Stock certificates are more than just pieces of paper that people trade back and forth speculating on their value and hoping to strike it rich. In fact it has been some time since there was any actual paper stock certificate printed. Anymore owning a share amounts to having your name in a database registering you as the owner. Owning a share of a company’s stock means that you are the proud fractional owner of the company. If the company does well and acquires more assets and generates more profits then the share will be worth more. If the company falters then the share will be worth less.
In a sane world the intrinsic value of a company would be: assets – liabilities + revenue – expenses. Those four factors would directly set the price. In a less sane world some speculation is applied to future earnings which is factored into the price. This is how we end up with a stock trading at 120 times EPS (Earning Per Share). In the short term this speculation is a popularity game. The price will rise and fall at the whim of the masses. In the long term the speculation washes out and the intrinsic value of a company shines through in its stock price.
Some companies pay out quarterly dividends to their share holders. This is the company taking their profits and distributing them to their owners, the stock holders. Some companies choose not to pay a dividend fancying themselves as being a growth company and capable of generating more value for their shareholders by re-investing the money that would have been used to pay the dividend into growing the company. I generally find this stance very circumspect. Cash in hand is hard to argue with. Future profit due to the value of the company increasing and being reflected in the value of the stock because management did such a good job plowing money back into the business that the gain in share price exceeds what the share price plus dividends would have been is something of a gamble.
So why own stock? After all if you have an excess of capital and are looking for a place to invest it there is no shortage of options. It could be placed in a savings account earning a low interest rate return but, in most cases there is no way to lose your initial investment. So the low return is coupled with a low risk. It could be used to purchase bonds that generally return a little higher interest rate than money market or deposit accounts earn. Bonds come with the caveat that if the company has trouble paying its debts, you are the debt holder who won’t be paid. Or sliding even higher up the risk scale owning a part of the company by purchasing its stock. If the company fails the value of the stock goes to zero. But if the company succeeds or even just maintains the status quo while throwing off quarterly dividend payments the total return can be high compared to other investment option.
Stashing money in a saving account returning 1% is a losing proposition when inflation is eating 3% of the value away every year. Even a bond returning %4 is grievously harmed by inflation slowly rotting away the value of the capital. A stock that pays out 1-2% of its stock price in dividends each year and then goes on to appreciate in value by 5% or so still takes a hit from inflation but, handily outstrips the slow rot. Even companies that choose not to issue dividends, as long as the company is using the funds that would have been paid out as dividends to build and grow the business. In this case value is returned to the share holders by increasing the value of the underlying business.
If a single company can be wildly successful or fail and have its stock price go to zero how do you pick which company to invest in? There are literally thousands of companies to choose from and the variety of choices is dazzling. I have dabbled in the stock picking game trying to answer this question. I read the quarterly reports written up by companies (10-Q) and poured over their yearly reports (10-K). I listened to earning calls or read the transcript after the fact. And for all that effort I under performed the market. After accounting for trading costs with the brokerage I really under performed. So now what I do is buy a low cost index fund that buys the broad market. My personal favorite is VTSAX from Vanguard. This index funds buys a wide assortment of companies listed for public trading in the US. By doing so the index fund returns very close to the index it tracks CRSP US Total Market Index minus the small expense ratio the fund charges its share holders.
The things to remember:
Owning a share of stock is owning a small portion of a company.
Stocks have historically had a higher return than other investment options.
Picking individual stocks that return more than the market average is hard.
Stock picking is unnecessary because index funds exist. The index fund is likely to return more with far less effort than picking individual stocks.