Stock Basics Tutorial

By Adam Hayes, CFA | Updated May 25, 2017 — 12:53 PM EDT

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Tutorial https://www.investopedia.com/university/stocks/#ixzz53sKIxt6d
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Turn on the TV news or open a newspaper, surf the internet or listen to the radio,
and you will probably come across some information about the stock market:
“The Dow Jones closed at record highs”; “The S&P 500 is trading down two-tenths of
one percent”; “The stock market is reacting to news from Washington.” The stock
market seems to be everywhere in our daily lives, but what exactly is the stock
market? And, what are stocks that are bought and sold on this market? What does it
mean for you, for your employer, or for your country’s economy when the stock
market had “a good day”?

The answers to these questions are not always obvious once we begin to think about
what stocks are. For example, you may have heard that owning stock means that
you become an owner of that company. But what does that mean? As an "owner"
can you rightfully walk into one of its offices and take home a chair or a desk? Can
you hire and fire people? Of course, if you only own a small number of shares, you
only “own” a small percentage of the company – but what if you own a majority of the
shares, could you then take home a chair or fire workers?

In this tutorial, we will answer these questions and more, often going into some
depth to explain core concepts. Once you’ve come to grasp these concepts and
understand what makes the stock market tick, the hope is that you’ll become a
smarter, more informed, and savvy investor. Even if you don’t have a brokerage
account of your own and invest with your own money, you may very well be exposed
to stocks via your 401(k) retirement account, pension plan, college savings plans,
health savings plans, or insurance policies. Once a tool for the rich, the stock market
has now turned into the vehicle of choice for growing wealth for many segments of
the population. Advances in trading technology and low-cost brokerage services on
the internet have opened up stock markets so that today nearly anybody can own
stocks with the click of a mouse.

Before proceeding, however, it is important to distinguish between two common uses

of the stock market: investing and speculation. Investing is when you hand over your
money so that it is put to use for productive projects such as growth or expansion.
Investing in a factory, in research and development, in a new business idea – these
are all done with the expectation that in the future, the factory, the research, or the
startup will be worth more than the original investment. That means you have a
reason to believe the factory needs to be expanded, or that you understand broadly
the type of research being done and what the payoff might be, or that you
understand and believe in the business plan of the new venture. In other words,
investing is a rational decision made with an eye to the future. When you invest, your
money is intended to be put to work increasing value.

Speculation, on the other hand, is akin to gambling. Speculators purchase something

with the hope that they can soon sell it at a higher price, but without necessarily
understanding – or even caring – about why the price should go up. Sometimes,
speculators have a gut feeling, or are trading on rumor, but ultimately they do not
concern themselves with the factory, the R&D, or the business plan. Speculation
should not always be viewed as a bad thing, however; speculators add liquidity to
markets, and many have done very well for themselves. At the same time, many
smart investors have lost their fortunes in the stock market through speculation. The
important distinction between investors and speculators is not a normative one, but
rather that investors are generally more interested in the processes underlying
prices; they are in it for the long haul, while speculators are more interested in the
price itself, and with shorter time horizons for making money.

What Are Stocks?

You have probably heard a popular definition of what a stock is: “A stock is a share
in the ownership of a company. Stock represents a claim on the company's assets
and earnings. As you acquire more stock, your ownership stake in the company
becomes greater.” Unfortunately, this definition is incorrect in some key ways.

To start with, stock holders do not own corporations; they own shares issued by
corporations. But corporations are a special type of organization because the law
treats them as legal persons. In other words, corporations file taxes, can borrow, can
own property, can be sued, etc. The idea that a corporation is a “person” means that
the corporation owns its own assets. A corporate office full of chairs and tables
belong to the corporation, and not to the shareholders.

This distinction is important because corporate property is legally separated from the
property of shareholders, which limits the liability of both the corporation and the
shareholder. If the corporation goes bankrupt, a judge may order all of its assets sold
– but your personal assets are not at risk. The court cannot even force you to sell
your shares, although the value of your shares will have fallen drastically. Likewise, if
a major shareholder goes bankrupt, she cannot sell the company’s assets to pay off
her creditors.

