Introduction to stocks
If growth is your long-term investing objective, you’ll likely want to allocate a portion of your portfolio to stocks. You may already invest in the stock market, indirectly if, like most Canadians, you own shares of an equity mutual fund or exchange-traded fund, have an employer pension plan, or contribute to the Canada Pension Plan (CPP). However, managing your own portfolio of individual stocks is different. You have to pick the stocks, do your research, and buy and sell stocks on your own.
If you’re new to investing in stocks, it can be a bit intimidating, with new systems and terminology to navigate. That’s where some know-how and the right tools come in handy.
What are stocks?
Companies sell stocks (also known as “equities” and “shares”) in order to raise money to run their business, to fund growth and expansion, or upgrade their equipment and technology. The portion of the company’s balance sheet funded by shareholders is called shareholders’ equity.
In exchange for providing the money, you, the shareholder, receive an ownership stake in the company, which includes a claim to its future earnings. The first time a company issues shares to investors is called an initial public offering (IPO). After that initial sale to the public, the shares can easily be traded—bought and sold—among investors. Stock exchanges and brokerages exist to facilitate those transactions and maintain an efficient, fast, accurate, and cost-effective market for stocks and related securities.
How is a stock valued?
The value of a company’s stock (or its shares) is dictated by a wide variety of things, including the value of its assets, level of debt, creditworthiness, location, brand, and reputation. External factors can also affect the value of a company’s stock. These include geopolitical events, regulatory change, interest rates, currency rates, or simply investors’ opinions about the company, its industry, or the financial markets in general.
The more optimistic (“bullish”) investors feel about a company’s potential to grow its earnings, the more they are willing to pay for a share of those future earnings. But when investors feel pessimistic (“bearish”) about a company’s prospects, the stock price falls.
If the company performs well, the value of its stock tends to increase. If the company doesn’t do well, like when its earnings or profits decline, the value of its stock tends to decrease. Like all investments, stocks entail risk. If the company’s share price declines below the price you paid to purchase its shares, and you then sell the stock, you’ll realize a loss on your investment.
If you invest in a company’s shares, you hope the company is successful and profitable, so that you’ll
receive a return on your investment. You can get a return in two ways:
- If the company grows its earnings and profits, shareholders may be willing to pay more for its shares. If you sell your shares for more than you paid for them, you’ll realize a capital gain.
- The company may also distribute a portion of its profits to shareholders in the form of dividends.
Common versus preferred stocks
There are two main categories for stocks: common stocks and preferred stocks. Common stocks are the most (pardon the pun) common, and generally entitles stock owner to vote at a shareholder meeting and receive dividends paid out by the corporation. In contrast, preferred stock owners do not have voting rights, but have a larger claim on a company’s assets and earnings.
Categories of stocks
All companies earn money differently. Some are fast-growing, while others take a slow and steady approach. Their stocks tend to be grouped into three basic categories:
Companies that are growing faster than the overall market and have substantial growth prospects in the foreseeable future. Generally, they don’t pay dividends in order to channel earnings towards expansion (think about those up-and-coming technology companies).
Companies that seem undervalued and relatively cheap, given their solid fundamentals (for example, sales, earnings, dividends). Value investors look for underdogs and invest before others move in and drive up the stock price.
Companies that have a track record of paying a regular dividend. Think about those slow and steady companies with solid cash flow—like a utility (people need to keep the lights on).
Market capitalization and sectors
Stocks are also often distinguished and categorized by their sector and/or market capitalization. These sector and market capitalization categories can help investors more easily compare a company to its peers within the same industry and to companies of roughly the same size.
The Global Industry Classification Standard (GICS) sets out the standard industry sector categories of public companies. Its 11 sector categories are:
- Consumer Discretionary
- Consumer Staples
- Health Care
- Information Technology
- Communication Services
- Real Estate
Market capitalization measures a company’s worth – it represents the value of a company that is trading on the stock market. It helps investors understand the company’s size, financial scope, and how its value is perceived by the market. You can calculate a company’s market cap by multiplying the total number of a company’s shares outstanding by its current market price. With respect to market capitalization, companies are usually categorized as:
- Large-cap (companies with a market cap of $10 billion or more)
- Mid-cap (companies with a market cap between $2 billion and $10 billion)
- Small-cap (companies with a market cap between $250 million and $2 billion
The next step
The information contained in this article was obtained from sources believed to be reliable; however, we cannot guarantee that it is accurate or complete. This material is for informational and educational purposes and it is not intended to provide specific advice including, without limitation, investment, financial, tax or similar matters.