The stock market is a complicated entity to understand. We’re bombarded with information about stocks, and the ebbs and flows of the trading day, but some people might have a hard time understanding the basics.
You may have read about Snapchat opening up an IPO, and wondered what an IPO is, and why they are important?
My goal here is to break down the basics of the stock market – the stuff you need to know if you want to impress your friends at dinner one night.
Get ready for Stock Market 101, and buckle in.
Disclaimer: This post will by no means make you a stock market expert. If you’re looking for trading tips and advice, I suggest you consult someone who does that for a living.
Dow Jones Industrial Average, Nasdaq Composite and the S&P 500
These are the three bigwigs that make up the New York Stock Exchange (the place where most of the trading goes down). Each of these is called a “stock market index,” which is just a fancy way of saying that they’re methods used to measure a section of the stock market.
The Dow Jones Industrial Average is an index that measures the stock trading of 30 different blue-chip companies, ranging from American Express to Walt Disney. Implemented in 1896, it’s probably the most-watched stock index in the United States.
The Nasdaq Composite is also closely watched for other reasons. Its more than 3,000 components consist primarily of technology companies and growth companies, but it also holds components of companies not in the United States.
The third horse in this race is the S&P 500. The S&P first came on to the scene in 1923, and the 500 stands for the number of companies that have their stock included in this index.
What Is a Stock, Anyway?
Stocks are pretty simple. Investors buy stock for a particular company because they feel that the particular company’s valuation will increase. You invest in the stock, sit on it and watch it appreciate (go up in value) – or depreciate and go down.
There are two types of stocks: common stocks and preferred stocks. Common stock is what most people think of when they think of stock. You buy shares in the company (it could be one share or 1,000) – and you watch the value go up or down. The goal is to buy low and sell high. Depending on the investment policies of the company, they may or may not give money back to the shareholders in the form of a dividend.
Preferred stocks are a combination of a traditional stock and the bond (more on bonds later!). The price doesn’t change as much as regular stocks, and there’s always a dividend. Common stockholders get the right to vote on certain matters, while preferred stockholders do not.
Shares and Stock Valuation
Whether the stock is common or preferred, publicly traded companies are sold in shares. When you buy stock in Alphabet (parent company of Google) or Snapchat or Hershey’s, you buy a small piece of the company, a share. The actual percentage of the company that’s represented by each share depends on how many shares are available for trading as well as the terms for shares that aren’t publicly available. These latter types of shares are typically reserved for company executives and early investors.
Stock valuation is a term for figuring out how much a stock is worth. Part of that is based on share price, but it goes beyond that. We’ll get into some of this later on, but for now, what causes stock prices to move?
What Causes Stock Market Fluctuations?
The basics of stock prices fall under the principles of supply and demand. If more people want to buy a stock (the demand is high) than how much stock is available to trade (supply is low), the price of that stock moves up. On the other hand, if people don’t want to buy a stock (low demand), and there is a surplus of said stock (high supply), the price of that stock will be low.
After that, it gets a little more complicated. There’s also a global economic element to this.
“It’s a Small World” may be a Disney song, but it becomes truer every day in business. The big corporations listed on the stock market tend to have investments all over the globe. Imagine something happens – anything from an oil spill to the election of an unexpected politician. Whatever it is, if it causes a big enough shock over a big enough area, it may cause people to take their money out of stocks and put it back into bonds, which are considered safer assets due to guaranteed returns.
While that tends to be good for mortgage rates, it’s not good for your stock portfolio.
Making things even more complicated is the fact that you can’t value a company on the share price alone. Let’s dig in just a little deeper.
Dividends, Dividend Yield and Market Capitalization
Dividends are the payments made by a corporation to its shareholders, and are based off of the company’s profits. If a company does well, the shareholders’ dividends increase. If a company is doing poorly, the shareholders’ dividends would decrease, and the holder would probably consider selling them off.
Market capitalization is simply the price of individual stock of a particular company multiplied by the number of shares being traded.
So if a company’s share is worth $100, and there are 50 million shares being traded, the company’s market capitalization would be $5 billion. If a company’s share is worth $50, but there are 150 million shares being traded, that company’s market capitalization would be $7.5 billion.
That’s why you cannot value a company based solely off of the price of their stocks.
Also, from an investing standpoint, you should be wary of investing in stocks simply because they’re trading at a high dollar value. You want to take a look at what is called the “dividend yield,” which is how much a company pays out in dividends each year divided by its share price.
To get the basics on dividend yields, let’s do a quick example. Let’s say Sabre is trading for $20 a share, and Dunder Mifflin is trading for $40 a share. If both companies pay out a dividend of $1 per share a year and you have the money to buy into one or the other, which company would you invest in based off of the dividend yield?
If you said Sabre, you’re right. Sabre would be yielding at 5%, while Dunder Mifflin would be yielding at 2.5%.
Initial Public Offering (IPO)
Snapchat is a perfect example to explain what an initial public offering is, simply because they just issued their IPO recently. It has dominated headlines and is probably the most anticipated public offering since Facebook, a fellow competitor in the social media space.
An IPO is the first sale of stock from a private company looking to be publicly traded. IPOs are usually used to raise capital to expand in some way, shape or form, by getting investors to invest cash into a business for a hopeful large return later on.
Companies go public for a variety of reasons. It enables them to raise a sizable wad of cash in order to carry out future plans for expansion and continued operations. It also allows the founders and initial investors to begin to reap the rewards of their hard work by making some of their own stock publicly available.
Bonds and Treasury Bills
Bonds and treasury bills (or T-bills) are similar and different at the same time. Although they aren’t stocks, if you’re going to participate in the market, it probably helps to understand how they work. Both bonds and treasury bills involve an upfront investment with the understanding that a fixed interest rate will give you a solid return on the investment – but how long it takes for you to get that return and how the return is calculated differs between the two.
Bonds offer a fixed rate of interest over a fixed period of time. You don’t get as much of a return on your investment as you would if you were to invest in the stock market, but since it’s a fixed rate, volatility is a non-issue.
T-Bills are bought for a shorter period of a time and are always bought back less than a year later. T-Bills are also only available in denominations of $1,000 and have a maximum purchase of $5 million. They are purchased from an auction setting, and your return value is calculated by the difference between the discounted value you paid for the T-bill and the amount you receive back.
Hypothetically, if you invested $9,000 in a 13-week T-bill, you would be getting a letter from the U.S. Government saying “Hey, pal. Thanks for purchasing this T-bill. In 13 weeks, with our 2.04% interest rate, we’re going to cut you a check for $9,183 for your trouble.” As a result, you just made $183 on your investment for letting the government borrow $9,000 for 13 weeks.
Overwhelmed yet? If, on the other hand, what you’re feeling is closer to excitement than exhaustion, you might want to figure out how to get started investing.