What shareholders own are shares issued by the corporation; and the corporation
owns the assets. So if you own 33% of the shares of a company, it is incorrect to
assert that you own one-third of that company; it is instead correct to state that you
own 100% of one-third of the company’s shares. Shareholders cannot do as they
please with a corporation or its assets. A shareholder can’t walk out with a chair
because the corporation owns that chair, not the shareholder. This is known as the
“separation of ownership and control.”

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So what good are shares, then, if they aren’t actually the ownership rights we think
they are? Owning stock gives you the right to vote in shareholder meetings, receive
dividends (which are the company’s profits) if and when they are distributed, and it
gives you the right to sell your shares to somebody else.

If you own a majority of shares, your voting power increases so that you can
indirectly control the direction of a company by appointing its board of directors. This
becomes most apparent when one company buys another: the acquiring company
doesn’t go around buying up the building, the chairs, the employees; it buys up all
the shares. The board of directors is responsible for increasing the value of the
corporation, and often does so by hiring professional managers, or officers, such as
the Chief Executive Officer, or CEO.

For ordinary shareholders, not being able to manage the company isn't such a big
deal. The importance of being a shareholder is that you are entitled to a portion of
the company's profits, which, as we will see, is the foundation of a stock’s value. The
more shares you own, the larger the portion of the profits you get. Many stocks,
however, do not pay out dividends, and instead reinvest profits back into growing the
company. These retained earnings, however, are still reflected in the value of a
stock.

Stocks – sometimes referred to as equity or equities – are issued by companies to

raise capital in order to grow the business or undertake new projects. There are
important distinctions between whether somebody buys shares directly from the
company when it issues them (in the primary market) or from another shareholder
(on the secondary market). When the corporation issues shares, it does so in return
for money.

Companies can instead raise money through borrowing, either directly as a loan
from a bank, or by issuing debt, known as bonds. Bonds are fundamentally different
from stocks in a number of ways. First, bondholders are creditors to the corporation,
and are entitled to interest as well as repayment of principal. Creditors are given
legal priority over other stakeholders in the event of a bankruptcy and will be made
whole first if a company is forced to sell assets in order to repay them. Shareholders,
on the other hand, are last in line and often receive nothing, or mere pennies on the
dollar, in the event of bankruptcy. This implies that stocks are inherently riskier
investments that bonds.

The same is true on the upside: bondholders are only entitled to receive the return
given by the interest rate agreed upon by the bond, while shareholders can enjoy
returns generated by increasing profits, theoretically to infinity. The greater risk
attributed to stocks has generally been rewarded by the market. Stocks have
historically returned around 8-10% annualized, while bonds return 5-7%.
Different Types Of Stocks
When a company is first founded, the only shareholders are the co-founders and
early investors. For example, if a startup has two founders and one investor, each
may own one-third of the company’s shares. As the company grows and needs more
capital to expand, it may issue more of its shares to other investors, so that the
original founders may end up with a substantially lower percentage of shares than
they started with. During this stage, the company and its shares are considered
private. In most cases, private shares are not easily exchanged, and the number of
shareholders is typically small.

As the company continues to grow, however, there often comes a point where early
investors become eager to sell their shares and monetize the profits of their early
investments. At the same time, the company itself may need more investment than
the small number of private investors can offer. At this point, the company considers
an initial public offering, or IPO, transforming it from a private to a public company.

Aside from the private/public distinction, there are two types of stock that companies
can issue: common stock and preferred shares.

Common Stock
When people talk about stocks they are usually referring to common stock. In fact,
the great majority of stock is issued is in this form. Common shares represent a
claim on profits (dividends) and confer voting rights. Investors most often get one
vote per share-owned to elect board members who oversee the major decisions
made by management.

