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What’s it: Stock is the ownership certificates of a company. When you buy stocks of a company, you own the company’s shares and are entitled to the assets and income of the company.
Stock is also known as share or equity. Specifically, the term stock is used to refer to a collection of shares in American English.
Furthermore, the terms stockholder and shareholder are often used interchangeably. Both are the same thing, which describes the parties who have shares in a company. They can buy company shares on the stock exchange or through non-public offers such as private placements.
Are stock transactions public?
Stock offerings through the stock exchange are more common than non-public offers. Stock trading on the stock exchange is more transparent and more liquid. You can observe the market price for a company’s shares and company financial statements more easily. Stock trading transactions are also active, making it more liquid. You can trade, for example, on the four largest world stock exchanges such as the New York Stock Exchange, Nasdaq, Shanghai Stock Exchange, and the Hong Kong Stock Exchange.
Companies issue their shares on the stock exchange to raise capital. We call them public companies or listed companies. Strict rules require them to be more open in corporate governance and policy. They routinely release financial reports, annual reports, press releases, and public exposures. All that makes it easy for investors to make decisions about the company.
Conversely, it is difficult to make decisions about private companies. That’s because access to company information is limited. The company is not required by the supervisory authority to publish financial statements and other relevant information. Therefore, it is challenging to determine the fair value of a company’s stock price.
Typically, transactions of shares of private companies are usually carried out by institutional investors through non-public offers, such as private placements. They are illiquid and require negotiation between investors. There is no active secondary market for these transactions. Therefore, shares do not have a quoted market price.
Why do companies issue shares?
Two common ways companies collect funds, namely issuing debt (such as bonds) and shares. Companies can use these funds to finance operations, for example, to build production facilities, make acquisitions, or develop distribution channels.
Issuing shares reduce corporate leverage. The company record the issuance in equity accounts. Shareholders have residual claims on company assets after all liabilities have been paid. Investors who buy equity securities are attracted to capital appreciation and dividend income. They usually focus on the long-term performance of the company.
On the other hand, issuing debt raises liabilities for the company. Therefore, the company is contractually obliged to make regular payments to its creditors. Investors who buy debt securities are primarily interested in interest income. Consequently, they are more focused on the company’s cash flow.
What are the two types of stocks?
Two main types of stock are:
- Common stock (or ordinary share)
- Preferred stock (or preferred share)
The company can issue various classes of ordinary shares. Each has different voting rights. Furthermore, these various classes of shares may be entitled to various claims on the company’s net assets in the event of a liquidation.
Ordinary shares usually give their owners the right to vote at a shareholder meeting. They are also entitled to receive dividends paid by companies.
However, ordinary shareholders receive dividends after they are distributed to preferred shareholders. Also, they have a lower asset and income claims than preferred shareholders. On the negative side, preferred stock does not have voting rights unless explicitly permitted at the time of issuance.
What constitutes risk and return in the stock market?
When you buy shares on the stock exchange, two sources of your income:
- Capital gain from price appreciation
- Dividend income
Capital income
The stock market is likely to increase in value from time to time. In Indonesia, for example, the Jakarta composite index has risen 149.5%, from 2,534.36 at the end of 2009 to 6,323.47 at the end of 2019. However, the price of each share might go up and down every day. When you buy a stock, you will get a capital gain when the price goes up.
Capital gain refers to a positive difference between the selling price and the purchase price. For example, you bought a stock at Rp100. Now, the company’s share price rises to Rp120. So, when you sell it, you get a gain of Rp20 per share. Conversely, the stock price fall to Rp90, and you sell it, you suffers a capital loss of Rp10.
To reduce the risk of falling prices, you need to be careful when choosing stocks. Most investors like blue-chip or companies with stable revenue streams such as utilities. These stocks usually produce profits for investors because their prices tend to increase from time to time.
Some investors also like stocks that regularly pay dividends. Dividend income reduces the risk of volatility from share price movements.
Furthermore, diversification helps to avoid unfavorable movements of a stock. They allocate investments in many different shares. Thus, when one share price falls, it is likely still to be compensated for the increase in other shares.
Dividend income
Dividends are part of the profits that the company distributes to its shareholders. It can be cash, stock dividend, or a combination of the two. Dividends are a potential source of stock investment besides capital gain. The company may still pay dividends even though the stock has lost its value.
