The American stock market has been surging. Many Americans who have never owned a stock are getting interested, and it’s easy to get swept up in tips from friends or social media.
If you’re new to investing, this is a good time to step back and understand what the stock market actually is. This three-part weekly series is for you.
The series starts with the basics of stocks and the stock market. Part 2 focuses on the psychology of the market, and Part 3 on a practical approach for everyday investors to build wealth.
The stock market is a vast and fascinating topic, so the three posts will focus on the broad ideas that matter most.
In all three parts, I’ll use a question-and-answer format to walk you through everything step by step.
What is a stock?
A stock — also called a share — means you own a piece of a company.
Suppose we start a business together. We fund it ourselves, using our savings and possibly a bank loan, to get it off the ground.
Eventually, we need more money than we can raise ourselves. So we look for another option: bringing in outside investors and selling them a part of the business.
Let’s say we divide our business into 1,000 equal ownership parts. Each part is called a share. We keep some shares for ourselves and sell the rest to investors.
Anyone who buys one share owns one-thousandth of the business, a small slice, but real ownership.
Owning a share also usually gives you a vote in major company decisions, such as who sits on the board of directors or whether to approve a big merger. In practice, small investors hold so few shares that their vote rarely changes anything. But the principle matters: shareholders have a say.
The money raised goes into growing the business. And in return, shareholders gain or lose along with the business.
What is a stock market?
Over time, we may want to sell our shares, perhaps because we need cash or want to invest elsewhere.
The stock market is simply the place, now mostly digital, where existing shares are bought and sold and where companies offer new shares to raise money.
What are the risks and rewards?
Most businesses exist to make profits. And since shareholders own the business, those profits ultimately belong to them in proportion to their ownership.
If the business does well, shareholders do well. If it struggles, shareholders share in that loss. That’s what makes stocks risky.
In everyday language, “risk” sounds purely negative. In investing, it simply means uncertainty — you don’t know whether your stock will go up or down, or by how much.
To understand why anyone would accept that uncertainty, it helps to think about the safest alternative: a short-term government bond. Think of it as a loan you make to the government. They pay you a fixed interest rate and return your money at the end.
Since the American government is unlikely to go broke, its short-term bonds are essentially risk-free.
If government bonds are so safe, why take the risk of buying stocks?
Investors take on more risk because they expect a chance at a better return. You wouldn’t accept the uncertainty of stocks if they were likely to earn you the same as a government bond, or less.
That brings us to one of the most fundamental ideas in investing: greater risk must come with the possibility of greater reward. If it didn’t, why bother?
That said, risk doesn’t guarantee a higher reward. It just means there’s a chance of one.
What is a return?
Return is your gain or loss, typically stated as a percentage of what you put in. Put $100 in a bond that pays $5 a year, and your return is 5%. The same logic applies to stocks, though the number is less predictable.
If profits belong to shareholders, why haven’t I received any?
Because the company is most likely reinvesting those profits rather than paying them out, and in many cases, you are better off for it.
There are three ways companies use their profits:
Reinvestment: putting profits back into the business, such as opening new stores, building factories, launching new products, or investing in technology.
Dividends: direct cash payments to shareholders, typically made quarterly.
Share Buybacks: the company purchases its own shares on the open market and cancels them. With fewer shares dividing the same business, each remaining share represents a slightly larger slice, which tends to push the stock price higher.
Many companies prefer buybacks to dividends because dividends, which are paid at regular intervals, create expectations. If the company cuts dividends, investors often see it as a sign of trouble. Buybacks carry no such obligation; the company can do them when cash is available and pause when it isn’t.
Buybacks can also be more tax-efficient for shareholders, since the benefit arrives as a rising stock price rather than cash, which shareholders would owe tax on right away.
Does a company always handle profits the same way throughout its life?
A company’s approach to profits evolves. Initially, as it spends heavily to establish itself, there may be no profits to distribute.
As the company grows and starts generating profits, reinvestment is the priority, and dividends are rare. A broader group of shareholders enters at this stage, attracted by the company’s track record and growth potential.
As the company matures and growth slows, it attracts more conservative investors who prefer stability and dividends to explosive growth. This is typically when the company has run out of highly profitable ways to reinvest its cash and begins returning more of it to shareholders through dividends paid directly and buybacks that raise the stock price.
But how do shareholders benefit if the company keeps reinvesting?