Over the long term, common stock, by means of capital growth, has tended to yield
higher returns than corporate bonds. This higher return comes at a cost, however,
since common stocks entail the most risk including the potential to lose the entire
amount invested if a company goes out of business. If a company goes bankrupt and
liquidates, the common shareholders will not receive money until the creditors,
bondholders and preferred shareholders are paid.

Preferred Stock
Preferred stock functions similarly to bonds, and usually doesn't come with the voting
rights (this may vary depending on the company, but in many cases preferred
shareholders do not have any voting rights). With preferred shares, investors are
usually guaranteed a fixed dividend in perpetuity. This is different from common
stock which has variable dividends that are declared by the board of directors and
never guaranteed. In fact, many companies do not pay out dividends to common
stock at all.

Another advantage is that in the event of liquidation, preferred shareholders are paid
off before the common shareholder (but still after debt holders and other creditors).
Preferred stock may also be “callable,” meaning that the company has the option to
re-purchase the shares from preferred shareholders at any time for any reason
(usually for a premium). An intuitive way to think of these kinds of shares is to see
them as being somewhat in between bonds and common shares.

Common and preferred are the two main forms of stock; however, it's also possible
for companies to customize different classes of stock to fit the needs of their
investors. The most common reason for creating share classes is for the company to
keep voting power concentrated with a certain group. Therefore, different classes of
shares are given different voting rights. For example, one class of shares would be
held by a select group who are given perhaps ten votes per share while a second
class would be issued to the majority of investors who are given just one vote per
share. When there is more than one class of stock, the classes are traditionally
designated as Class A and Class B, etc.. For example, billionaire Warren Buffett’s
company Berkshire Hathaway has two classes of stock, represented by placing the
letter behind the ticker symbol in a form like this: "BRKa, BRKb" or "BRK.A, BRK.B".

How Stocks Trade

We saw in the last section that once a company completes an initial public offering
(IPO), its shares become public and can be traded on a stock market. Stock markets
are venues where buyers and sellers of shares meet and decide on a price to trade.
Some exchanges are physical locations where transactions are carried out on a
trading floor, but increasingly the stock exchanges are virtual, composed of networks
of computers where trades are made and recorded electronically.

Stock markets are secondary markets, where existing owners of shares can transact
with potential buyers. It is important to understand that the corporations listed on
stock markets do not buy and sell their own shares on a regular basis (companies
may engage in stock buybacks or issue new shares, but these are not day-to-day
operations and often occur outside of the framework of an exchange). So when you
buy a share of stock on the stock market, you are not buying it from the company,
you are buying it from some other existing shareholder. Likewise, when you sell your
shares, you do not sell them back to the company – rather you sell them to some
other investor.

The first stock markets appeared in Europe in the 16th and 17th centuries, mainly in
port cities or trading hubs such as Antwerp, Amsterdam, and London. These early
stock exchanges, however, were more akin to bond exchanges as the small number
of companies did not issue equity. In fact, most early corporations were considered
semi-public organizations since they had to be chartered by their government in
order to conduct business.

In the late 18th century, stock markets began appearing in America, notably the New
York Stock Exchange (NYSE), which allowed for equity shares to trade (the honor of
the first stock exchange in America goes to the Philadelphia Stock Exchange
[PHLX], which still exists today). The NYSE was founded in 1792 with the signing of
the Buttonwood Agreement by 24 New York City stockbrokers and merchants. Prior
to this official incorporation, traders and brokers would meet unofficially under a
buttonwood tree on Wall Street to buy and sell shares.

The advent of modern stock markets ushered in an age of regulation and

professionalization that now ensures buyers and sellers of shares can trust that their
transactions will go through at fair prices and within a reasonable period of time.
Today, there are many stock exchanges in the U.S. and throughout the world, many
of which are linked together electronically. This in turn means markets are more
efficient and more liquid.

