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Getting to know stocks

Lesson in Course: Stocks (beginner, 4min)

What are stocks and why do investors buy or sell them?

Eureka!

What it's about: Owning a stock means we have fractional ownership in a company.

Why it's important: Ownership means we have voting rights and are entitled to receive some of the company's profit.

Key takeaway: The value of the stocks we own will rise as the company's value grows.

Investors have been buying and selling stocks for centuries. The Dutch East India Company and the Amsterdam Stock Exchange created one of the oldest stock markets in the world in 1602. The Philadelphia Stock Exchange opened in 1790 and is the oldest in the US, two years before the New York Stock Exchange.

The clip from this video gives us some basics on stocks.
https://www.youtube.com/embed/R98EpiTtzI0?start=60&end=168
What is Stocks?

Also known as equity, represent fractional ownership in a company. 

The ownership comes with certain rights, such as receiving profits through dividends, voting on shareholder decisions and company strategy, and receiving money after all debts settle if the company gets acquired or goes into bankruptcy.

Why do companies issue stock?

Companies offer stock for investors to purchase for fundraising. They use the money received from selling stock to run operations and invest in future growth. There are two different "markets" where investors can buy and sell stocks.

Stocks are purchased and sold in a marketplace for investors 
What is Primary markets?

When the company sells shares directly to investors. This is how companies raise money, and it's often called a direct offering. Examples of primary markets include IPOs, venture capital, and private equity financing.

What is Secondary markets?

Where investors trade shares with other investors. When we buy stocks through a brokerage account, we buy them from other investors. While the company does not receive cash from these trades, it can make another direct offering in the future and raise more money if the stock price has gone up in the secondary markets.

Types of stocks

Common stock and preferred stock are two main types of stock available to investors.

What is Common stock?

The most common type of stock issued by a company that's actively traded on the secondary market.

Common stock has fundamental rights such as dividends and voting. However, many of us aren't experts in the company's business, so we usually either outsource our vote or skip it altogether when voting happens.

Votes can be delegated to knowledgeable investors active in overseeing operations 

Sometimes we can buy different classes of common stock, such as Class A, Class B, or Class C. The difference between them usually has to do with voting rights. Class C shares may have no voting rights, while Class A shares may have extra, or super-voting, rights. This setup allows companies to maintain a certain level of control to prevent hostile takeovers. In those situations, a competitor could try to buy a majority of the company's shares on the market to vote for outcomes beneficial to the competitor.

The benefit of common stock is the very high upside potential if the business does well. For instance, when Amazon IPO’ed, the stock price was $18 per share, and today it’s grown well over 190,000%!! The tradeoff is common shareholders are last in line for distributions or payouts. If the company is sold or goes out of business for any reason, common shareholders get paid after debt holders and preferred shareholders.

What is Preferred stock?

Is a classification of stock that has additional rights and priority compared to common stock; however, it isn't actively traded on the secondary market.

The importance of preferred stock's priority

Suppose a company is sold or liquidated. In this case, debt holders get paid first, followed by preferred shareholders who receive a payout on invested principal (their liquidation preference) before common shareholders receive anything. Common shareholders could receive nothing if there isn't any money left after paying the preferred shareholders.

A company with excess earnings will pay dividends to all preferred shareholders before issuing dividends to common shareholders. The tradeoff for the priority of dividend payments is that preferred shares don't trade and increase in value the way common shares do.

Preferred stock behaves like a hybrid mix of debt and common shares, where the steady cash payments make it a safer investment than common stock and riskier than debt.

Venture capital and startup investing

Venture capitalists invest in startups through preferred stock. This provides investors with the most protective rights in a very risky investment since most startups might not have the profitability or revenue to qualify for debt financing. In the case of an acquisition or bankruptcy, any money left over from selling assets is returned to those investors first before the common shareholders, usually the founding team and employees.

VCs typically don't use preferred shares to earn their return through dividends. Instead, they take advantage of a right to convert their shares into common shares in a favorable liquidation event, whereby they would make more money holding common shares than their preferred shares.

Buying back stock

Repurchasing shares increases prices

On occasion, companies will implement stock buyback plans. These plans allow the company to set aside a certain amount of cash to go into the secondary markets to repurchase shares from other investors. 

To boost the stock price

The board of directors at companies elect to do this when they think the stock price is low. By buying back shares at low prices, the company retires these shares into the treasury, effectively lowering the supply of shares traded in the markets. Due to the inverse relationship of supply and price, a lower supply causes the stock price to go up.

For protection

The board of directors at companies may also elect to purchase stock to block an acquisition. An outside company (usually a competitor) or investment firm can attempt a hostile takeover. They try to do this by acquiring a 51% majority of the company. In this case, the target company will usually try to protect itself by repurchasing shares on the secondary market to prevent anyone else from reaching majority ownership. These cases are very rare but do happen from time to time.

Actionable ideas

Remember that buying a stock is buying ownership in a company, a slice of the corporate pie. Stocks are a central part of most investment portfolios, and owning them is often the main contributor to building wealth. By purchasing common stock through your brokerage account, the value of those shares will rise and fall as the company grows and shrinks. You're also entitled to receive profits from the company through dividends. 

If you work for a private company and receive stock options, other investors probably own preferred stock. It's important to realize that those investors would get paid out before you, which lowers the value of your common shares.

 

Glossary

What is Stocks?

Also known as equity, represent fractional ownership in a company. They give the investor voting rights, rights to the company's assets, and a fraction of the income earned by the company based on the number of shares.

What is Primary markets?

When the company sells shares directly to investors. This is how companies raise money, and it's often called a direct offering. Examples of primary markets include IPOs, venture capital, and private equity financing.

What is Secondary markets?

Where investors trade shares with other investors. When we buy stocks through a brokerage account, we buy them from other investors. While the company does not receive cash from these trades, it can make another direct offering in the future and raise more money if the stock price has gone up in the secondary markets.

What is Common stock?

The type of stock that's actively traded on the secondary market. They have fundamental rights to income and voting but are paid distributions after debt holders and preferred shareholders.

What is Preferred stock?

Has additional rights and priority compared to common stock; however, it isn't actively traded on the secondary market.

What is Buyback ?

When the board of directors at a company elects to repurchase shares from investors. Buying back shares increases the stock price.