How Stocks Work


As one of the foundations of most investment portfolios, stocks represent ownership stakes in publicly-traded companies. By allowing you to participate in the growth of these businesses, they can help you achieve long-term wealth goals like building your retirement savings and paying for college educations. While there is no guarantee that stocks will increase in value, over the longer term, historically they have provided higher rates of return than many other types of investments.

Stocks are divided into shares, and each share represents a fraction of ownership in the company. As a result, each share has a claim on the company’s assets and earnings. If the company is successful, it will increase its profits and its assets, and that can lead to an increased value for its shares. However, if the company is unsuccessful, its assets and profits will decrease, and the value of its shares will decline as well.

The price of a stock is determined in the market, which works much like an auction system. Investors on the buy and sell side of the equation constantly bid and offer prices, and those prices fluctuate second by second. Investors who are willing to pay more for a share than the seller is able to accept will push the price up, and those who are willing to sell at a lower price will push it down. Benjamin Graham, a mentor of billionaire Warren Buffett, famously described the stock market as “a voting machine in which buyers and sellers continually adjust prices.”

There are many different ways to determine the intrinsic value (IV) of a stock. These include using business valuation, capitalization of earnings, discounted cash flows and other methods. The key is to understand the factors that influence the demand for a particular stock and then use the right method to calculate its true value.

Besides market fluctuations, the price of a stock can be affected by news about a company or the economy. For example, if a company is struggling or if it’s rumored that it may fail, the stock price could drop even if the company hasn’t actually done anything wrong. On the other hand, good news about the company or the economy could cause its stock to rise.

Another important factor is the dividends that companies pay their shareholders. Depending on the company and its industry, some stocks can pay out significant dividends while others might not pay any at all. The amount of the dividend depends on the profit that the company earns each year. These dividends can be used to generate income or can be reinvest into the company to drive future growth.

When investing in stocks, it’s important to diversify your portfolio. This will help you reduce the risk of losing money if a specific industry crashes or if the overall economy slows down. You can do this by buying stocks in a variety of industries and by focusing on quality companies that will continue to grow even during difficult economic times.

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