Nature of Stocks

Taking Stock
Have you ever dreamed about IPOs and the
making it big in the business Secondary Market
world someday? Perhaps you’d A corporation introduces its stock
like to own a company and be to the market through an IPO, or
involved in all the important initial public offering. The cor-
decisions about running it. poration goes through an invest-
Well, what are you waiting ment bank or brokerage house to
for? You can be an owner in a determine how many shares it will
corporation right now simply by offer, and at what price. Then, the
purchasing stocks. government must give its approv-
al. After that, the shares become
Why Stocks? available to investors (usually
Stocks are pieces of ownership, favored clients of the investment
or shares, in a corporation. Why bank or brokerage house) on a
would companies sell shares specified day.
of their ownership to ordinary
Once the corporation’s shares
people who may not have any
have been initially issued, they
business savvy or training at
can be traded on the secondary
all? To put it simply, they need
market. A secondary market is a
the money! Running a company is expensive. To collect the
place where investors can trade (buy and sell) their investments
cash they need, corporations often sell shares of stock in their
in securities that have been issued by another party. Don’t get
business. The people who invest money in the business become
confused—it’s simply what we commonly refer to as “the stock
shareholders, or owners in the corporation. Corporations
market.” When you trade shares on the stock market, you are
issue stock to raise money for a variety of different reasons—to
buying them from and selling them to other investors, not deal-
fuel growth and expansion, to develop new products, to acquire
ing directly with the issuing corporation. This trading is “second-
other companies, and more.
ary” to the “primary” market.
If a company wants to issue more stock after the original IPO,
it can do so. Current investors aren’t always happy when this
occurs, however. When more shares of stock are issued, each
investor’s proportionate percentage of ownership goes down.

Discuss reasons for trading stocks. Investing in Stocks

You understand why companies sell stock, but why should you
Explain different types of stocks. buy it? If you want to reach your financial goals for the future,
you’ll need to invest your money in securities that earn a good
rate of return. And over the long term, no other securities perform
as well as stocks do.

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 There are two ways you can make money by investing in the value of the holdings remains the same. Say, for example,
stocks—earning profits through dividends and earning profits you have 100 shares of stock, valued at $10 per share, in an oil
through capital appreciation. company. In a two-for-one stock split, you would wind up with
200 shares of stock. However, the value of each share would go
Dividends. When the company you invest in makes a profit,
down to $5. Your investment is worth $1,000 either way.
you may be paid a dividend, or a portion of the company’s
earnings. The company’s board of directors decides whether or Although stock splits have no real financial relevance, corpo-
not to pay dividends; it is not a legal requirement, even if the rations choose them for several reasons:
company has made a profit. When a company does decide to pay • An increase in the number of outstanding shares makes
out a dividend, it can do so in a variety of different ways, but the the stock more liquid, meaning it can be bought and sold
most common is cash. Most companies that pay cash dividends more easily.
do so on a quarterly basis. Companies that have a reputation for
paying regular dividends are known as blue-chip companies. • Lower prices per share may attract more investors.
Capital appreciation. Sometimes, a company you invest • Existing investors like having “more shares” than they
in will choose not to pay a dividend, even if it has the earnings did before.
to do so. The company may keep its profits and use them to fuel
continued growth and development. When a company reinvests Stock Exchanges
this income into itself, its value goes up and so should the value A stock exchange is a place (physical or virtual) where stocks
of its stock. are traded by brokers who represent buyers and sellers. There
Capital appreciation occurs when the stock you own are over 100 stock exchanges operating worldwide. The two ma-
becomes worth more than what you paid for it. Let’s say you jor stock exchanges in the United States are the New York Stock
purchased 100 shares of Cassie’s Cupcake Company for $5 Exchange (NYSE) and the NASDAQ.
per share, a total of $500. Over the past two years, the stock • NYSE. Located in New York City, the NYSE is the most
has grown in value to $7.50 per share. Your $500 is now worth famous stock exchange in the world. An average of 1.5
$750. If you want, you can cash out of your Cassie’s stock and billion shares, worth more than $45 billion, are traded
take your $250 profit. Or, you can keep your money in the stock there each day.
and see how much further it might grow.
Keep in mind that earning profits through stock investments
is not guaranteed. To receive dividends or capital appreciation,
the company you invest in must make money. If you invest in a
company that’s losing money or just breaking even, you’re not
going to see any return. As a matter of fact, you might even lose
your initial investment! As an owner of the company, you win
when the company wins and lose when the company loses.

Stock Splits
Occasionally, a company’s board of directors may announce a
stock split. When this happens, stockholders receive additional
shares of stock for each share they already own, perhaps two for
one or three for two. Each share then diminishes in price, but

Companies that issue stock only to

select people are considered to be
“privately held” or “closely held” com-
panies. When a company issues stock
for anyone to purchase, it is considered
a public company, or “publicly traded.”

