In order to understand what a stock is, it is first important to understand why a company would issue stock in the first place.
As an example, let’s say that you own a coin laundry company, and over the last several years you have built your company from a one-man operation, to the most popular service in your city with 100’s of location and 100 employees. Now that you have gone through the process in one city, you feel you can can easily expand operations into additional cities, and would like to put a significant amount of money towards quickly expanding your operations. There are several ways that this could be done:
1. You could use your own money. The benefit of doing things this way is that you maintain 100% ownership and control of your company. The disadvantage of doing this is that you take 100% of the risk, and this is money that you won’t have in your savings or to buy other things.
2. The company could borrow the money by going to the local bank or issuing debt (something known as bonds). The advantages of doing this is that you maintain 100% ownership and control of your company, so long as the terms that you have agreed to in order to borrow the money continue to be met. The disadvantage of this route is that you have to pay back the loan with interest, and if you are not able to meet your payments, then the bank that lent you the money or the holders of the bonds that were issued will take control of your company.
From the public’s perspective we will buy a company’s bond’s for the advantage of receiving a fixed payment for the life of the bond on the money that we lend the company, so long as the company stays in business. The downside for us of owning a bond, is that the company may go bankrupt, in which case we may not get back the money we have lent the company plus the interest payments we are owed on the bond. Secondly here, is the fact that the interest payments remain fixed regardless of how well the company does, so bondholders do not get to participate in the upside growth of the company.
3. You could issue stock. This is what is known as going public and where the term IPO which is short for initial public offering comes from. Unlike getting a loan from a bank or issuing debt in the form of bonds, when a company issues stock, they are selling off a part of the company to the public. The advantage of issuing stocks is this allows the company to raise capital without having to pay the money back. The disadvantage of issuing stock is that you give up partial, or in some cases full ownership control of the company. This basically means that you have to divvy up your profits with the people who bought stock in your company, who are referred to as your shareholders. The shareholders of the company also have a say in how the company is run, which can vary from minor to major, depending on how much of the company is sold through a public offering.
From the public’s perspective, we will buy a company’s stock in the hopes that the company will do well, and that we as shareholders will get to participate in the upside growth of the company through increases in the price of the stock that we own, and payouts of the firms profits through something called dividends. The downside of owning a company’s stock is that the profit that you will earn from the stock is not fixed and guaranteed so long as the company stays in business like it is with bonds, and just as the price of your stock will go up if the company does well it will go down if the company does poorly. Lastly here, is the fact that in the event of a bankruptcy of the company, the stockholders are the last people in line to be paid, behind the bond holders and others that have loans out to the company.
So a stock is very simply representative of a small piece of ownership in the company whose stock you are buying.