A Beginner's Guide to Investing in Stock

A Beginner's Guide to Understanding and Investing in Stock

What Is Stock?
Before you can begin investing, you need to understand the answer to a simple question: "What is stock?" A share of stock represents an ownership interest in a business, entitling the owner to a share of the profits or losses. DNY59 / E+ / Getty Images

Have you ever wondered what stock is or why shares of stock even exist? This guide will go far beyond answering the question, "What is stock?" and serve as a great foundation in our Complete Beginner's Guide to Investing in Stock.  My hope is that it will help you begin your journey toward financial independence and ignite a love of finance that turns you into a lifelong investor.  The rewards can be enormous to the point that even janitors making near minimum wage leave behind $8,000,000 secret fortunes.

Shares of Stock Represent Pieces of Ownership in a Business

Imagine you wanted to start a retail store with members of your family. You decide you need $100,000 to get the business off the ground so you incorporate a new company. You divide the company into 1,000 pieces, or "shares" of stock. (They are called shares because each piece of stock is entitled to a proportional share of the profit or loss). You price each new share of stock at $100. If you can sell all of the shares to your family members, you should have the $100,000 you need (1,000 shares x $100 contributed capital per share = $100,000 cash raised for the company).*

If the store earned $50,000 after taxes during its first year, each share of stock would be entitled to 1/1,000th of the profit. You'd take $50,000 and divide it by 1,000, resulting in $50.00 earnings per share (or EPS as it is often called on Wall Street). You could call a meeting of the company's Board of Directors - the people the stockholders elected to watch over their interest since they couldn't run the business - and decide to use the money to pay cash dividends, repurchase stock, or expand the company by reinvesting in the retail store.

At some point, you may decide you want to sell your shares of the family retailer. If the company is large enough, you could have an initial public offering, or IPO, allowing you to sell your stock on a stock exchange or the over-the-counter market.  In fact, that is precisely what happens when you buy or sell shares of a company through a stock broker.

You are telling the market you are interested in acquiring or selling shares of a certain company and Wall Street matches you up with someone and takes fees and commissions for doing it. Alternatively, shares of stock could be issued to raise millions, or even billions, of dollars for expansion. To provide a real-world, historical illustration, when Sam Walton formed Wal-Mart Stores, Inc., the initial public offering that resulted from him selling newly created shares of stock in his company gave him enough cash to pay off most of his debt and fund Wal-Mart's nationwide expansion.  It ultimately led to his private family holding company, Walton Enterprises, LLC, through which the family holds the bulk of its Wal-Mart stock, becoming one of the largest fortunes in human history.

Shares of Stock on Wall Street Are No Different

It doesn't matter if you invest in shares of stock of multi-billion dollar conglomerates or tiny publicly traded retailers, when you buy share of stock, you are purchasing a pro-rata piece of a company. For instance, when I first wrote this piece years ago, McDonald's Corporation had divided itself into 1,079,186,614 shares of common stock. Over the twelve months before I penned the original words, the company had earned net income of $4,176,452,196.18 so management took that profit and divided it by the shares outstanding, resulting in earnings per share of $3.87.

Of that, the company's Board of Directors voted to pay $2.20 out in the form of a cash dividend, leaving $1.67 per share for the company to devote to other causes such as expansion, debt reduction, share repurchases, or whatever else it decided was necessary to produce a good return for its owners, the stockholders.

At that time, the stock price of McDonald's was $61.66 per share.  The stock market was, and is, nothing more than an auction. Individual men and women working on behalf of themselves and institutions are making decisions with their own money and their institution's money in a real-time auction.

If someone wanted to sell their shares of McDonald's and there were no buyers at $61.66, the price would have had to continually fall until someone else stepped in and placed a buy order with their broker. If investors thought McDonald's was going to grow its profits faster than other companies relative to the price they had to pay for that ownership stake, they would be willing to bid up the price of the stock (which is affected by supply and demand because there are only a fixed amount of shares in existence, in this case 1,079,186,614 shares). Likewise, if a large investor were to dump his or her shares on the market, the supply could temporarily overwhelm the demand and drive the stock price lower.