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 • NASDAQ. NASDAQ, which stands for National As- company is headed for, investors scramble to buy its stock, and
sociation of Securities Dealers Automated Quotation the price goes up. But, a few months later, several news stories
System, is an online stock exchange that lists over 3,000 break about the company’s CEO being involved in some shady
companies. The world’s first stock exchange to conduct business dealings. With the bad press, many investors want to
online trades, it was founded in 1971 by the National jump ship and sell their stock, and the price goes down. These
Association of Securities Dealers. are just a few examples of the many, many factors that can affect
stock prices.
Supply and Demand
Many factors affect the price of a company’s stock. Take the gen-
eral law of supply and demand, for instance—the more investor
demand there is for a certain company’s stock, the more that
stock will cost because only a limited number of shares exist.
And when investor demand goes down, so does the price.
So, what drives investor demand up or down? Sometimes, a
new product introduction can make a company’s stock more at-
tractive. Perhaps a company has just developed the most lifelike
baby doll on the market, and it’s predicted to be the hottest sell-
ing toy this Christmas. Knowing what a great quarterly profit the

Understanding Stock
Common Stock Types of Stock
Most investors purchase common stock. Common stock gives Cap size. Stocks can be classified according to the company’s
investors a basic share of ownership in the company as well market capitalization, or cap size. Market capitalization is the
as voting rights (usually one vote per share of stock). Voting total value of a company’s outstanding shares. It is calculated
rights are important when it comes to electing the company’s by multiplying the number of shares by the price per share. Dif-
board of directors. The board of directors represents all of the ferent sources give different ranges, but in general—large-cap
company’s stockholders and makes major business decisions for companies are those worth over $8 billion; mid-cap companies,
the company. Common stockholders also vote on matters such worth between $1 billion and $8 billion; and small-cap compa-
as company objectives. If the company goes bankrupt, common nies, worth less than $1 billion.
stockholders are entitled to company assets, but only after the Growth, income, value. Most stocks can be classified as
company has met its obligations to bondholders and preferred growth, income, or value. Growth stocks belong to companies
stockholders. with sales and earnings that grow at high rates. Because these
companies typically reinvest these earnings back into them-
Preferred Stock selves, growth stocks either pay very small dividends or do not
Like common stock, preferred stock gives stockholders a ba- pay dividends at all. They are ideal for long-term investors who
sic share of ownership in the company, but it comes with some are trying to achieve capital appreciation.
extra rights as well. For example, preferred stockholders are
Income stocks belong to companies with a reputation
entitled to fixed dividends, dividends that are either a percentage
for paying out high dividends. Income companies are usually
of the stock value or a specific dollar amount. Also, if a company
mature companies that are not growing as rapidly as they once
goes bankrupt, it is obligated to pay its preferred stockholders
were. However, just because their growth rate has reached a
before it pays its common stockholders. Preferred stockholders
plateau doesn’t mean that income companies are no longer
do not, however, enjoy the voting rights that common stockhold-
profitable. Income stocks are ideal for investors looking for high
ers do.
dividends with low risk.

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 Value stocks are named so because they are good “bar- certain daily averages for the stock market so that investors can
gains.” These stocks have been overlooked by investors and are, know the general direction of stock prices for that day. Here are
therefore, trading at lower-than-average prices. Investors who a few examples:
purchase value stocks expect them to appreciate in value over • The Dow Jones Industrial Average. The most
the long term. Value stocks are ideal for investors who have the commonly quoted stock market index is The Dow Jones
time and patience to wait for their value to go up. Industrial Average. Each day, the Dow Jones measures
Domestic or foreign. Domestic stocks are issued by the stock prices of the 30 largest companies in the United
companies in the country where you live; foreign stocks are States. Over 100 years old, it is considered to be the best
issued by companies in other countries. Many investors choose general indicator of the state of the stock market.
foreign stocks as a way to diversify their portfolios (spread out
their investment dollars) and receive potentially higher rates of • The Standard & Poor’s 500 (S&P 500). Created
return. in the 1950s, the S&P 500 is one of the most popular
stock indices and is much broader than the Dow Jones,
Economic response. Stocks can be further classified by including 500 companies instead of just 30. Many people
their response to the current state of the economy. The value of consider it to be the most accurate of all the stock market
cyclical stocks goes up and down with the economy. If the indices.
economy is poor, cyclical stocks do poorly; if the economy is
good, cyclical stocks do well. For example, when the economy • The NYSE Composite Index. This index averages
is booming, more people build houses. During these times, the prices of all the stocks listed on the NYSE. It is
companies in the construction industry do well. But when the automatically updated after each transaction, and the
economy is in a state of recession, construction slows down, information is sent out worldwide every 15 seconds.
and construction companies’ stocks take a hit.
• The NASDAQ Composite Index. The NASDAQ
Defensive stocks belong to companies that are expected Composite Index includes all of the companies listed
to do well regardless of the state of the economy. Think of goods on NASDAQ. Since many of the companies listed on
and services that are necessary no matter what—food, pharma- NASDAQ are technology companies, some people don’t
ceuticals, and utilities such as electricity and gas. Even during consider the NASDAQ Composite Index to be a good
periods of economic recession, the stock of companies in these indicator of the market as a whole.
industries will hold value.
Trading stock can be fun and can help you reach many of
Speculative. Speculative stocks belong to companies
your financial goals. However, it’s important to have a thorough
that have not yet established themselves on the market, usually
knowledge of what stocks, stock exchanges, and stock indices
start-up companies that are developing new ideas and products.
are before you begin investing.
These stocks have potential for high price increases, but with no
track records to prove themselves, they are risky investments.
They are not for investors who are faint of heart! Penny stocks
are speculative stocks that sell at very low prices, usually $1 or Classes of Stock
less per share. One thing to keep in mind is that if a stock’s price Both common stock and preferred stock can
is extremely low, there is usually a good reason for it. be issued in different classes. For example, a
company may issue both Class A stock and
Stock Market Indices Class B stock. The two classes won’t mean the
The stock market is so complex and has so many trades going same thing for each and every company. For
on at once—is there any way to get an overall idea of how the example, at one company Class A stock may
market is doing and how your investment portfolio is faring in signify stock that is issued only to board mem-
relation to it? Definitely! A stock market index measures aver- bers; at another company, Class A stock may
age stock prices. There are several different indices that measure signify stock with a different dividend rate.
Different stock classes occur more often with
preferred stock than with common stock.

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