In this Question of the Week, Matt Horsley explains what a stock is and how it is issued and traded.
I’m Matt Horsley, CERTIFIED FINANCIAL PLANNER™ with Pure Financial Advisors, and this is your Question of the Week.
The question is: what is a stock and how does a stock work? Let’s first go back to how companies raise capital. They can raise capital one of two ways: they can either issue bonds, which is essentially taking loans out from individual investors, or they can issue stock. And essentially by issuing stock what a company is doing is they’re giving up ownership, an ownership stake in their firm, in exchange for investors sharing the future profitability of that firm.
So if you think about it this way, let’s say I was a small corporation just a startup firm, maybe I’ve started up a restaurant, and I wanted to raise money via issuing stock. So let’s say if I wanted to raise a half a million dollars to build my restaurant, I may have to give up 30, 40, 50% of my ownership stake in the firm for someone to invest that money with me because it’s such a risky venture.
Now, let’s take a company like Microsoft or Caterpillar, or Coca-Cola, if they wanted to raise a half a million dollars for investors, they would have to give up a very very small ownership percentage in that firm because they have such a long history of profitability, and, the expectations of large future growth and profitability in the future as well.
So once a stock is initially issued, then it’s traded on public exchanges. And then, the stock during the course of a trading day quite frankly, is worth whatever investors are willing to pay for it. It’s all supply and demand that dictates the price of a stock, once it’s initially offered to the public. That’s how a stock works.
I’m Matt Horsley, that’s your Question of the Week.