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Stocks: a slice of the business.

A share of stock is a small piece of ownership in a company. You get a cut of what the business earns, a vote on how it is run, and a price that changes every second the market is open. Here is what you actually own, and how it pays.

Concepts in this lesson
Market cap
What the stock market values the whole company at: the share price times the number of shares.
Dividend
Cash a company pays its shareholders out of profits, usually every quarter in the US.
Total return
The gain from the price change plus dividends, assuming each dividend is reinvested.
Trailing P/E
The share price divided by the last 12 months' earnings per share: dollars paid per dollar of profit.
Every term in Table Talk

01What you own

Three friends open a pizza shop, each putting in $10,000. Each owns a third: a third of the profits, a third of the say in big decisions, a third of whatever the shop sells for if they ever sell it. A public company is the same arrangement split into millions or billions of pieces, called shares, that anyone can buy and sell on a stock exchange.

Owning a share gives you a claim on the company's profits after everyone else is paid: suppliers, workers, lenders and the tax collector. It usually comes with a vote at the annual meeting. And it comes with limited liability: if the company fails, you can lose what you paid for the shares, but nobody can come after you for the company's debts.

Multiply the share price by the number of shares and you get the market cap: what the stock market says the whole company is worth today.

03The price chart hides part of the money

A dividend isn't a bonus on top of the share price. It is part of the company's value handed to you in cash instead of kept in the business, and the share price drops by about the dividend on the day the stock starts trading without it. A company that grows 8% a year and pays nothing, and one that grows 6% and pays 2%, deliver about the same total return. What changes the outcome is what you do with the cash: spend it, or use it to buy more shares.

That's why a price chart understates what a dividend payer earned. The price line shows only what stayed in the share; the dividends went out in cash along the way.

Total return, roughlyyearly total return ≈ price growth + dividend yield
Worked example: $10,000 for 30 years

Price grows 6% a year and the dividend yield is 2%. Spend the dividends and the shares themselves grow to $57,435. Reinvest them and the holding grows 8% a year, to $100,627. About 43% of that final value came from reinvesting the dividends, and each reinvested dividend bought shares that paid dividends of their own.

Try it: dividends reinvested, or not

With JavaScript on, this box grows $10,000 with and without dividends reinvested as you change the price growth, the dividend yield and the years.

Total return, dividends reinvestedPrice return only, dividends taken as cash

04What a share is worth

A share is worth the cash it will hand its owners over its whole life, counted in today's money. A dollar arriving in ten years is worth less than a dollar now, because today's dollar could be earning a return in the meantime. So every future dollar is shrunk, or discounted, by the return you could earn elsewhere for similar risk.

For a company whose dividend grows at a steady rate, that sum collapses into one line, the dividend growth model (also called the Gordon growth model):

Dividend growth modelvalue = next year's dividend ÷ (required return − dividend growth rate) It only works when the required return is above the growth rate, and it assumes the growth lasts forever, which no company quite manages. Treat it as a way to think, not a price tag.
Worked example

Next year's dividend $2; you want 8% a year; the dividend grows 5% a year. Value = $2 ÷ (0.08 − 0.05) = $66.67.

Now nudge one input. Growth of 6% instead of 5%: $2 ÷ 0.02 = $100. Growth of 4%: $2 ÷ 0.04 = $50. A one-point change in the growth you expect moves the value by a quarter to a half, and so does a one-point change in the return you demand (9% with 5% growth: $50).

That sensitivity is the whole story of stock prices. Small changes in what investors expect, about growth or about interest rates, move prices a lot, even when nothing about this year's profits has changed.

05The P/E shortcut

Most investors don't run the formula. They compare prices with profits using the price-to-earnings ratio: the share price divided by the profit per share (EPS) over the last year. A P/E of 25 means paying $25 for each $1 of yearly profit.

Flip it over and you get the earnings yield: 1 ÷ 25 = 4%. That is the profit each dollar of stock earned over the last year, comparable to the interest on a bond. A stock at 25 times earnings is a bet that profits will grow, because a 4% earnings yield alone is close to what cash has paid in recent years.

The share price alone says nothing about cheap or dear: a $500 share isn't dearer than a $5 share until you divide each by what it earns. A high P/E isn't automatically expensive and a low one isn't automatically cheap. The dividend growth model says why: a fast grower deserves a higher price for each dollar of today's profit. Every stock report on this site sets the company's P/E beside its industry and the S&P 500.

06Why prices swing

A stock's price moves when investors change their view of the company's future, or the return they demand for holding it. Earnings reports, new products, lawsuits and interest-rate moves all feed in. Over a day or a month most moves are noise; over many years, prices tend to follow profits.

Swings are the price of the higher return. The broad US stock market, measured by the S&P 500, has fallen 20% or more several times in living memory, and a single company can fall much further. See the five-year chart and the largest falls on any stock report.

07What can go wrong

  • A company can go to zero. Shareholders are paid last; if the business fails, the shares can be worthless.
  • Overpaying. A great company bought at too high a price can be a poor investment for years.
  • Concentration. A few stocks can sink together. Owning many companies, through an index fund for example, spreads the risk.
  • Timing. Needing the money during a downturn turns a fall on paper into one you can't undo.
  • Dividends can be cut when a business struggles.
The fine print, lesson edition. This page explains how stocks work. It is education, not advice to buy or sell any security. The growth rates, yields and returns in the examples are round numbers for the arithmetic, not forecasts; real returns vary and can be negative for years at a time.