STOCK MARKET FOR DUMMIES
Updated: Nov 23
Author: Andrea Sferrazza Papa
Date of Publication: 23/05/2022
"Imagine you have started your business. You have followed your dream and you have finally opened the bakery shop you have always dreamed of."
Weeks go by, and soon your shop is always full. From all over the city, people want to taste what you have for sale, and you also manage to create a takeaway service. The mood is so high that some customers would appreciate you opening other stores in other streets and you start seriously considering it. Unfortunately, you don't have enough money.
You don't know enough about banks and how they work to ask for help. On top of that, it's your first business and you don't have any credit reliability. Finally you get an idea, and you gather your most loyal customers.
Your proposal is to divide the business into many parts, or many “shares” of equal value, and divide them among several people in exchange for money. For now, it can be considered as a simple exchange: a part of your business is given in return of funds from outside the company. These people really believe in your business. They appreciate the way it’s running, and want to see it grow and expand. Hence, they are enthusiastic about your proposal.
Here is the point: these customers will become owners of the business as a percentage of the shares held. In addition, they will be able to participate in the most important business decisions. The more the value of the emerging shop will grow, the more their shares will increase. Subsequently, the “new owners”, or “shareholders”, will be able to choose whether they want to keep or resell their shares to other people at a different price.
How exchanges work today
The story mentioned above is an example of the logic underlying the stock market of companies all over the world. The stock market has become a global and ever-changing phenomenon, whose repercussions influence our lives in many ways.
However, let's try to clarify some important features: not all shareholders enjoy the same rights or advantages. In fact, there are different types of shares even within the same company, and each of them has different rights connected to the person who holds them. Mainly, the difference revolves around different administrative rights and different patrimonial rights.
Different stocks, different rights
Let's review some examples.
COMMON STOCK
Talking about stocks, we generally refer to common stocks. These are the majority of stocks issued by companies. When you own common stocks, they give you the right to vote on board members and other corporate issues at a company’s annual meeting. Normally, one share equals one vote. From the economic side, some common stocks also pay dividends at the end of year, but payouts are not always guaranteed.
PREFERRED STOCK
The main features in this case are about paying dividends. If a company’s board decided to pay dividends, they would compare common stockholders to others based on voting rights associated with the shares. The preferred stock income would then be much higher.
CLASS A AND CLASS B STOCKS
This type is less common. The main point is creating a sort of “stock class”. Stocks of preferred class will give more rights. This means that a few shareholders could influence the board and prevent it from following its own strategy and ideals. Historically, Google’s founders used this system to make their company bigger while maintaining a great influence. In fact, the company’s class B shares are held by Google’s original founders and a few early investors who carry 10 votes per share.
We should specify that another gain could come from selling stocks if the company is performing well. Following this way, we differentiate the price between dividend and capital gain. This applies to all types of shares that can be traded on the market. This difference can be easily connected to the next question: why do we invest in stocks?
Investing in stock markets
The stock markets today work digitally, and from your home you can access them and conclude trades during opening hours. The idea that exchanges are concluded continuously may seem strange. However, there are many motivations and incentives that can lead even a non-professional investor to buy shares.
In fact, buying shares means being able to participate in the successes of the company, so as to obtain an economic return. Many people prefer using part of their money in business rather than depositing it in a bank. Moreover, there is often an emotional component involved. That is, people who buy shares are free to support, even in small parts, the companies they believe in. This can be gratifying.
Something additional that may motivate people to buy shares is that, even without experience or knowledge, money can be invested to escape inflation. The main focus when talking about stocks and analyzing data is on the “market price” of each share. This can change in value depending on the share.
Analyzing stocks value
It is important to understand that the market essentially moves by expectations: if investors believe that the value of a share should be higher, it is likely that it will grow. The opposite is also true.
In particular, there are two different approaches that can be used to undertake investments: fundamental analysis and technical analysis. Fundamental analysis is usually taught in business administration schools. It involves the use of economic data, financial statements and balance sheet indices to arrive at a total measure of a company’s value. Consequently, the value of each individual share can be estimated.
On the other hand, technical analysis is based more on mathematical and statistical data, in an attempt to predict price fluctuations. The main work phase is the observation of price charts, identifying trends and patterns. Finally, as opposed to fundamental analysis, technical analysis usually leads to short-term investments.
Generally, it is not easy to say which of the two approaches is better. In fact, they follow different logics for a common goal. However, they can be combined into a better, more comprehensive investment strategy that takes both methods into account.