Of all the financial markets, none receives as much media coverage as the stock market. Unlike bond markets, where investors are making loans to governments and firms, the stock market is where investors are able to purchase partial ownership in firms represented by shares of stock. Firms are able to raise the money they need for capital investment by issuing stock in an initial public offering (IPO). Investors purchase the stock with the expectation that it will either pay dividends or earn capital gains. Investors earn dividends when a company divides a portion of the profits among all of the owners according to the number of shares each owns. For example, if there are 100 shares of stock for a company, and the firm earns profits of $1,000,000 and decides to distribute half of the profits to its shareholders while reinvesting the other half, each share will earn a dividend of $500,000/100, or $5,000. Stock earns capital gains when it is sold at a higher price than for what it was purchased.
What are stock options?
Stock options are a type of derivative that allow for the purchase of shares of stock at a predetermined price. Companies often issue stock options to key employees as a reward for performance. The recipients can either sell their option contract on the options exchange or wait and exercise their option when the share price of the stock increases.
The majority of stock purchases and sales occur in the secondary market. When you place an order to buy stock, you are most likely buying shares that were previously owned by another individual. If Tina buys Coca-Cola stock in the market, she is buying it from someone else, not Coca-Cola. If she pays $150 for two shares of Coca-Cola stock, some other investor who sold the stock will receive $150, but Coca-Cola will receive nothing. The only time the firm receives money in a stock purchase is through an IPO or when the firm sells stock that it had repurchased earlier.
Companies issue two types of stock, common or preferred. Common stock provides investors with partial ownership of a firm and also grants them the right to vote for the firm's leadership. Preferred stock also provides an ownership claim on a firm but does not allow for voting privileges. Preferred stock is so named because preferred stockholders get paid before common stockholders when it comes time to pay dividends. The decision to issue common stock or preferred stock is influenced by the possible downsides of each. Because common stock allows shareholders a voice in corporate governance, the original founders of a firm might find themselves displaced if new common stockholders gain either a majority or plurality of the shares and elect new leadership. Because preferred stock guarantees dividends to shareholders, firms seeking to grow by reinvesting profits in the company might be hindered by this liability.