This article will cover some of the core concepts underlying stock market investing including what drives stock prices, how dividends work, and more.
What is a Stock?
A stock is a piece of ownership in a company. For example, who owns Apple? There is no one person that owns Apple - there are many shareholders of Apple, regular people like you and me. While Apple is an example of a public company, you can think about stocks in the context of a private company too. Say my friends and I opened a candy store and we each own 25% of the store, we would each have a 25% share in that candy store. Think about that the same way as is you purchase one share of Apple. You would own one share of Apple as a company, only there are a lot more shares in that world than in our candy store example.
An IPO, or initial public offering, is the first time that a company becomes public and allows the public to buy shares in their company. There are a couple of reasons a company might want to go public, with the largest one being to raise capital. When a company goes public and sells their shares to the public, they get cash in return from people who buy those shares. They may want that capital/cash to invest in their business for growth initiatives, to cover expenses, or something else that requires funds.
Why do Stock Prices Move?
At the simplest level, supply and demand dictate the price of a stock. Every time you buy a stock, someone else must be willing to sell it at that price for the transaction to go through. At a deeper level, there is an embedded return that investors are expecting from that stock from the profits of the company, so the expected profitability is what underlies the stock price and valuation.
Why do Stocks Generally Rise?
They say that if you invest in the S&P 500 you should expect positive returns over the long run. The primary reason for the expectation of positive returns is that the company will continue to generate profits over the long term and pay that out to shareholders, whether it be now or long term.
What is a P/E Ratio?
The P/E ratio, or price-to-earnings ratio, is a measurement of a company's profitability (earnings) relative to its price (value). If I have a candy store that makes $10K in profit every year, that candy store should be worth more than $10K today because we are expecting to make $10K every year. Depending on what we think this candy store will do in the future, we may value the company at different P/E’s. We may be willing to pay 3 or 4 times earnings for that candy store in one situation, or a lot more if we think it will grow nationally in the next couple of years. The more a company is expected to grow, the higher the price-to-earnings multiple will be, which is why big tech companies like Amazon and Google are valued at many times earnings.
What is a Dividend?
As we alluded to earlier, dividends are payments from a company to its shareholders. In general, if a company is generating profits they can choose to invest that money back into their business, pay it out to shareholders, or most commonly, a combination of both of those. To calculate the dividend yield of a company you can divide the annualized dividend by the stock price. If the company is worth $100 and it pays $1 per quarter, then the dividend yield is 4% (4/100).
As mentioned above the company can use its profits to pay investors or invest in the business. The dividend ratio is the ratio of profits (earnings) that a company pays out in the form of dividends. Say the company made $10 per share and paid out $2 per share in dividends, then the dividend payout ratio would be 20%.