There also exists a number of loosely regulated over-the-counter exchanges,

sometimes known as bulletin boards, that go by the acronym OTCBB. OTCBB
shares tend to be more risky since they list companies that fail to meet the more
strict listing criteria of bigger exchanges. For example, larger exchanges may require
that a company has been in operation for a certain amount of time before being
listed, and that it meets certain conditions regarding company value and profitability.
In most developed countries, stock exchanges are self-regulatory organizations
(SROs), non-governmental organizations that have the power to create and enforce
industry regulations and standards. The priority for stock exchanges is to protect
investors through the establishment of rules that promote ethics and equality.
Examples of such SRO’s in the U.S. include individual stock exchanges, as well as
the National Association of Securities Dealers (NASD) and the Financial Industry
Regulatory Authority (FINRA).

The prices of shares on a stock market can be set in a number of ways, but most the
most common way is through an auction process where buyers and sellers place
bids and offers to buy or sell. A bid is the price at which somebody wishes to buy,
and an offer (or ask) is the price at which somebody wishes to sell. When the bid and
ask coincide, a trade is made.

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Some stock markets rely on professional traders to maintain continuous bids and
offers since a motivated buyer or seller may not find each other at any given
moment. These are known as specialists or market makers. A two-sided market
consists of the bid and the offer, and the spread is the difference in price between
the bid and the offer. The more narrow the price spread and the larger size of the
bids and offers (the amount of shares on each side), the greater the liquidity of the
stock. Moreover, if there are many buyers and sellers at sequentially higher and
lower prices, the market is said to have good depth. Stock markets of high quality
generally tend to have small bid-ask spreads, high liquidity, and good depth.
Likewise, individual stocks of high quality, large companies tend to have the same
characteristics.

In addition to individual stocks, many investors are concerned with stock indices
(also called indexes). Indices represent aggregated prices of a number of different
stocks, and the movement of an index is the net effect of the movements of each
individual component. When people talk about the stock market, they often are
actually referring to one of the major indices such as the Dow Jones Industrial
Average (DJIA) or the S&P 500.

The DJIA is a price-weighted index of 30 large American corporations. Because of its

weighting scheme and that it only consists of 30 stocks – when there are many
thousand to choose from – it is not really a good indicator of how the stock market is
doing. The S&P 500 is a market cap-weighted index of the 500 largest companies in
the U.S., and is a much more valid indicator. Indices can be broad such as the Dow
Jones or S&P 500, or they can be specific to a certain industry or market sector.
Investors can trade indices indirectly via futures markets, or via exchange traded
funds (ETFs), which trade like stocks on stock exchanges. (See also: Opinion: Dow
20,000 Is Stupid.)

Trading Stocks and Order

Types
In this section, we discuss the practical matter of going about buying and
selling shares of stock. Individuals typically buy and sell shares by using a licensed
brokerage firm or broker who makes the actual trade. Historically, stockbrokers were
hired only by wealthy individuals and families, but today a wide range of brokerages
exist for all price ranges. So-called “full-service” brokers offer a suite of research,
opinion, and expert advice and can offer a personal relationship between the broker
and the client. For more budget conscious clients, discount brokerages exist that
offer a much more bare-bones service offering, in some cases simply executing
purchases and sales. Over the past two decades, electronic trading has grown
significantly, with many online brokerages offering both research and opinion as well
as trades at low prices, some asking as little as $5 or less per trade in commission.
(See also: Picking Your First Broker.)

Regardless of the type of brokerage used, the mechanics of buying or selling shares
is fairly uniform. First, a stock quote is obtained. In the early days of stock
exchanges, price information was transmitted via tickertape – a long ribbon of paper
that printed basic data via telegraph wire. That is why today we still refer to stock
quotes as the ticker.

A stock quote carries a lot of information including the current

bid and offer (sometimes called the ask) prices as well as the last price that traded.
The bid is the highest price that somebody in the market is willing to pay at a given
time, while the offer is the lowest price that somebody is willing to sell. If you are
interested in buying shares, you will make a bid, and if you want to sell an offer.
When the price of a bid and offer coincide, a trade is effected.

