual funds in the
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