What a stock is
A stock is a share in a company. You're a co-owner, entitled to a slice of the profit, and in exchange you carry the business risk.
Picture a bakery split into a million equal pieces. Buy ten of them, and you own ten millionths of the bakery: the oven, the recipes, the customers, and the profit.
As a co-owner you have two rights. You get a share of any distributed profit, the dividend. And you get to vote at the shareholder meeting, though honestly, ten millionths of a vote doesn't accomplish much.
In exchange, you carry the risk. If the bakery does badly, there's no dividend. If it goes bankrupt, your share is gone. But you can never lose more than the money you put in, and that's an important difference from leveraged products.
The price fluctuates because other investors are constantly reassessing how the bakery will do in the future. In the short run, that's often got little to do with the bread and a lot to do with mood. In the long run, profit decides.
Legally, a common share represents a fractional interest in a corporation's registered capital, and with it, membership rights: voting rights, a claim on dividends, subscription rights in a capital increase, and a claim on any liquidation proceeds. That last claim is subordinate: in bankruptcy, creditors and bondholders are paid first, and shareholders receive only what's left over, which in practice is usually nothing. Preferred shares typically trade voting rights for a preferential dividend.
In theory, a stock's value can be represented as the present value of all future payments to its owner. In the simplified dividend discount model, P = D₁ / (r − g), with D₁ the expected dividend next period, r the required return, and g the growth rate. Its practical value lies less in the calculation, which is hardly reliable given how sensitive it is to r and g, and more in the insight that a price is always a statement about the future.
Empirically, short-term price movements are dominated mainly by changes in valuation multiples, while long-term movements are dominated mainly by earnings growth. Over periods of ten years and more, stock returns converge toward the sum of dividend yield and earnings growth, while the multiple's contribution shrinks. That's the quantitative version of the saying that the market is a voting machine in the short run and a weighing machine in the long run.
Summary
- A stock makes you a co-owner with a claim on a share of the profit.
- In bankruptcy, you're behind every creditor, so you usually get nothing.
- In the short run, mood decides; in the long run, profit decides.
Did you get it?
What do you actually own with a stock?
A share of the company, with voting rights, a claim on dividends, and a subordinate claim on any remaining assets.
Where do you stand as a shareholder in a bankruptcy?
Dead last. Every creditor gets paid first, then shareholders.
What drives stock returns over ten years and more?
Essentially dividend yield and earnings growth. Valuation swings matter less and less over time.
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