What is a Stock?

I have had a few friends who are not in finance ask me to explain to them how the stock market works. These discussions usually end up occurring over a few beers and the lack of a written record tends to leave my audience with a bunch of confused ideas. As a result, I have decided to add a series to my blog to educate the layman on just how the stock market (should) function.

The most basic question to be answered is "what is a stock?". If an investor buys a share of a company, they are buying an interest in that company which represents a claim on a proportion of the companies earnings (after payouts to debt holders and preferred shareholders - more on them later). For example, if an investor buys one share of Company X and there are 100 total shares on the market (and no debt or preferred shares), that investor essentially owns 1% of the company. Therefore, if the company earns $500 net of taxes, the shareholder has a claim to $5 of those profits ($500 X 1% = $5). Additionally, publicly owned corporation are run as a democracy and the shareholder who owns 1% of the company has 1% of the votes in this democracy.

Since it is too cumbersome to hold a shareholder vote for each business decision, the shareholders elect a Board of Directors to oversee running the company. The Board appoints a management team (CEO, CFO, COO, etc.) who they see fit to best run the company and if the shareholders are unhappy with any of them, they can vote them out.