In addition to this price information, data on trading volume (number of shares

traded) is often included. Stock quotes obtained online are often real-time quotes
that confer second-by-second details, and online quotes also often include charts
and interactive tools. Stocks are quoted by their ticker symbol, represented by
between one and four capital letters, which are often loosely representative of the
company name. For example the ticker symbol for Microsoft Corp. is MSFT,
Caterpillar Inc. is CAT, and Apple Inc. is AAPL.

Market Orders and Limit Orders

Next, the type of trade has to be determined. A market order is simply an order that
instructs the broker (or online trading platform) to buy or sell shares at the best
available price. If you wanted to buy 100 shares of AAPL at market, and the quote
shows: Bid: $139.80 (100), Offer: $140.00 (50), Last: $139.95 (250). This tells us
that the last trade was 250 shares at $139.50 and it indicates 50 shares are offered
at $140.00. Suppose another 200 are offered at $140.05. Your market order would
buy the 50 shares at $140.00 and then purchase 50 more at the next best price at
$140.05.

A market order does not guarantee the price you will get, but it does guarantee that
you will get the number of shares that you want, in this case 100. When an order is
completed, it is said to be filled. A market order is most often used in cases where
the buyer or seller is most concerned with filling the size of the order and not
concerned with the price. A limit order specifies the price at which you want to trade.
For example, you may specify that you want to buy AAPL for $140.00 but no more,
in which case you would buy the 50 shares offered at $140.00 and then wait for
some other seller to come down to your price. Until that happens, the new quote
would be Bid: $140.00 (50), Offer: $140.05 (200), Last: $140.00 (50).

A limit order can also be designated all-or-none (AON), meaning that you won’t
agree to buy your shares unless you can get all 100 that you want. If the original limit
order in this example were AON, you would not buy the 50 that are offered until
another 50 came along. Limit orders are used by those who are primarily concerned
with the price they want to receive, but they are not guaranteed that the size of their
order will be filled. Price versus getting filled on the size of your order are the primary
trade-offs between market and limit orders.

Stop Orders
Stop orders are contingent on a certain price level being attained to activate the
trade. With a stop order, your trade will be executed only when the security you want
to buy or sell reaches a particular price (the stop price). Once the stock has reached
this price, a stop order essentially becomes a market order and is filled. For instance,
if you own stock ABC, which currently trades at $20, and you place a stop order to
sell it at $15, your order will only be filled once stock ABC drops below $15. Also
known as a stop-loss order, this allows you to limit your losses.

This type of order can also be used to guarantee profits. For example, assume that
you bought stock XYZ at $10 per share and now the stock is trading at $20 per
share. Placing a stop order at $15 will guarantee profits of approximately $5 per
share, depending on how quickly the market order can be filled. Stop orders are
particularly advantageous to investors who are unable to monitor their stocks for a
period of time, and brokerages may even set these stop orders for no charge.
One disadvantage of the stop order is that the order is not guaranteed to be filled at
the preferred price the investor states. Once the stop order has been triggered, it
turns into a market order, which is filled at the best possible price. This price may be
lower than the price specified by the stop order. Moreover, investors must be
conscientious about where they set a stop order. It may be unfavorable if it is
activated by a short-term fluctuation in the stock's price. For example, if stock ABC is
relatively volatile and fluctuates by 15% on a weekly basis, a stop-loss set at 10%
below the current price may result in the order being triggered at an inopportune or
premature time.

Other Kinds of Orders

Orders may also be tagged with instructions regarding how long an order is good for.
An immediate-or-cancel (IOC) order is cancelled if the order isn’t executed right
away. This is typically used in conjunction with a limit order. When an IOC order is
combined with an AON order, it is designated fill-or-kill (FOK). A day order is a limit
or stop order that is cancelled at the end of the trading day, and will not be active the
next morning. A good-til-canceled (GTC) order is active until the instruction is given
to cancel it, and may remain active for many days at a time or longer.