What should you have done if you believed McDonald's would generate far higher earnings per share of stock within five years?  Say you bought 1,000 shares at $61.66 for a total investment of $61,660 and, the very next day, the stock fell to $30 per share? Should you have been upset?  No.  Not if your thesis about the underlying operating performance was correct relative to the price you paid.

As of today, April 30th, 2016, McDonald's stock price is $126.49.  The reason investors are willing to pay more for it is because new management has done a good job of increasing profits and raising dividends.  Thanks to the introduction of all day breakfast and some other initiatives, the world's largest restaurant earns $4.80 per share after taxes, not $3.87.  It sends out $3.56 in per share cash dividends to owners, not $2.20.  Under most probabilistic scenarios, no matter what the stock market does in the short term, whether it be bidding McDonald's shares up to $200 each or down to $50 each, ultimately, the experience you are going to have as an owner is tied to the earnings and dividend figures.  If the business, the actual operating company, keeps pumping out more and more cash, and sending more and more of that cash to you, whether it is undervalued or overvalued at any given price doesn't mean a whole lot to a long-term owner except in the most extreme situations.  Personally, I own McDonald's.  My husband owns McDonald's.  My parents own it.  My brother owns it.  My niece owns it.  My in-laws own it.  We don't spend a lot of time thinking about the stock price on any given day.  I expect, absent some presently unknown factor, we'll still hold it 25 years from now and, I would hope, a substantially larger amount as we reinvest profits from our careers, private businesses such as our letterman jacket company, and future dividends, interest, and rents.

Keep Perspective on Stocks and Never Forget What They Represent

Had you allowed yourself to get upset about McDonald's hypothetical decline in value, growing more miserable as the share price collapsed, you would be allowing yourself to suffer misery due to "other peoples' mistakes in judgment", to borrow a phrase from the legendary Benjamin Graham.  The share price of McDonald's may move around wildly as millions of investors throughout the world make decisions about how much they are willing to pay, but the ultimate value of your shares will come from the profit the company generates and the dividends it sends to you.  Never forget it.  Throughout your lifetime you will witness manias, panics, and crashes.  Friends, family, financial institutions, and even some professionals will conspire to convince you otherwise.  Ignore them.  It is a mathematical, fundamental law.  You cannot ignore basic arithmetic indefinitely.

Deciding How to Invest in Stocks

If you decide that you want to become a business owner by investing in stocks, there are a few things you need to settle upon, some of which I explained in an article called How to Start Investing.  Specifically, you need to answer the following:

  • Which business do you want to own?
  • How will you determine the methodology through which you acquire them?  Someone like me, who has been doing this a long time, uses a modified free cash flow metric called owner earnings among other things to determine the level of the margin of safety between the price I am paying and my estimate of intrinsic value.  I talked about this when I explained that, when it comes to investing, your job is to buy the most net present value profits you can, adjusted for risk and other variables relevant to your unique situation.  In other words, how will you acquire these businesses?  Personally, I think there are only two rational approaches: One is valuation, the other is systematic or formulaic acquisitions.  The former is the one chosen by many of the world's wealthy investors, the latter is often a useful solution for inexperienced investors who don't know what they are doing and want to harness the power of compounding for themselves.  For example, many investors opt to throw in the towel and outsource their stock purchase decisions to a handful of people on a committee at Standard and Poor's.  They determine the methodology for things like the S&P 500 index.  Certain asset management companies pay them a licensing fee to use this methodology and build a portfolio attempting to mirror the active management changes the S&P committee decrees from time to time.  

Ultimately, the end game, the final objective, is to build a collection of wonderful businesses that throw off large gushers of cash you can use to enjoy your life; to give to charity, to fund other investments, to add to your cash reserves.  

More Information About Investing in Stocks

For more information about investing in stocks, read Complete Beginner's Guide to Investing in Stock.  Beyond that, this site contains more than 1,000 articles and essays about investing that I've written since becoming the Investing for Beginners Expert in 2001.  There are also a couple of thousand articles and posts on my personal blog, including many that deal with far more advanced concepts.  As you grow in your understanding of not only the stock market but intelligent portfolio management, risk management, and finance, I wish you all the best.  I can say from firsthand experience that the sacrifices and effort is worth it.  

* Footnote: These days, due to changes in state laws, most startups and private businesses are likely to opt to issue membership units, instead of shares, because they prefer the limited liability company structure.