What are stocks?
A stock is a share of ownership in a company. Stocks are also referred to as "shares" (popular in Europe) or "equities". Ownership of stock in a company gives you certain rights. Among others, you have a right to a portion of the profits which are paid as dividends to shareholders. You have the right to go to shareholder meetings and can vote on issues.
You also have the right to your share of the value of liquidated assets if the company files for bankruptcy and its assets are auctioned off. However, the common stockholders don't get paid until all the other creditors get paid, including bondholders and preferred stock holders. As a beginning or intermediate investor you shouldn't be investing in bankrupt companies or companies looking like they may be bankrupt soon. Investing in bankrupt companies is a very specialized area, which is best left to people who have a very deep knowledge of bankruptcy proceedings.
Why do companies issue stock?
Most companies issue stock in order to raise funds to meet the long-term capital needs of their business. Many times it can be because the company has strong growth prospects but can't fund their growth just through internal profits.
When a company decides it wants to raise money, it has to decide whether to do so by issuing stocks or borrowing money. From the company's perspective, the advantage of issuing stock is that the company is bringing in money that they don't have to pay back. The downside is that other people now own part of the company and have a right to vote on issues regarding the company. Another downside is that the company has to make its financials public information which may help the competition.
The company also has the option of borrowing money by issuing bonds or taking out a bank loan. The advantage of borrowing money is that the company gets to keep 100% ownership of the company so it retains all profits and has complete control. The downside is that they have to pay back any money that is borrowed, plus interest. Having to make debt payments each month will lower the profits of the company as long as the debt is outstanding as well as possibly raise the risk that the company may fail due having to meet higher expenses.
Why do people buy stocks?
People buy stocks for the obvious reason of making money. Profits from stock ownership are derived from two sources. The first is the dividends that the company pays out to shareholders. Not all companies pay out dividends and sometimes the dividends that are payed out are very small. The second source of profits is from the appreciation of the stock price, which is referred to as a capital gain.
More specifically, people invest in stocks because stocks have historically offered a higher rate of return than other types of assets. Since the 1920's, stocks have returned around 10% to 12% per year for the while the returns for bonds and T-bills have have been in the 4% to 6% range.
At first glance, the differences in the rates of return between stocks and less-risky investments may not look substantial but the power of compounding can greatly magnify these differences over time.
How are stocks valued?
Generally speaking, the value of a stock is based on the information released by the company as well as broader information regarding the industry and economy as a whole. But because the value is not just based on objective facts but also subjective interpretation of the facts, the value of stocks is also affected by the mood of investors (commonly referred to as "investor sentiment").
Measuring the market with stock indexes
Investors measure the market by looking at a "stock index". A stock index is a collection of stocks with similar characteristics that is designed to represent a particular group, or subgroup, of stocks. Stock indexes are created published by different organizations - sometimes stock exchanges or brokerage firms. An index may be based on some or all of the stocks in the index.
When a stock index is created, it starts at an arbitrary number - many times 100 - and then is adjusted proportionally going forward. Some indexes are very new - especially some of the industry indexes. Occasionally, stocks are added or dropped from an index for different reasons - like if a company gets bought out or goes bankrupt. Adjustments to an index are also made to make sure the index accurately represents the market it is tracking. A stock will typically jump a little when it is announced that it will be added to a popular index.
How a stock index is calculated can influence the value of the index. Some indexes are "equal weighted", which means that each stock in the index has the same amount of weight as other all other stocks in the index. A "price-weighted" index means that a stock with a higher price has more weight than a stock with a lower price. In other words, a stock selling for $100 per share has twice the weight as a stock priced at $50 per share. Price-weighted indexes are criticized for having arbitrary weightings because the price per share of a stock, by itself, doesn't tell you anything about the company or stock (most of the time). Similarly, a stock shouldn't have it's weight cut in half just because it has a 2-for-1 stock split. The Dow Jones is a price-weighted index. A "cap-weighted index" means that the weighting of each stock is based on the capitalization of the company. This means a movement of a larger company will have a greater influence on the index than the movement of a smaller company. The S&P 500 and the Nasdaq index are a cap-weighted indexes.