At some point, just about everyone experiences money crunch situations in their personal lives. Similarly, companies experience money crunch situations too in their lifetimes. Companies need to raise money to build a new factory, start a new office, hire additional employees, invest in R&D, or ramp up advertising to generate revenue.
In each case, companies have two choices: (1) Borrow the money from the bank or investors, or (2) raise it from investors by selling them shares of a stock in the company.
When you buy shares of a stock, you are essentially buying a part of the company. Like an owner, you have a claim on every asset and every penny in earnings that is proportion of the shares you own in that stock.
It is this ownership structure that gives a stock its value. If shareholders didn't have a claim on earnings, then the stock shares would have no value. As the company's earnings improve, investors are willing to pay more for the stock. This is why the price of a stock goes up.
If you own shares of a stock, you will typically receive profits made by the company in the form of dividends. Not all profit is returned by the company to its shareholders, though. Most companies invest remaining part of their profits for their own growth.
When a company invests its profits for its own growth, its motive is to gain new customers, retain existing customers, develop new products, or branch out in other markets. If the company is successful in this endeavor, it makes higher profits. When shareholders see higher profits, they purchase even more shares. When there is more demand for company shares than the supply, it results in the appreciation of its value. This is what happens during bull market runs. More and more companies generate profits leading to more stock purchases by investors and sharp increases in stock market indices.
Therefore, the total return of stock is the appreciation of its value plus the dividends it received over the lifetime of your holding of that stock. Therefore, investing must be considered a long-term endeavor for it to be successful. This way, the longer you keep the stock, the greater the time the company has to work out its kinks to generate higher revenue and profits.
Of course, the stocks of companies cannot always keep on climbing. Value of the stock can decline when the company fails to deliver on its promises or the economic, regulatory, or political conditions change adversely. Investors can punish the stock's value by selling it in droves. When there are more sellers than buyers of a stock, its value declines. There is a system of checks and balancing because investors' money is at stake. During bear markets, investors flee stocks thus causing sharp declines in the stock market indices.
Over a long period of time, stock markets have provided better return on investments than any other investment vehicle be it real estate, gold, bonds, fixed deposits, or anything else. The reason for this performance over extended period of time is due to growth of companies and the compounding of dividends. Since 1926, the US stock market has returned 8% on an annualized basis. Of course, there have been periods of recessions and declines such as the great recession of 2008-2009. BUT, such recessions also provide great opportunities for investors to scoop up stocks at value bargain prices. There is always silver lining in the cloud.
I hope this post helps you understand what is a stock and how the stock markets work.
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