Stock Market Basics

What is a corporation?

A corporation is a legal entity that is separate from its owners. Corporations are owned by shareholders. The shareholders have a legal claim on the corporation’s assets and profits, but are not personally liable for the company’s debts or actions.

It means that corporations make it easy for businesses to raise money from investors, and they also offer legal protection to the investors in case business gets sued or goes bankrupt.

What is a stock?

A stock is also called “equity” or “shares”. A stock or equity is a financial security that represents the ownership of a fraction of a corporation.

A very common way for a corporation to raise money is selling stock. Owning stock means that you own a piece of a real business. You become an owner of a real company who hires people, produces goods or delivers services, a business that expands and grows.

What it means is that the shareholders have a claim on a portion of the company’s assets and profits.  Shareholders also get to vote on how the business is managed.

Stocks are a simple tool for investors to identify how much of the corporation they own. In order to find it out, the shareholders divide the number of shares that they own, by the total number of shares.

Let’s make up a business called Best Coffee Shop owned by Natalie, Ethan and Lauren. They decide to turn it into a corporation and sell stock in the new business for $1 per share.

Let’s say that Natalie contributed 60% of the funding and owns 60% equity in the company. If there are 10,000 shares, she owns 6,000 of them. Ethan contributed 30% of the funding, he owns 30% equity in the company and 3,000 shares. Lauren contributed 10%, therefore she owns 10% of equity in the company and 1,000 shares.

Why do stocks have value?

If a company is successful and makes profit, the owners of the business equity can claim the profits and pay them out as dividends.

Imagine that Best Coffee Company is successful and it makes $5,000 in profit during its first year. Natalie, Ethan, and Lauren make a decision to pay the $5,000 in earnings to themselves. They would be paying themselves a dividend which is a portion of the company’s profits.

Since each of the owners own a different percentage of the company’s equity, in order to find out how much of that $5,000 should go to each of them, we need to divide the total dividend payment by the total number of shares.

This means that Natalie would receive a $3,000 payment, Ethan would receive a $1,500 payment and Lauren would receive a $500 payment.

Just think about the fact that Best Coffee Shop made $5,000 in earnings after one year and it pays out $0.50 per share of stock they own in dividends.

Does it make you interested in owning a portion of the company? Probably yes, and it means that the shares have value.

When you own shares, you have a legal claim on a piece of a company’s assets and profits. If the company makes money, that money belongs to the shareholders. Not always profits are paid out to shareholders in the form of dividends. It’s very common for the company’s management to keep the profits within the company and use them to pay off debt, buy equipment or invest in hiring new employees.

What is the stock market?

A stock market is a place where businesses and investors can connect with others to buy and sell stocks. You simply trade your money for shares of the business.

Publicly held businesses enter the stock market by issuing shares, which later on are being exchanged between investors.

The largest stock market in the world was founded in 1972 in New York City at the very famous Wall Street, which is called the New York Stock Exchange (NYSE).

Other world-renowned stock markets to mention are: Hong Kong Stock Exchange, London Stock Exchange, Tokyo Stock Exchange, and NASDAQ.

Stock market indexes

Now, let’s look at some of the common stock market indexes. An index is a group of stocks that are combined to figure out whether the stock market as a whole is going up or down, which helps track the performance of the stock market.

• Dow Jones Industrial Average

Dow Jones is a stock market index invented by Charles Dow and Edward Jones in 1896. The idea was to add up the share price of 12 of the most popular and biggest publicly traded companies at the time. Then the total amount was divided by 12.

The result was supposed to be a proxy for what was going on with the stock market that day.

In 1928 the Dow Jones expanded to include 30 companies, and every couple of years some of the declining companies are removed and replaced by businesses which are growing and becoming popular.

Dow Jones is a price-weighted index, which means that each stock is weighted by the current share price. Stocks with higher share price have more influence over the index than stocks with a lower share price. The dollar price of each stock is what matters, not the actual size of the business.

• S&P 500

Standard Statistics Company created a new stock market index in 1923, but then, merged with Poor’s Publishing to create the Standard & Poor’s (S&P) company, thus S&P 500. In 1957, it was already competing with Dow Jones by increasing the number of tracked companies from 233 to 500.

S&P enabled larger businesses to have more influence over index’s movements than smaller businesses. S&P 500 would judge the size of each business by using its market capitalization, meaning, the total dollar market value of a company’s equity.

To find market capitalization you need to multiply the total number of a company’s shares by the current market price of one share.

S&P 500 is a capitalization-weighted index, meaning that each stock is weighted by its current market capitalization, so bigger companies have more influence from the small ones.

• NASDAQ

The National Association of Securities Dealers (NASD) created a brand-new stock exchange in 1971 which allowed investors to buy and sell stocks on computers that were connected to each other. The new stock market was called the National Association of Securities Dealers Automated Quotations —in short NASDAQ.

It provided many advantages over other stock exchanges since all the buying and selling was completed on computers with accurate prices visible and accessible for all investors in real time.

The NASDAQ stock exchange also created an index that tracked the price movements of all companies that were listed on the exchange, which was called NASDAQ Composite Index.

NASDAQ Composite Index is a capitalization-weighted index just like S&P 500. Meaning that larger companies have a bigger influence over the movement of the NASDAQ Composite Index than smaller companies.

Stock Market 101 is a series of videos and articles meant to help you take first steps in investing with understanding and clarity. Read the next part to know why companies go public.