As one of the most widely discussed financial products, stocks dominate financial news and are often linked to the economy’s overall performance. There are two types of stock: common stock and preferred stock. This chapter focuses on common stock.
Common stock represents ownership in a company (the issuer). If you “go long” (buy) one share of stock in a company like Coca-Cola, you become an owner (stockholder) of Coca-Cola.
That ownership is usually a very small slice of the company. For context, Coca-Cola has over 4 billion shares outstanding. Many companies have millions or billions of shares outstanding, and together those shares represent the company’s total ownership. Because common stock represents ownership, it’s called an equity security.
Common stock prices rise and fall in the stock market based on supply and demand. Most of the time, demand is influenced by the company’s success.
We’ll dig deeper into how trading works in the the secondary market chapter.
There are two general ways to make money on common stock:
When an investor purchases stock, it’s purchased at a specific price per share. If the stock price later rises and the investor sells at the higher price, the difference is a capital gain.
For example, Stacy purchases Ford Motor Company stock at $10 per share. She invests in Ford because she believes in its products and business model. Over the next few years, the company sells more cars and trucks than expected and demand for Ford stock increases. With more demand in the stock market, its stock price rises to $25. Stacy sells her shares and locks in a $15 per share profit. The increase in the value of her shares is an example of capital appreciation.
Issuers may also pay cash dividends to their stockholders. A cash dividend represents profit made by the company that is distributed to shareholders.
Not all publicly traded companies pay cash dividends. Many companies - especially those focused on expansion - retain and reinvest profits back into the business. For example, Amazon has never paid a dividend to its shareholders. Instead, it reinvests those retained earnings to expand operations, hire employees, and pursue opportunities in new industries.
Companies like Amazon are known as growth companies. Their goal is to increase the size of their operations and profitability. While Amazon is large and well-established, start-ups and small businesses can also be growth companies. Investments in growth companies may offer capital appreciation, but they generally do not pay income (dividends) to shareholders.
When a company is closer to the end of its growth cycle (when there’s less room to expand operations), it’s more likely to share profits with shareholders through dividend payments. Companies typically won’t distribute all profits - they still need funds to run the business - but they may distribute what they consider “excess” profits.
Ford Motor Company is an issuer with a long history of paying cash dividends. Referring to our previous example (above), Stacy could have made more than her $15 per share profit from capital appreciation. If Ford paid dividends amounting to $1 per share over the time Stacy held her shares, her overall profit is $16 per share ($15 per share from capital appreciation + $1 per share from dividends).
To receive a dividend payable by a company, investors must purchase their shares before the company pays the dividend. We’ll go further with dividend timelines later in this chapter.
This video serves as a quick visual guide to the basic characteristics of common stock:
Cyclical stocks are shares that tend to move with the broader business cycle.
Cyclical stocks are considered more volatile than non-cyclical (defensive) stocks because their performance is closely tied to the economy. They can offer strong growth during upswings but also carry higher risk during downturns.
Cyclical stocks are usually associated with industries that produce discretionary goods and services that consumers can delay purchasing in tough times. Common examples include automobiles, manufacturing, hotels, clothing, furniture, and restaurants. These sectors are sensitive to changes in consumer income and confidence.
In contrast, defensive stocks (such as utilities, food, and healthcare) tend to be more stable because their goods and services are always in demand, regardless of economic conditions. Investors who expect the economy to grow may favor cyclical stocks to capitalize on potential gains.
Unlike cyclical stocks, defensive stocks tend to hold their value through all business cycle phases. These companies typically operate in industries that provide essential goods and services that consumers continue to buy even during economic downturns. As a result, defensive stocks are known for being less volatile and are often favored for their reliable dividend payments.
Defensive stocks often underperform during economic expansions, when investors favor growth and cyclical opportunities. During economic contractions or recessions, defensive stocks tend to outperform because their revenues remain steady while other sectors experience losses. This stability makes them attractive for risk-averse investors or those looking for income through dividends. Common examples of defensive industries include healthcare, utilities, food and beverages, and tobacco. These sectors meet basic consumer needs, which means demand stays relatively constant regardless of economic conditions.
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