STOCK IS OWNERSHIP, simple as that.
Buy a share of Microsoft and you acquire a tiny sliver of the software giant, tying your fate to that of Chairman Bill Gates, for better or worse. This is ownership in the most literal sense: You get a piece of every desk, contract and trademark in the place. Better yet, you own a slice of every dollar of profit that comes through the door. The more shares you buy, the bigger your stake becomes.
Chairman Gates owns by far the most Microsoft shares. Over the past decade, his stake in the company has hovered around 21%, although more recently it's dropped down to around 11.4%, thanks, in part, to his moving some of his assets into his charitable foundation. But his stake also changes with everybody else's as the company's value on the stock market changes from day to day.
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Sources: Dow Jones, Microsoft
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OK, So How Is a Stock Valued?
The stock market itself is basically a daily snapshot of the value of the companies that trade there. All those guys screaming at each other? Their job is to take in the day's news and break it down to a single question: Will it help the companies I own make money in the future, or will it prevent them from doing so? Take a look again at the Microsoft applet above. You can see how its ongoing antitrust case — which came to a head in June 2000 when Judge Thomas Penfield Jackson ordered that the company be split in two — helped to shave billions off the company's stock. Cleary, at that time, a lot of traders were uncertain about Microsoft's future. But since then the decision has been reversed and the prospect of a breakup has been virtually eliminated. Then in 2001 Microsoft traded higher, up more than 40% from the beginning of the year until Nov. 2, 2001, when the federal government announced that it had reached a deal with the software maker. However, the party didn't last long — 2002 proved to be another disaster for tech stocks. Microsoft shed 22%, while the Nasdaq plummeted 31.5%.
Whether it's Microsoft or some other stock, the supreme measure by which companies are valued is their earnings (a.k.a. profits). Wall Street is obsessed with them. Companies report their profits four times a year and investors pore over these numbers — expressed as earnings per share — trying to gauge a company's present health and future potential.
The market rewards both fast earnings growth and stable earnings growth. But what about a company with a great idea but no immediate prospects for profitability? As Internet investors learned, Wall Street won't tolerate that situation for long. In 2000, the stock prices of many dot-coms went into a free-fall as the market re-evaluated the worth of these companies. And the carnage only continued through 2002, leaving many investors with huge losses.
The market also has little patience for companies with declining earnings or unexplained losses. Bottom line? Companies that surprise Wall Street with bad quarterly reports almost always get punished.
What About Risk?
While history shows that stocks will rise given the fullness of time, there are no guarantees — especially when it comes to individual stocks. Unlike a bond, which promises a payout at the end of a specified period plus interest along the way, the only assured return from a stock is if it appreciates (increases in value) on the open market. (While many companies pay shareholders dividends out of their earnings, they are under no obligation to do so.) The worst-case scenario is that a company goes bankrupt and the value of your investment evaporates altogether. Happily, that's rare. More often, a company will run into short-term problems that depress the price of its stock for what seems an agonizingly long period of time.
For all the risk, however, there are ways to manage your exposure. The best is to diversify by owning a variety of stocks. That way, no single company can harm you. (Check out our Risk vs. Reward section for more on diversification strategies.) It's also important to remember that investors are well compensated for rolling the dice with equities. Historically, the long-term return from stocks is about 11% annually, while bonds — which are less risky — return just 5.2%. Over time, that spread can make a huge difference in the earning power of your savings (see The Power of Compounding).
One final note: Along with ownership, a share of stock gives you the right to vote on management issues. Company executives work at the behest of shareholders, who are represented by an elected board of directors. By law, the goal of management is to increase the value of the equity of the corporation. To the extent this doesn't happen, shareholders can vote to have management removed.
That's the way it is supposed to work, anyway. One of the grim realities of the stock market is that individual investors rarely gain enough stock to be able to exert any tangible influence over a company — that's left to big institutional shareholders or groups of company insiders. Consequently, it's in your best interest to carefully research management's competence before you buy a stock. And the best measure of that may be the company's ability to consistently deliver earnings over time.