Margin Trading and Short Selling

In addition to the mechanics described above, many brokerages offer margin trading,
allowing their customers to borrow money to buy shares in excess of the amount of
cash in their account. Margin also allows for short selling, which is where a market
participant borrows shares they do not own in order to sell them with the hope of
buying them back in the future at a lower price. A short seller is betting that the price
of a stock will go down, rather than up.

In addition to using a brokerage, there are two less common ways to own
shares: dividend reinvestment plans (DRIPs) and direct investment plans (DIPs).
DIPs are plans by which individual companies, for a minimal cost, allow shareholders
to purchase stock directly from the company. DRIPs are where the dividends paid by
shares are automatically used to purchase more of those shares (including fractions
of a share).

Bulls, Bears & Market

Sentiment
Investors often have differing opinions about particular stocks or about the direction
of the economy as a whole. Each trading day is analogous to a struggle between
optimists and pessimists who buy and sell at various prices given different
expectations. The stock market is said to incorporate all of the information that exists
about the companies it represents, and that manifests itself as price. When optimists
dominate, prices trend upwards, and we say that we are in a bull market. When the
opposite is true, and prices trend lower, we are in a bear market.

A bull market is when everything in the economy is running objectively well: people
are finding jobs and unemployment is low, the economy is growing as measured
by gross domestic product (GDP), and stocks are rising. Picking stocks during a bull
market is arguably easier because everything is going up. If a person is optimistic
and believes that stocks will go up, he or she is called a bull and is said to have a
bullish outlook. Bull markets cannot last forever though, and sometimes they can
lead to dangerous situations if stocks become overvalued. In fact, one severe form of
a bull market is known as a bubble, where the upward trajectory of stock prices no
longer conforms to fundamentals, and optimistic sentiment completely takes over.
Historically, bubbles have occurred regularly dating back to the Dutch Tulipmania of
the 1600’s – where the price of tulip bulbs rose so high that one could be worth more
than a house – through to the housing bubble of 2008 that sparked the Great
Recession. Bubbles always burst when reality catches up with overinflated prices,
and people often realize bubbles in hindsight. It is difficult to recognize when
investors are in a bubble and even harder to predict when it will pop.

A bear market is informally defined as a 20% drop in broad indices. Bear markets
happen when the economy appears to be in or near recession, unemployment rises,
corporate profits fall, and GDP contracts. Bear markets make it tough for investors to
pick profitable stocks. One solution to this is to profit from when stocks are falling via
short selling. Another strategy is to wait on the sidelines until you feel that the bear
market is nearing its end, only starting to buy in anticipation of a bull market.

Bear markets are typically associated with an increase in stock market volatility,
since investors typically fear losses more than they appreciate gains at an emotional
level. People are not always rational actors – especially when it comes to money and
investments. During bear markets, prices do not drop in an orderly or rational way to
some fundamental level of price-to-earnings, but rather market participants often
overreact in panic and send prices below reasonable valuations.

When there is panic, there is fear. Irrational behavior can spread, and markets can
collapse. Expectations about future cash flows essentially drop to zero and people
become more concerned with converting investments into cash than future growth.
Only when rational investing behavior is restored does a bear market turn a corner. It
is also worth pointing out that bear markets can be great opportunities for long-term
investors to buy stocks “on sale” at relatively low prices, which can actually boost
overall returns over long time horizons.
How to Read A Stock
Table/Quote
Any financial paper has stock quotes that will look something like the image below:

Columns 1 & 2: 52-Week High and Low - These are the highest and lowest prices
at which a stock has traded over the previous 52 weeks (one year). This typically
does not include the previous day's trading.

Column 3: Company Name & Type of Stock - This column lists the name of the
company. If there are no special symbols or letters following the name, it is common
stock. Different symbols imply different classes of shares. For example, "pf" means
the shares are preferred stock.

