What is a Stock?

When you buy stock you become part owner of a public company—no matter how many shares
you own. Most people buy stock to make money by: earning dividends (cash paid to investors from the company’s profits) or selling the stock at a higher price. If the stock price exceeds what you paid for it, your investment increases in value. If the stock price goes lower than what you paid for it, your investment decreases in value. However, stocks have limited liability, since you risk only the money you invest.

Not all companies are public. Private companies are composed of an individual/family or a small group of investors that have private sources for funding growth; their shares are not for sale to the general public. Mars Corp, the snack food giant, is privately held. Google, the search engine company, was privately held until 2005, when it went public, offering its stock for sale.

If a company’s product or service is in great demand, demand may outstrip the ability of banks and venture capitalists (who privately supply funding) to provide money for the company’s expansion to meet that demand. At that point company leaders may decide to “go public.”

Company management goes to investment bankers to negotiate an agreement to underwrite a stock offering known as an IPO (Initial Public Offering). The investment bankers buy all the shares that will be offered to the public at a set price (primary market). The investment bankers then sell the stock to the general public (secondary market) in the hopes of making a profit. These bankers also prepare what is known as a tombstone ad to announce the IPO in financial publications such as the Wall Street Journal. The underwriters may also organize meetings with people who buy large amounts of stock for institutions such as pension funds, mutual funds, banks or insurance funds that they hope will buy shares in the company.

A stock exchange provides a platform (live, electronic, or both) for investors to buy and sell stock with each other. There are three major US stock exchanges: the American Stock Exchange, the NASDAQ Stock Market, and the New York Stock Exchange. Each exchange has its own listing standards, rules, and methods.

In addition to finding underwriters, company management must register its stock with the Securities and Exchange Commission (SEC) before “going public.” Generally, companies can offer two types of stock, common and preferred. Common stock entitles the owners (called stockholders or shareholders) to collect dividends, if the company declares them. It also entitles the owners to vote in company elections and decisions. Stockholders who purchase common stock share in most of a company’s profits and losses.

Stockholders who purchase preferred stock are usually guaranteed a dividend payment. This payment is made before any payments to common stock holders. If a company fails, preferred stock holders are repaid before common stock holders. Preferred stock holders do not share in most of a company’s profits or losses. Preferred stock holders also do not have any voting rights.

An important difference between common stock and preferred stock is that the price of the preferred stock tends to be more stable, changing little over time, than that of common stock.

Stockholders should make investment decisions based upon their “risk tolerance.” A number of issues contribute to an investor’s overall risk tolerance, including the investor’s age, health and their overall financial outlook. An investment with a lot of risk but great potential for return might make sense for someone who is 28 and financially stable, but not for someone who is sixty and plans to retire in five years.

Questions: Indicate whether each of the following statements is true or false. For true statements write a reason or example in the space below. For false statements, rewrite the sentence to correct it.

1. _____ Stockholders can only make money by collecting dividends.

2. _____ People who invest in the stock market will automatically make money.

3. _____ People can only buy stock in publicly held companies.

4. _____ Preferred stock means the company is preferred over other companies in a particular industry.

5. _____ A dividend is a portion of a company’s profits paid to its shareholders.

6. _____ Profits represent ownership of shares of a company.

7. _____ Risk is only associated with the purchase of common stocks.

8. _____ A person who is 25 should not be willing to take the same amount of risk when investing as someone who is 55.

9. _____ It is possible for stockholders to lose more money than they invested, if a company fails.

10. ____ A tombstone ad is prepared for companies that are facing bankruptcy and financial failure.

11. ____ Investment bankers buy shares of stock on the same type of market that the general public does.

12. ____ The general public buys new issues of stock on the primary market.