When starting on your first foray into the stock market, you should understand what stocks are all about. Stocks of a listed company actually represent the shares or ownership of the company itself. As an example, we shall use a small food stall for our illustration.

Why do company issue stocks?

The food stall is worth $1,000 in all, with the potential of $100 of earnings a year. Now the owner wishes to expand his business, but he does not have the funds to do so. Therefore he divides his food stall into 1000 parts or shares. Based on the par value of his stall, each share is worth $1. Supposedly he issues 500 shares (so that he retains ownership of the stall), and they are all taken up. Now the owner has $500 in funds for expansion and he still has the stall. This is the simplified version of why company issue stocks.

What determines the stock price?

The price of the stock is always determined by the market. There exist buyers and sellers in the market for the particular stock. Buyers want to buy low and sellers want to sell high, when a price agreement is reached between a buyer and seller, the stock price is updated. However, that price may not reflect the actual value of the share.

Remember that our food stall is valued at $1, but the stock may not be traded at $1. Based on its value at $1, there is also the prospect of the business earning $100 a year or $0.10 per share. By holding on to the stock, the shareholder may expect his share to worth $1.10 by the end of the year and therefore decides to buy the share at higher than its value of $1. On the other hand, should shareholders believe that the food stall is not doing well, they would likely want to off load their shares by attracting buyers with a selling price below par value.

Investing in a stock and investing in a company

Despite the fact that holding a share is holding a stake in the company, there is a big difference between investing in a stock and investing in a company. Investing in a stock is based on the belief that the stock will rise due to prevailing market sentiment; there is little regard with respect to the fundamentals of the company. Investing in a company is when you believe that the company is set to grow in the future.

Using our example, someone investing in stock will buy the shares of the food stall at $1 when he believes that the trend is for the stock price to go up. Someone investing in the food stall will buy its shares because he believes that the food stall’s business is good and is likely to make more money or grow bigger in the future.

Investing in stock tend to be short term while investing in company is usually a long term affair.

How does investing grow your money?

Using the $500 from the issue of stocks, the owner expands his food stall’s business such that now the stall is worth $2,000; each stock will then be worth $2. Shares owned by shareholders would have increased in value, thus growing their money.

The owner may also distribute his earnings of $100 to all the shareholders since he does not intend to use them for expansion, thus each shareholder receives $0.10 per share. In this way, shareholders get return on their investment as well.

The most important thing is that money must be invested in businesses with potential or are at least sustainable so that the investment is being used to grow the business. Money cannot grow more money; it must be used to grow a business that generates more money. This is the reason why shareholders may not always opt for shares that issues them dividends from their earnings since distribution of dividends mean that earnings are not reinvested in growing the business. However, reasons for investment differ, and some investors are simply interested getting returns from their investments as dividends.

This leads to the diversification of stock types as different companies vie for investors by targeting groups with different interests.

Value stocks and growth stocks

Value stocks are stocks whose trading price is considered undervalued relative to its fundamentals. This evaluation of value is somewhat arbitrary and different investors will have their own take on a stock’s value. For example, our food stall share is worth $1 based on par value. Some investor will find it a value stock if it is trading at below $1. Other investors may take into account its earnings of $0.10 per share and valuate the share price as undervalued at $1.

If the stall owner wishes to target value stock investors, he may wish to share up to 80% of the $100 earnings as dividends to attract investors.

Growth stocks are shares of a company that is expected to its business or earnings better than the market average. Since this is about predicting the company’s future, a growth stock to one investor may not be to another. If our food stall is expected to grow its earnings from $100 to $150 (50%) because of the expansion while the market average is expected to grow by only 10%, the food stall’s stock becomes a growth stock.

The earnings or business of a company can only grow if earnings are reinvested into growing them. If the stall owner is now looking to target growth stock investors, he will want to reinvest more of his earnings to demonstrate his stall’s potential for growth. Therefore he may wish to reduce the amount of dividend he distributes to shareholders.

There is no sure way of evaluating a stock’s value or future performance. But it is important to understand how they work and know what choices you are making. Do not run away from the market whenever the crowd is shaken. Re-evaluate the situation and determine for yourself if the reasons for buying the shares in the first place are still relevant. If they are, then why is there a need to leave just because everyone else is? Remember, investment targets differ for every investor; your investments should be based on your own reasons and aims.

Eric is an adventurous guy who loves exploring his own life’s passions. He has recently got himself a new hobby in mini digital cameras. To complement his new hobby, he’s found the need to have portable and high memory capacity which he found in memory cards for digital cameras. Join him in his world of photography.

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