Even if you never see a dividend, you can still benefit through the rise in the stock’s price itself.
As a company grows and becomes more profitable, it becomes more valuable, which drives its stock price higher. This is the primary way most investors in growing companies make money.
If that’s the case, are stock prices based on the business’s earnings?
In theory, yes. Earnings — what investors call profits — are at the heart of how stocks are valued.
Imagine our business earns $1,000 in profit this year. With 1,000 shares, that works out to $1 of earnings per share.
Now suppose someone offers to buy a share for $10. That means the buyer is paying 10 times the company’s annual earnings per share, a ratio investors call the price-to-earnings ratio (P/E), in this case 10.
One simple way to think about that price is this: if earnings stayed the same every year and all profits were paid out as dividends, the buyer would get their $10 back in roughly ten years, and every dollar after that would be profit.
The example is simplified — earnings can grow or shrink — but the underlying idea holds: what you are buying is the stream of earnings the business will generate over its lifetime, plus whatever the business might be worth if it were ever sold or acquired.
Crucially, a dollar of those future earnings, say ten years from now, is worth less today than a dollar in hand, because every dollar tied up in a stock is not earning interest in a bank. The further out an expected dollar of profit is, the less an investor is willing to pay for it today.
Does that mean a stock’s value depends on when its earnings are expected to arrive?
Very much so. That said, a company whose best earnings are still years away is inherently harder to value than one generating strong profits today.
Even after careful research, unforeseen factors may cause future earnings to fall far short of expectations. And the further out those earnings are, the greater the uncertainty.
Two investors can therefore look at the same company and come to very different conclusions about whether the expected growth justifies today’s price.
Nonetheless, investors are often willing to pay a premium today for a company they believe will grow strongly in the future, even though those higher earnings have not yet arrived.
If earnings expectations are so central to valuation, should I solely rely on the earnings numbers a company reports?
Not entirely, and any gap isn’t necessarily dishonesty-related. Companies calculate earnings according to accounting rules, which differ from how most of us think about profit in everyday life.
For instance, a company may record a sale as revenue before the customer has actually paid, which increases reported earnings even though no cash has arrived yet.
Or let’s say our business uses a chunk of the cash we raised to buy a $1 million machine. Rather than recording the full cost upfront, accounting rules spread it over the machine’s useful life, say, $100,000 a year for ten years. In computing our annual earnings, we record only $100,000 in costs this year. That makes our reported profit for that first year look higher than it would if we had counted the full million as a cost, even though the cash is already gone.
Over the long run, many of these timing differences between earnings and cash flows tend to even out. But in any given year, the gap between reported earnings and actual cash on hand can be significant.
Accordingly, many investors track the cash a business generates after covering what it needs to keep running. Accounting rules shape reported earnings. As for cash, it either came in or it didn’t.
How does a rising or falling share price affect the company?
The money in stock trades flows between buyers and sellers, not to the company. The company receives cash only when it issues new shares.
That said, the stock price matters to the company in important ways. A higher stock price makes raising new money cheaper.
Example: Suppose a company wants to raise $100 million by issuing new shares.
- Scenario A: If its stock trades at $50 per share, it only needs to issue 2 million new shares.
- Scenario B: If the stock trades at $25, it must issue 4 million shares to raise the same amount of money.
Existing shareholders’ ownership is diluted much more in the second case; their ownership is spread across more shares.
Companies also use their shares as currency in acquisitions, so a higher price makes those deals more favorable. And since many employees receive part of their pay in stock, a rising price helps attract and keep talent.
A falling price works in reverse, and in some cases, a significantly depressed price can make it easier for another company or investor to take control of the business.
So what does it actually mean to own a stock?
Legally, you own a proportional share of the company, with the rights and risks that come with it.
But there is a more personal question worth asking: what does ownership mean to you?
For some people, a stock is simply a number on a screen that they hope will go up. They are not especially interested in the business itself: its products, its people, or its direction. They want a return, and that is understandable.
For others, ownership means something more. However small their stake, they think of themselves as genuine part-owners, curious about what the company does, attentive to how it is run, and invested in where it is headed.
Most people fall somewhere between these two viewpoints, and where we sit on that spectrum shapes both how well we understand what we own and how we behave as investors.
That’s a thread we’ll pick up in Part 2, where we look at who is buying and selling in the market, what drives their decisions, and why stock prices so often move in ways that seem disconnected from the underlying business.
