A stock is a piece of ownership in a company.
If you own a stock, you are the pro-rata owner of all the future profits a company makes as well as a pro-rata owner of everything it owns. If a company decides to close its’ doors, it will sell all its’ equipment and attempt to pay off all its’ debts. If there is money left over after that, it would pay it pro-rata to the owners.
The most important part of this is the future profits. If a company is earning $3 per share (EPS) (per year) in profits, it might cost 20 years worth of income for a stock price of $60. That multiplier varies for companies of different sizes and in different industries and based on how fast the company appears to be growing.
EPS is calculated by subtracting all the costs to run the business from all the money they made that year.
If people think the company won’t grow that $3 EPS quickly, the multiplier will go down. If people think the company will grow that $3 EPS quickly, the multiplier will go up.
In the long term, the earnings per share per year is by far the biggest factor in the stock price. If the EPS goes up to $4 and the forward multiplier says at x20, the stock price should move up to $80. If you sold the stock, you could take the 80 – 60 = $20 of profits you made on the stock and find something else to do with your money.
That EPS is pro-rata yours. You want to know that the company is spending it wisely. There are 3 main things they can do with their extra money to add extra value to you:
1) Pay it to you directly. This is called dividends. They can just give you the extra collected and let you decide what to do with it yourself. The price of a stock is most consistent when the company does this because this is valued most highly by investors. You have to pay taxes on the money they pay you if they do this. In the above example, they might just give you the $3 EPS at the end of each year. This money is taxable.
2) Reinvest it. This means that they can find some way to use it that will cause the EPS to go up in subsequent years. That could mean paying off debt, or building more stores, or buying a competitor, or a lot of other things.
3) Buy out current owners. The company can go on the stock market and pay the stock price to buy pro-rata ownership from you. This ends your ongoing interest in exchange for a one time payment. If they do this, they destroy the stock they buy from you. In doing this, they slightly increase the pro-rata ownership of all the other owners. Everybody else’s piece of the ownership pie gets slightly larger when this happens. This allows a company to be able to increase EPS while making the same amount of money as last year.
The Board of Directors (the boss of the CEO, elected representatives of the owners) decide which of those things to do. Good boards will direct companies to do some or all of those, whichever happens to be the best way to increase EPS. Bad boards will waste money on making the corporate office more pretty or something like that.
If you are going to buy a stock, it helps to look at a lot of things, like:
1) Reputation and ability of the CEO
2) Current EPS and likelihood of higher future EPS
3) How hard is it for other companies to compete
4) How the company is spending EPS to benefit the owners