How Stocks Work: The Promising Building Blocks of Investing

STOCKS PILLARS SERIES – PART 1

Ever wondered how people can build life-changing wealth by investing in companies like Apple, Google, or Tesla? The secret lies in understanding the fundamental concept of stocks. Stocks are not just pieces of paper or random numbers on your trading app—they represent something much more significant. By grasping how stocks work, you unlock the door to smart investing, long-term wealth, and even financial independence.

In this article, we’ll take a deep dive into the basics of stocks, how they operate within the market, and why investing in them can be one of the most powerful wealth-building tools at your disposal. Let’s get started on your journey to becoming a smarter investor!

What Are Stocks? The Foundation of Wealth Building

At its core, a stock is a piece of ownership in a company. When you buy a stock, you're essentially purchasing a small fraction of that business. Owning a stock gives you a claim on a portion of the company’s assets and earnings, meaning that as the business grows, your investment in it can grow too.

Think of stocks as ownership certificates. If a company has 1 million shares and you own 1,000 shares, you own 0.1% of that company. Simple, right? But the implications of owning even a tiny fraction of a successful company can be huge.

Why do companies offer ownership to the public in the first place? It all comes down to raising capital. Businesses often need more money than they can borrow or generate internally, especially if they want to fund large projects like research, expansion, or acquiring other companies. To raise this capital, they issue stocks through an Initial Public Offering (IPO), allowing the general public to buy shares.

As a stockholder, you’re not just buying a piece of paper (or, in today’s world, a digital asset). You’re buying into the potential future profits of the company. If the company thrives, so does your investment. If it fails, your investment could lose value, which is why investing in stocks carries both opportunities and risks.

Common vs. Preferred Stocks: What’s the Difference?

When you’re ready to start investing in stocks, it’s important to know that not all stocks are created equal. There are two main types of stocks: common and preferred.

Common stock is, as the name suggests, the most common type of stock that investors buy. If you hold common stock, you typically have voting rights, which means you can vote on corporate policies or elect the board of directors. More importantly, common stockholders have the potential for capital appreciation. This means that as the company's value grows, so does the value of your shares.

However, there’s a trade-off. If the company goes bankrupt, common stockholders are among the last to get paid. Preferred stock offers some additional benefits. While preferred shareholders usually don’t have voting rights, they enjoy priority over common stockholders when it comes to dividends and assets during liquidation. Preferred stocks often behave more like bonds, providing a steady dividend income but typically less opportunity for significant growth.

Knowing the differences between these types of stocks can help you make informed decisions that align with your investment goals. If you’re more interested in steady income, preferred stock might be the way to go. If you’re aiming for higher long-term growth, common stock is generally a better fit.

How the Stock Market Works: A Simplified Guide

The stock market can feel like a complex, intimidating place, but it’s actually much simpler than it seems once you understand the basics. The stock market is essentially a marketplace where buyers and sellers come together to trade stocks.

Stocks are traded on stock exchanges like the New York Stock Exchange (NYSE) or the Nasdaq in the US, which are the biggest stock exchanges in the world, but most of the countries have their own. These exchanges function like any other market, where the price of an item (in this case, shares of a company) is determined by supply and demand. When more people want to buy a stock than sell it, the price goes up. When more people want to sell than buy, the price goes down.

According to Visual Capitalist, these are the 25 biggest stock exchanges in the world, as of 2024:

Investors can buy or sell equities in any os this stock exchanges through primarily two different ways:

International Stocks and ADRs (American Depositary Receipts)

One of the simplest ways to invest overseas is by purchasing foreign stocks directly. Many companies in other countries offer their shares on foreign stock exchanges, allowing investors to buy them using international brokerage accounts. However, for U.S. investors, a more convenient route may be through American Depositary Receipts (ADRs).

ADRs are certificates issued by a U.S. bank that represent shares in foreign companies, making it easier for U.S. investors to buy and sell foreign stocks without dealing with the complexities of foreign exchanges. ADRs trade on U.S. exchanges like the NYSE and NASDAQ, and dividends are paid in U.S. dollars, simplifying the investment process.