However, not all companies pay dividends. Some companies do not distribute it for reasons of company policy or poor financial performance.
The company opts not to pay dividends because it wants to reinvest it. By not sharing it, the company has more capital to take advantage of growth opportunities. That way, the business can grow bigger and be profitable in the future. Usually, companies in the growth stage do it.
On the other hand, companies in the mature stage may not have opportunities for profitable growth in the future. Thus, they distribute profits to investors in the form of dividends or through share repurchases.
Poor financial performance is another reason companies don’t pay dividends. For example, they are unable to compete with competitors, thus posting a loss. That forced them to streamline business operations. Even worse, the company’s stock price has fallen sharply. So, not only do you not get dividends, but you also lose money when selling shares.
Translation risk
The translation effect arises because of changes in exchange rates between your domestic currency and foreign currencies. That happens when you, for example, buy shares abroad. You must convert your local currency with a foreign currency in a stock transaction. Therefore, the value of your investment will also be affected by the exchange rate, not just the movement of the stock price.
Exchange rate movements may provide negative or positive exposure. When the domestic currency appreciates (depreciating foreign currencies), you incur a foreign exchange loss. The reverse effect applies if the local currency depreciates .
For a simple example, let’s say you bought company shares in the United States for $10 per share at an exchange rate of Rp2/USD. To purchase these shares, you spent Rp20.
Now, the share price is unchanged, but the exchange rate appreciates Rp1/USD. When selling the share, you still get $10. But, if you convert into domestic currency, you only get Rp10. Conversely, when the local currency exchange rate depreciates to Rp3, the sale of shares will generate as much as Rp30.
Varies by type of stock
Risks and returns vary between types of stocks. Preferred shares are less risky than ordinary shares. When you buy preferred shares, you are entitled to receive dividends before ordinary shareholders. Nominal dividends can also be known and fixed, thereby reducing uncertainty about future cash flows. Also, in the case of liquidation, you are entitled to the company’s assets before ordinary shareholders receive them.
Ordinary shareholders, indeed, offer potential significant returns from future capital gains and dividends. However, that is uncertain. Therefore, they are riskier.
What are the advantages and disadvantages of stocks?
In the long run, stocks offer higher returns than other investments, such as bonds. However, it also comes with a high risk. Individually, share prices may fall, and companies do not pay dividends. And, of course, you will lose money. Therefore, you should be selective in choosing stocks.
Investment diversification
For investors, the stock market provides diversified investment allocations. Its performance is relatively unaffected by the performance of other asset classes such as bonds and real estate. Holding shares can help you deal with losses on different investment products. You can expect stock prices to rise when the performance of other assets is negative.
However, the positive performance of shares does not apply to all conditions and individual stocks. Systematic risks can arise and result in the collapse of prices of all shares in the market. In this condition, the only way to secure investment is to hold safe-haven assets such as gold and safe-haven currencies.
Offer voting rights
Buying shares means taking ownership of shares in the company. You can vote on company board members and other critical business decisions. Of course, your voting significance depends on how much percentage of the shares you own.
When you own a majority of shares, the strength of your voice increases, so you can indirectly control the direction of the company. And, you can appoint a board of directors.
Difference between stock and bond
Stock represents ownership, while bonds represent liabilities. The issuance of shares increases the company’s capital. By issuing stock, the company obtained funds to grow a business or undertake new projects. In the financial statements, shares are listed in the equity section.
Meanwhile, the company recorded bonds as liabilities. By buying bonds, investors are the company’s creditors. They are entitled to interest and principal repayment.
Companies must pay coupons and principal, regardless of the company’s financial condition. That contrasts with stocks, where companies opt not to pay dividends when financial performance is deteriorating. In contrast, When not paying coupons or principal, the company fails to pay.
Bondholders can force companies to go bankrupt if the company fails to pay its obligation. When assets are liquidated and sold, they are entitled to payments before shareholders receive them. Shareholders are in the last line if bankruptcy occurs.
What to read next
- Stock: Types, Risk, Return, Advantages, and Disadvantages
- Common Stock: How it Works, Types, Features, Advantages, and Disadvantages
- Preferred Stock: Meaning, Characteristics, Pros and Cons
- Stock Dividend: Definition and Brief Explanation
