What is Stock?
A share of stock represents a part of the equity capital of a publicly held company. This means that a private company decided to allow the public to be part owners of the firm and sold shares of ownership through a stock offering. If a company has one million shares of outstanding stock, then owning one share means that you own one-millionth of that company. So why would a company "sell out" to the public?
Usually because the company has plans (and needs money) for growth and expansion, and its bankers feel that borrowing the money might create too heavy a debt burden. The company looks for "investors" to finance this growth and taps the public markets for these funds.
How does the shareholder have any voice in the process? The board of directors acts as the voice of the shareholders and conducts meetings to ensure that the interests of the shareholders are being met. Shareholders usually have the right to elect board members. Each shareholder is entitled to his or her proportionate share of all the earnings — or the profits — generated by the company. This is where the stock gets its true value. As a shareholder in that firm, you are entitled to a proportional share of this and all future years' earnings (after paying interest to the bondholders). However, these earnings may or may not be distributed to shareholders as dividends. Periodically, the board convenes to decide how much of the earnings will be paid to shareholders as dividends and how much will be retained by the company to finance future growth. This is a critical decision that reflects a careful balancing act between the present cash needs of the shareholders and the future potential of the company. For instance, had McDonald's paid out all its earnings in dividends in the early 1960s, its shareholders might well have sacrificed that company's enormous growth.
One of the advantages of owning stock is the ease of trading it. After glancing at the newspaper, you can call a broker or connect to an electronic trading account on the Internet, and instantly buy or sell most stocks listed on the organized exchanges. Note, however, that you are not buying stock from the company, but from another owner of the shares who has decided to sell. When a company first brings its shares to the market, this is an initial public offering (IPO), or "new issue." Immediately after the initial public offering, shares begin trading on the exchanges as investors call their brokers to buy or sell.
Making Money in the MarketBy now you should sense that the major factor in stock prices is the earnings potential — or profitability — of a company. The value of a company, and hence a share of its stock, is equivalent to today's assessment of the value of all future earnings paid out by that company. The stock market is an auction where prospective buyers of stock, represented by brokers, meet with the sellers of stock, represented by other brokers, to agree on the price. If a company were to announce a major advancement, one that could double the earnings of the company in the future, a seller of stock would certainly expect a higher price than before the announcement. The buyer, on the other hand, would be willing to pay a higher price. Thus, we would expect to see the price of a share of stock climb immediately after a major announcement of this sort. Conversely, if a company announces bad news, we would expect the stock price to fall.
So, the fundamental cause for stock price fluctuations is the changing projection of future earnings. In addition, all things being equal, falling interest rates cause stock prices to go up, and rising interest rates cause stock prices to fall.