Exchange-Traded Funds (ETFs)

ETFs are one of the most popular and efficient ways to invest in international markets. These funds pool money from many investors to buy a diversified portfolio of assets, often tracking a specific region or country's stock index. International ETFs can focus on specific regions (such as Europe, Asia, or Latin America) or entire global markets. Some ETFs even target specific sectors or industries within foreign markets, such as emerging market tech companies or international healthcare stocks.

Companies go public through an Initial Public Offering (IPO), which is the process by which a private company becomes publicly traded by offering its shares to the public for the first time. It's a significant milestone for a company, allowing it to raise capital from investors and gain access to public markets.

After that, those shares are traded in the secondary market. Unlike the primary market, where the company itself raises capital by selling shares, the secondary market involves trading between investors, with no direct involvement from the issuing company. This is where most retail investors (like you and me) buy and sell stocks. These transactions typically occur on stock exchanges, like the NYSE or NASDAQ, or over-the-counter (OTC) markets.

In the secondary market, the prices of securities are determined by supply and demand, influenced by factors such as company performance, economic conditions, and market sentiment. This market is essential for providing liquidity, allowing investors to easily buy and sell securities. It also plays a crucial role in price discovery, establishing the fair value of securities through real-time trading activity.

There are two main types of secondary markets: stock exchanges, which are centralized platforms for trading, and OTC markets, which are decentralized and often used for smaller or less liquid securities. The secondary market offers several benefits. For investors, it provides an opportunity to enter or exit positions, diversify portfolios, and manage risk. For companies, it enhances the visibility of their shares, encourages investor confidence, and establishes a benchmark for valuation.

For example, purchasing Apple shares on the NASDAQ or selling bonds previously bought in the primary market are common secondary market transactions. The secondary market is where the majority of trading activity takes place, offering a platform for investors to exchange securities efficiently and pursue their investment goals.

But the stock market is more than just a venue for transactions. It’s influenced by a variety of factors—some logical, some emotional. Company performance, global economic events, interest rates, and even investor sentiment can cause prices to fluctuate wildly. This is why understanding the fundamentals of a company, as well as keeping an eye on broader market trends, is so important.

Key Metrics Every Investor Should Understand

While the price of a stock is the most visible metric, it’s by no means the most important. If you want to be a successful investor, you need to dive deeper into the fundamental data of the companies you’re considering. Here are some essential metrics to know:

• Price-to-Earnings Ratio (P/E): The P/E ratio tells you how much investors are willing to pay per dollar of earnings. It’s a quick way to assess whether a stock is overvalued or undervalued compared to its earnings. A high P/E ratio might suggest that the stock is overvalued, while a low P/E ratio could indicate that it’s undervalued.
• Earnings Per Share (EPS): EPS is a measure of how much profit a company makes per share. A company with a high EPS is generally more profitable than one with a low EPS. As a rule of thumb, you want to invest in companies with strong, consistent earnings growth.
• Market Capitalization (Market Cap): This metric represents the total market value of a company's outstanding shares. It’s used to categorize companies as large-cap, mid-cap, or small-cap. Large-cap companies are typically more stable but offer slower growth, while small-cap companies can offer rapid growth but are more volatile.
• ROE (Return on Equity): ROE measures how efficiently a company generates profit from shareholders' equity. To increase ROE, companies can improve profitability through cost management and operational efficiency, use debt strategically to leverage returns, and maximize asset utilization to drive higher revenue with the same equity base. A rising ROE often indicates a well-managed company with strong financial performance.
• Debt Metrics: Debt metrics, such as the debt-to-equity ratio or interest coverage ratio, measure a company's financial stability. Improving these metrics involves reducing high-interest debt, increasing operating earnings to cover interest expenses, or restructuring debt to achieve more favorable terms. Better debt metrics signify reduced financial risk and improved overall resilience.
• Revenue CAGR (Compound Annual Growth Rate): Revenue CAGR indicates the annualized growth rate of a company's revenue over time. Companies can boost this metric by entering new markets, launching innovative products, or expanding sales channels such as e-commerce and partnerships. A high revenue CAGR demonstrates strong and sustainable growth potential.
• Margins: Margins measure a company’s profitability relative to its revenue. Expanding margins requires improving pricing power, reducing costs, or focusing on high-margin product lines. Higher margins reflect operational efficiency and a competitive advantage, which are essential for long-term profitability.
• Dividend Yield: For income-seeking investors, the dividend yield is critical. This tells you how much dividend income you can expect based on the stock’s current price. High-dividend stocks can provide steady cash flow, especially in times of market volatility.

