Common stock represents ownership in a corporation. Successful operation of the corporation means more funds available for reinvestment in the corporation and for distribution to the stockholders. Such payments to stockholders are called dividends.
The proportion of earnings which is paid to stockholders compared with the amount retained for reinvestment depends upon the individual company’s objectives. Companies which retain a high percentage of earnings are generally considered to be growth-oriented stocks. Those that pay out a large percentage of their earnings in the form of dividends are usually more attractive to investors who are willing to sacrifice some degree of growth for current income.
The value of a common stock is determined by the forces of supply and demand in the marketplace. Theoretically, stock of a successful company or one with bright prospects should rise in value due to rising demand for its ownership. However, this is not always true because of the wide variety of factors affecting stock prices. For example, the price of a stock may reach an unreasonably high level due to excessive enthusiasm on the part of investors and then may drop as a corrective function, irrespective of the company’s continuing success. On the other hand, a company with poor operating results and marginal prospects may drop to a level that is absurdly low in relation to the value of the underlying assets, only to be bid up in price by investors seeking undervalued issues.
The general movement of the stock market can affect the price of an individual issue. The stock market as a whole rises and falls as a result of almost limitless factors, constantly reacting to current events and anticipating future trends. Sometimes these factors have little effect on the operations of a single company, but a particular company’s stock price may be affected by the general movement of prices.
Millions of shares of stock change hands daily. These transactions usually take place in centralized continuous auction markets called exchanges, or in the over-the-counter market where the price is negotiated between dealers. Shares of most large companies trade on exchanges.
Institutional investors such as banks, insurance companies, and pension funds generally buy and sell large blocks of stock and, therefore, have a significant effect on the stock market.