Column 4: Ticker Symbol - This is the unique alphabetic name which identifies the
stock. If you watch financial TV, you have seen the ticker tape move across the
screen, quoting the latest prices alongside this symbol. If you are looking for stock
quotes online, you always search for a company by the ticker symbol. If you don't
know what a particular company's ticker is you can search for it on our markets
page.

Column 5: Dividend Per Share - This indicates the annual dividend payment per
share. If this space is blank, the company does not currently pay out dividends.

Column 6: Dividend Yield - The percentage return on the dividend. Calculated as

annual dividends per share divided by price per share.

Column 7: Price/Earnings Ratio - This is calculated by dividing the current stock

price by earnings per share from the last four quarters. For more detail on how to
interpret this, see our P/E Ratio tutorial.
Column 8: Trading Volume - This figure shows the total number of shares traded
for the day, listed in hundreds. To get the actual number traded, add "00" to the end
of the number listed.

Column 9 & 10: Day High and Low - This indicates the price range at which the
stock has traded at throughout the day. In other words, these are the maximum and
the minimum prices that people have paid for the stock.

Column 11: Close - The close is the last trading price recorded when the market
closed on the day. If the closing price is up or down more than 5% than the previous
day's close, the entire listing for that stock is bold-faced. Keep in mind, you are not
guaranteed to get this price if you buy the stock the next day because the price is
constantly changing (even after the exchange is closed for the day). The close is
merely an indicator of past performance and except in extreme circumstances
serves as a ballpark of what you should expect to pay.

Column 12: Net Change - This is the dollar value change in the stock price from the
previous day's closing price. When you hear about a stock being "up for the day," it
means the net change was positive.

Quotes on the Internet

Nowadays, it's far more convenient for most to get stock quotes off the Internet. This
method is superior because most sites update throughout the day and give you more
information, news, charting, research, etc.

Compare how different online brokerages display stock prices by visiting

our Brokerage Review Center.

To get quotes, simply enter the ticker symbol into the quote box of any major
financial site like Yahoo! Finance, CBS Marketwatch, or MSN Money. The example
below shows a quote for Microsoft (MSFT) from Yahoo Finance. Interpreting the data
is exactly the same as with the newspaper.
Valuing Stocks
Stock prices change often (sometimes many times a minute) as the result of market
forces. By this we mean that share prices change because of fluctuations in
their supply and demand. If more people want to buy a stock at a given moment
(demand) than sell it (supply), then the price moves up. In our previous example of
buying Apple Inc. (AAPL) stock with a market order, the purchase caused the price
to increase to $140.05. Conversely, if more people are motivated to sell a stock than
buy it, there would be greater supply than demand, and the price would fall. Of
course, for any trade to actually happen there needs to be exactly one buyer and
one seller – so the number of buyers and sellers is technically the same. What we
mean here is the number of motivated buyers or sellers, i.e. those that are willing to
buy for higher or sell for lower.

The price of a stock represents the “value” of the corporation. At its most basic level,
this value is computed by dividing the dollar value of the company, known as
the market capitalization (or “market cap”) by the number of shares outstanding. For
example, if XYZ Corp. is valued at $1,000,000 and it has 100,000 shares
outstanding, the price of each share is $10.00. Working backwards, one can
determine the market value of a company thus by multiplying the share price by the
number of shares. The question then becomes what causes fluctuations in the value
of the corporation?

But what does a company’s value represent? A company has stuff and it sells stuff.
The stuff it has – buildings, machinery, patents, money in the bank, etc. – constitute
its book value, or the amount of money a company would get if they sold all that stuff
at once. But companies are primarily in business of trying to make a profit, and in
doing so they earn cash by selling products or services, so the total value of a
company has to do with the stuff it owns now and the cash flows it will receive in the
future. The value of the stuff it owns now is fairly easy to determine, but the value of
all the future cash flow streams is a bit trickier to nail down – and it is this piece that
is responsible for market gyrations.