By using these metrics, you’ll be able to make more informed investment decisions, rather than relying on emotion or gut feelings.

Why Do Companies Issue Stocks?

You might be wondering, why do companies bother issuing stocks in the first place? The answer is straightforward: capital.

When companies want to raise money—whether to expand, fund research, or pay off debt—they can either borrow money (through loans or bonds) or issue stock. By issuing stock, companies are essentially selling ownership stakes in the company to investors. This helps them raise large sums of money without taking on debt.

From an investor's perspective, buying stocks allows you to participate in the company’s success. As the company grows and becomes more profitable, the value of your shares can increase. Plus, if the company pays dividends, you’ll receive regular income from your investment.

What are Dividends and How They Are Calculated

Dividends are distributions of a company’s earnings to its shareholders, serving as a way to share profits with the owners of the business. Typically, they are paid in cash, but they can also be issued as additional shares of stock, or occasionally as other assets.

Dividends are one of the primary ways investors can earn a return on their investment, alongside capital appreciation (the increase in a stock’s price over time). They are usually expressed as a fixed amount per share or as a percentage of the stock price, known as the dividend yield. Here’s how dividends are calculated:

1. Per Share Basis:
   The company decides on a fixed dividend amount per share. For example, if a company announces a dividend of $2 per share and you own 100 shares, your total dividend is $200 (2 x 100).
2. Dividend Yield:
   The dividend yield is calculated as the Annual Dividend per Share divided by the Stock Price × 100. For instance, if a company pays $2 per share annually and the stock price is $50, the dividend yield is 4% ((2 / 50) x 100)
3. Payout Ratio:
   Some companies also base dividends on their earnings, expressed as the payout ratio, which is the percentage of earnings paid out as dividends. A payout ratio of 50%, for example, means the company is distributing half of its earnings to shareholders.

Why Companies Pay Dividends

Companies pay dividends for several strategic and financial reasons:

1. Rewarding Shareholders:
   Dividends are a way to share profits with shareholders, providing a direct return on their investment. This is particularly appealing to income-seeking investors.
2. Signaling Financial Health:
   Regular dividends indicate a company’s confidence in its profitability and financial stability. It reassures investors that the company generates sufficient cash flow to sustain operations and reward shareholders.
3. Attracting Investors:
   Dividend-paying companies attract income-focused investors, such as retirees and institutional funds, who prioritize steady returns over growth. Dividends can also reduce a stock’s volatility by providing a consistent return.
4. Excess Cash Distribution:
   When a company has surplus cash that isn’t immediately needed for reinvestment or debt repayment, paying dividends is an efficient way to use those funds.
5. Stabilizing Stock Price:
   Regular dividends can help stabilize a company's stock price, as income-seeking investors are less likely to sell during market downturns, knowing they’ll receive dividends regardless of market conditions.
6. Shareholder Loyalty:
   Paying dividends fosters goodwill among shareholders, enhancing loyalty and encouraging long-term investment in the company.

The Role of Dividends: Extra Income for Investors

When you own stock in a company, your profits can come in two forms: capital appreciation (when the stock price increases) and dividends. Dividends are payments made to shareholders out of the company’s earnings, typically distributed quarterly.

Not all companies pay dividends. Growth companies often reinvest their profits into the business to fuel expansion, while more established companies (like blue-chip stocks) are more likely to pay regular dividends. For investors looking for steady income, dividend-paying stocks can be a fantastic choice.

The power of compounding dividends over time can significantly boost your returns, especially if you reinvest those dividends into more shares.

Now that you have a solid understanding of what stocks are, how they work, and why investing in them can build your wealth, you’re well on your way to making informed investment decisions. But this is just the first step. Building wealth through stocks isn’t just about buying shares—it’s about developing the right investment strategy for your goals and risk tolerance.

In the next article, we’ll explore different investment strategies and styles that can help you succeed, whether you’re aiming for long-term growth, short-term gains, or steady income. You won’t want to miss it!