1.3 Basic Stock Terminology

Many people associate "business" or at least "finance" with the stock market. This is a natural thing to do. Movies like Wall Street and television programs like Billions portray colorful characters who make (or lose!) huge amounts of money in the stock market and live very exciting lives. Thus, stocks and the stock market garner a lot of fascination.

Stop and think, however, about the financial transactions that you make each day. When you leave a garment to be dry cleaned, it is likely not at a business that has any stock, which is tradable ownership in a company that has been regulated by the government and may generally be bought or sold by anyone. Most dry cleaning businesses are private operations and are owned completely by one person or a small partnership. Such a limited arrangement allows the owners to maintain complete control over their business and to recognize all of the gains, or endure all of the losses, which come with ownership.

When you shop for groceries or deposit your paycheck you might be doing so with a public company, which uses stock as its ownership structure, such as WalMart or Bank of America. Or you may be doing so with a private retail store or a community bank. We would also note that there are cases of private companies whose ownership structure is also in stock, but typically, when we think of the stock market or stock exchanges we are talking about an open structure where anyone may come together to buy or sell publicly traded stocks. Nowadays, this is mostly done electronically.

When companies decide to "go public" they typically do so because they need more money in order to grow and meet their vision for the future. Thus, the company founders are willing to share in the ownership of the company with you if you would like to buy shares of company stock (this is where the term "shares" originates). The growing company now has your cash as an asset, and might quickly use it to buy other assets like a new machine or computer system. Simultaneously, the company's equity has increased with your contribution as an owner. For example, if you buy $500 worth of new company stock, the company's equity goes up $500 and its cash or other assets also increase a total of $500. Thus, the primary accounting equation, Assets = Liabilities + Equity, still holds.

While we often say that the new owner is "buying" shares of stock and the company is "selling" shares of its stock, the reality is that ownership is being transferred. After stock is initially issued by the company, its owner may generally sell it to a third party at any time. This is done (electronically) in the stock market. Well over 99% of stock transactions are old owners selling shares to a third party. Millions of shares of stock in WalMart and Bank of America change hands every day, almost always between old owners who want to sell and new owners who want to buy. This seamless transfer of ownership, which can occur in mere seconds, is the essence of the stock market, and it is very different than the level of effort necessary for a small business, like most dry cleaners, to sell ownership from the old partners to new partners.

If ownership in a company is based on 1,000 shares of stock, and I decide to buy 40 shares, I now own 4% of the company (40/1000). This can be a very attractive arrangement for an investor. I now own 4% of any cash profits that the company elects to pay out to its shareholders in the form of dividends (more on dividends in section 1.6). If the company is "bought out" i.e., sold to others, then I will take in 4% of the purchase price. I have proportional ownership (4% in this case) of the company.

If the value of company stock goes up, I'll also be able to sell the stock for a profit when I choose to do so. Stock prices, like all prices, are based on supply and demand, and the market price or market value of a share of stock shows what people are willing to currently pay for it, and you can look this information up immediately on the internet or find it on television or in a newspaper. Different observers have different opinions about the value of stock. No one knows exactly what cash dividends will be shared by the owners in the future, or what buy out value a company will be worth if it's sold (its sales value). As opinions about these items change, the stock price changes accordingly. Generally speaking, if my company is well run and continues to grow, then opinions about its future dividends and buyout value will get higher, and thus the value of my shares will get higher too, and I'll profit from my 4% investment. I can hold on to my shares indefinitely, and continue to actually receive my cash dividends or my piece of any buyout value, or I can sell my shares to someone else at a market price, receive my cash immediately, and the new owners will be the ones to share in the payments of the company going forward.

Stock purchases are now done via electronic stock markets. Historically, transactions were recorded on paper at a physical, central meeting location (and that's why it was indeed called a market). The most famous of these has been the New York Stock Exchange (or NYSE) which is still a huge marketplace for the sale of shares of most of the largest companies we think of, but the actual transactions are now done by computers that find one another, rather than people. The physical headquarters of the NYSE in Lower Manhattan in New York City is more of a headquarters for server space and financial media than a necessity for trading.

Other stock exchanges exist too, perhaps most famously the NASDAQ, which traditionally has specialized in the trading of technology companies. The NASDAQ has always been a completely electronic stock market. Generally, companies like the visibility of trading on large exchanges as it generates attention, and thus serves as a type of advertising. Some small public company stocks don't trade on formal exchanges at all because there is not enough interest from potential investors. They are said to trade only over the counter (OTC).

Stockbrokers execute the buying and selling of stock. Historically, the most typical example of this would be if I wanted to sell shares of a stock that you wanted to buy. We might have never met one another and live in different cities, but our stockbrokers would connect with one another and the trade of shares would be made from me to you via our brokers with each broker making a small fee. With modern communications, physical contact between brokers isn't necessary and much trading can now be done via brokers' computer systems. Happily, this automation has led to lower commission rates for customers.

There are specialized types of stockbrokers, and some do not even specialize in the aforementioned buying and selling of shares for clients. Some stockbrokers only trade for an employer and do it to try to make a profit by carefully selecting investments. Some stockbrokers are specialists who are tasked with making stock trades by the stock exchange that employs them when no other customer wants to buy or sell. Part of the function of stock exchanges is to always provide availability for customers, and they do so by providing these specialists who are also known as "market makers."

Reconsider my 4% ownership stake discussed above. While all of these cash dividends are coming to me, and all of this potential growth is happening, I don't have to do any of the day-to-day work of running the company, making strategic decisions, or managing personnel. This is the power of ownership, and the ownership has taken the form of stock. We say that such an arrangement is passive in that an owner might make money from and have an interest in a company, but has no expertise in its business mission or operations. Some people may not even know which companies they have an interest in. In the modern day, many employees own mutual funds as part of a retirement system, and these mutual funds own many individual stocks.

Someone has to make important decisions and efficiently run public companies like Coca Cola and WalMart. Who? The owners of shares are represented by a Board of Directors and shareholders typically have voting rights to determine exactly who will serve in this role. For example, with my aforementioned 40 shares of a 1000-share company, I control 40 votes for board members. This 4% control matches exactly with my 4% level of ownership.

Board members are generally not full time employees of a company. In fact, to maintain oversight at least some of the directors are not "insiders." The board is tasked with monitoring the overall performance of the company, particularly its most important areas and highest level employees. Therefore, the board decides when to hire and fire the employees of a public company, especially its highest level full time employee, the Chief Executive Officer (CEO).

This passive type of system does lend itself to abuses. Occasionally boards of directors do a poor job of overseeing their companies, either because it is difficult to understand the company for any outsider or because the CEO has become powerful or ingratiated with board members. Sometimes managers obscure bad decisions or poor company performances in order to confuse boards (and therefore the owners) and sometimes managers make decisions that benefit themselves, personally and professionally, at the cost of the shareholders. However, it is the hope that such abuses are relatively small and infrequent, and thus shareholders can participate and benefit with wealth from a passive ownership system where no effort on their part is necessary to operate the company.