Because of the time value of money, profits to be earned in the future must be
discounted back to represent today’s dollars – just as a dollar put into a bank
account today will be worth more in the future after it has earned some interest, but
in reverse. How much to discount these future cash flows depends on a lot of things
including the cost of capital (which is the cost to borrow or find investment, and this
depends on interest rates), the riskiness of the business (in the stock market this is
often estimated using beta), and the foregone cost of doing nothing and keeping
your money in the bank (the opportunity cost or risk-free rate).

Once an appropriate discount rate has been estimated, the hard part is to figure out
what future cash flows will be – a month from now, a year from now, five years from
now. Sentiment and expectations are a big component of these predictions, and
financial analysts try to figure these amounts out in a number of ways accounting for
both company-specific factors and macro factors such as overall economic health.
Fortunately, the stock market reflects the expectation of future cash flows in an easy
to compute ratio of price-to-earnings, also known as the P/E ratio. A P/E ratio of 10x
means that a company is being valued today at 10x its current earnings. A P/E ratio
of 20x for the same company would mean that given the same amount of earnings,
the market is giving it twice as much value, indicating that those future cash flows
are going to be larger. Of course, there are a number of sophisticated pricing models
that analysts can use in addition, or instead of, the P/E ratio such as using dividend
discount models or free cash flow models.

Because the future is unknown today, various peoples’ estimates will be different
from one another, giving some a higher expected stock price and some a lower stock
price. If the current price is lower than their expected price, people will buy it. If it is
higher, people will sell it. When an economy is growing, people are spending and
profits are rising. Companies invest in projects, expand their businesses and hire
more people. Investors are optimistic and expectations of future cash flows rise, and
stocks enter a bull market. Simply put, stock markets can fall when expectations of
future cash flows decrease, making the prices of companies seem too high,
therefore causing people to sell shares. If many more people come to this decision
than there are people to buy those shares, the price will fall until it reaches a level
where people will begin to believe that they are fairly valued.

The important things to grasp about this complicated subject are the following:

1. At the most fundamental level, supply and demand in the market determines stock
price in any given moment.

2. Price times the number of shares outstanding (market capitalization) is the value
of a company. Comparing just the share price of two companies is meaningless.

3. Theoretically, earnings are what affect investors' valuation of a company, but there
are other indicators that investors use to predict stock price. It is investors'
sentiments, attitudes and expectations that ultimately affect stock prices.

4. There are many competing theories that try to explain the way stock prices move
the way they do. Unfortunately, there is no one theory that can explain everything.

Conclusion
Let’s recap some of the main points we’ve learned in this tutorial:

 Stocks are claims to a company’s profit stream and are granted voting rights
in installing its board of directors or in approving large corporate actions such
as being acquired. Shareholders are not owners of a corporation’s assets and
do not involve themselves with corporate management.
 Stock is equity, bonds are debt. Bondholders are guaranteed a return on their
investment and have a higher claim in recovery from a bankruptcy than
shareholders. This is generally why stocks are considered riskier investments
and require a higher expected rate of return.
 You can lose all of your investment with stocks. The flip-side of this is you can
make a lot of money if you invest in the right company.
 The two main types of stock are common and preferred. It is also possible for
a company to create different classes of stock.
 Stock markets are places where buyers and sellers of stock meet to trade.
Most trading takes place today via electronic trading.
 Stock market indexes give an overview to how the stock market is “doing.”
 Stock prices change moment to moment according to supply and demand.
There are many factors influencing prices, the most important of which is
expectations about earnings. Still, there is no consensus as to why stock
prices move the way they do.
 To buy stocks you can either use a brokerage or a dividend reinvestment plan
(DRIP).
 There are a number of different order types, and the type of order you use will
depend on whether you are more concerned with price or with completing
your order.
 Stock tables/quotes actually aren't that hard to read once you know what
everything stands for!
 Bulls are optimistic and bull markets are defined by increasing stock prices.
Bears are pessimists and bear markets occur when prices fall.