Stocks are tiny slivers of ownership of a company. When you own a share of stock (“stocks” is basically a short way of saying “shares of stock”), you actually own a very tiny piece of the company that stock is associated with. If you own a share of Coca-Cola, you own a very tiny sliver of the Coca-Cola Corporation.
How does that have value? There are a couple of reasons.
First of all, a share of a company entitles you to a tiny sliver of the company’s profits. When a large company makes a profit, the board of directors has to decide what to do with it. Should they investing it in the company? They do that sometimes. Much of the time, however, they choose to give that money to the shareholders in the form of a dividend.
A dividend is simply a small payment to the owner of each share of stock of the company. Usually, a dividend is a small amount – say, $0.25. If you own a share of Coca-Cola and the board of directors issues a dividend of $0.25, you’ll receive $0.25. This usually pops up in your brokerage account and is often just quietly reinvested in more shares.
The promise of future dividends is what gives a share of stock much of its value. People buy and sell them in hopes of earning those future dividends. If a company’s future looks great, that probably means lots of dividends coming in the future, so the price of that share goes up. Similarly, if a company is struggling, the likelihood of lots of future dividends goes down, so the price of that share goes down.
Another reason is that in some situations, a share of stock gives you voting rights and the ability to attend the company’s annual meeting. Voting rights usually just refer to the ability to be involved in electing new people to the board of directors. For some people, this voting right is enough to make the stock desirable (for example, if you want to control the company’s future direction).
In rare cases, companies may buy back their stocks, actually paying the shareholders for each share.
Because shares of stock confer dividends and (sometimes) voting rights and the possibility of being bought back, they have value, which is why it costs money to buy a share and why others will pay you for the shares you have. Companies will often issue new shares in order to raise money for the company (often for some big new initiative). It’s a way for a company to raise money without going into debt.
Speaking of debt, let’s talk about bonds.
A bond is like a small loan that you give to a business or a government entity. A bond usually consists of several elements: a principal, which is the amount that the bond is issued for and is usually the amount paid by the person buying the bond to the business or organization issuing the bond; the end date, which is the date at which the amount will be repaid; and the interest payment plan, which is the dates and amounts where interest on the loan will be paid.
So, let’s say for example that a company wants to raise $1 million for a project. They might issue 1,000 bonds, each with a face value of $1,000. These bonds state that the $1,000 will be repaid in ten years and that every six months, the company will pay the person holding the bond $20.
You buy that bond for $1,000. Every six months, the company sends you a check for $20, until ten years are up, at which point they send you $1,000 and the bond is terminated.
Bonds are also bought and sold. A bond where the interest payments are high might sell for more than the face value, while a bond with really low interest payments might sell for less.
There are services out there, like Moody’s, Standard and Poor’s, and Fitch, that offer grades for bonds, evaluating how stable the company or government is. The more stable the company or government, the lower the interest rate on their bond probably will be.
So, if a company isn’t very stable and issues a bond, it might have a high interest rate with it, meaning the person buying the bond will earn a nice return, but if the company were to grow more stable and the bond rating goes up, that bond will probably sell for more than the face value because now it’s suddenly a safer investment with a higher interest rate.