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Getting to know stocks

Lesson in Course: Stocks (beginner, 4min )

What are stocks and why do investors buy or sell them?

Investors have been buying and selling stocks for centuries. The Dutch East India Company and the Amsterdam Stock Exchange created one of the oldest stock markets in the world in 1602. The Philadelphia Stock Exchange opened in 1790 and is the oldest in the US, which was two years before the New York Stock Exchange.

This video gives us some basics on stocks.

Stocks, or equities, represent partial ownership of a company that an investor can buy. The ownership comes with certain rights, such as receiving profits through dividends, voting on shareholder decisions and company strategy, and receiving money after all debts settle if the company gets acquired or goes into bankruptcy.

 

Why issue stock?

Companies offer stock for investors to purchase for fundraising. They use the money received from selling stock to run operations and invest in future growth. There are two different "markets" where investors can buy and sell stocks in.

Learn about primary markets

Primary markets are when the company sells shares directly to investors. This is how companies raise money, and it's often called a direct offering. Examples of primary markets include IPOs, venture capital, and private equity financing.

Learn about secondary markets

Secondary markets are where investors sell shares to other investors. When we buy shares on Robinhood or any brokerage account, we buy them from other investors and the company. While the company does not receive cash from these trades, the company can make another direct offering in the future and raise more money if the stock price has gone up in the secondary markets.

Types of stocks

Common stock

Most investors purchase common stock, and it trades actively on the secondary market. Common stock has fundamental rights such as dividends and voting. However, many of us aren't experts in the business, and so when voting happens, we either outsource our vote or skip it altogether.

Sometimes we can buy different classes of common stock, such as Class A, Class B, or Class C. Voting rights are usually the difference between them. Class C shares may have no voting rights, while Class A shares may have super-voting rights. This setup allows companies to maintain a certain level of control and prevents hostile takeovers. A competitor may buy a majority of the shares on the market to vote for outcomes beneficial to the competitor.

The benefits of common stock is that the upside potential is very high if the business continues to do well. For example, when Amazon IPO’ed, the share price was $18 a share, and today it’s nearly $2000 a share. The tradeoff is that as a common shareholder, we’re last in line for distributions or payouts. In the case the company sells for any reason, common shareholders are behind preferred shareholders.

Preferred stock

Preferred stock has additional rights and priority compared to common stock. Suppose a company is sold or needs to liquidate. In this case, debt holders are paid first, followed by preferred shareholders who receive a payout on invested principal (their liquidation preference) before common shareholders receive anything. Common shareholders may not receive anything if there isn't any money left after paying the preferred shareholders.

Preferred stocks receive any dividend payouts from the company before common stock. A company with excess earnings will pay out all of the preferred dividends before issuing dividends to common shareholders. The tradeoff for the priority of dividend payments is that preferred shares don't trade and increase in value the way common shares do.

Preferred stock behaves like a hybrid mix of debt and common shares, where the steady cash payments make it a safer investment than common stock and riskier than debt.

Venture capital and startup investing

Venture capitalists invest in startups through preferred stock. This provides investors with the most protective rights in a very risky investment since most startups do not have the profitability or revenue to qualify for debt financing. In the case of an acquisition or bankruptcy, any money left over from selling assets is returned to those investors first before the common shareholders, usually the founding team and employees.

Typically VCs don't use preferred shares to earn their return through dividends. Instead, they take advantage of a mechanism and right to convert their shares into common shares in a favorable liquidation event, whereby they would make more money holding common shares than their preferred shares.

Buying back stock

Companies, on occasion, can choose to implement stock buy-back plans. These plans allow the company to set aside a certain amount of cash to go into the secondary markets to buy shares back from other investors. 

Boosting stock price

The board of directors at companies elect to do this when they think the stock price is low. 

By buying back shares at low prices, the company retires these shares into the treasury, effectively lowering the supply of shares traded in the markets. As we know with the inverse relationship of supply and demand, a lowered supply means more demand for the stock and an increase in stock price.

Protection

The board of directors at companies may also elect to purchase stock to block an acquisition.

An outside company or investment firm may attempt a hostile takeover by acquiring a majority or 51% of the shares of a company that doesn't want to be acquired. In this case, the target company will attempt to buy shares back on the secondary market to prevent anyone else from reaching 51% ownership. These cases are very rare but do happen from time to time.

 

We need to remember that buying a stock is buying ownership in a company, a slice of the corporate pie. We purchase common stock through our brokerage accounts, but perhaps we work for a private venture-backed company and receive some stock options. It's important to know that those VCs probably have preferred shares that would get paid out before ours since that impacts our common shares' value.

Glossary

What is Buy back (Buy-Back, buyback)?

The board of directors at companies elect to buy back shares when they think the stock price is low. 

By buying back shares at low prices, the company retires these shares into the treasury, effectively lowering the supply of shares traded in the markets. As we know with the inverse relationship of supply and demand, a lowered supply means more demand for the stock and an increase in stock price.

At Archimedes, our goal is to make investment literacy accessible and free for everyone.

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