Sunday, December 6, 2015

What are common stocks?

I have talked about how to get rich in previous posts. One of the ways to get rich is to start a business and sell a good or service that people are willing to pay for. However, many people think they are not suited for operating their own business. I disagree but that is another post. A way to have an interest in a business without actually operating a business yourself is to invest in a business through the purchase of common stock.

What are common stocks? Investopedia defines a common stock as, "A security that represents ownership in a corporation. Holders of common stock exercise control by electing a board of directors and voting on corporate policy." So basically a share of stock is a percentage ownership of a business. For example, if a company has 1000 shares and you own 100 of the shares then you own 10% of the company.

Typically companies have millions if not billions of shares outstanding. Nevertheless, ownership of common stock in a company represents a percentage ownership in all of the assets and the potential earnings of the company. In addition, ownership of shares entitles holders of  shares to a portion of the company's earnings, assuming the company makes money, and the board of directors elects to pay a dividend.

Typically a public corporation will have an operating management team that runs the day to day business of the corporation. The company also will have a board of directors that meets several times a year and has fiduciary oversight of the corporation and the management team. Sometimes members of the management team will serve as directors on the board. Shareholders have the opportunity each year to vote on who serves on the board of directors.

So if we understand that shares of stock represent a percentage share of a business then it stands to reason that if we are going to invest in stocks we must approach the analysis of each stock we invest in from a business perspective.

If someone is just putting money into stocks with no full understanding of the underlying business or the targeted company's financial condition than this is not investing this is speculating. I talked about the difference between investing and speculating in a previous article.

Investing in a stock requires a couple of actions on the part of the investor. An understanding of the company they are investing in along with an ability to understand basic financial metrics. This is necessary in order to determine whether or not the company being considered will have the ability to compound earnings and cashflow over time. This is the key to investing; consistent growth in earnings and cashflow over a long period of time.

Many people will not invest in common stocks because of what has happened to them in the past i.e. losing their ass in the 2008 financial crisis. However this is shortsighted and stupid long term. Common stocks have historically been the best asset class for building wealth over the long term.

The key is to treat these stock investments as the businesses that they are and to understand that you are attempting to buy a portion of a business's future earnings stream. If you were investing in a business of your own you would not do it with the intent to sell it in a week, a month, or even a year.

Wall Street has made it so easy for people to set up brokerage accounts and to trade via computer and now their smartphones that many have forgotten this principal and reduced stock investing into a roulette game of chance. That is gambling and a game you cannot and will not win.

In future articles I will explain the consistent time proven way to create wealth through investing in common stocks.

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