What do I own when I buy a Stock?

So you saw Tesla’s stock flying high last year, you really dig Elon Musk, and you think the cars are kind of cool. If you won the lottery, you’d probably like to buy one. Or maybe you saw General Electric’s stock price getting pounded after a seemingly endless stream of bad news. In one case, you may have said, “Gee, I really love everything about Tesla and the stock keeps going up, maybe I should buy some.” On the other hand, looking at GE, you might have said, “Hey, it can’t really be that bad. Maybe I’ll take a chance and throw a few bucks in there.”

In both cases, you are taking a risk. And the risk is that you could lose everything you invest in either of those companies.

But why is that the case?

The answer to this question lies in the very definition of what a stock is.

When you own common stock in a company, you own a heavily subordinated claim to the cash flows of the underlying company. That’s a whole lot of lawyer-speak and jargon, so let’s break down what that actually means since it helps to tell us about why stocks behave the way they do.

First, let’s talk about what the heck “heavily subordinated” means. In short, this term signifies where you stand in line with other people invested in the company if it were to go out of business. Unfortunately, when you own common stock, it’s typically at the back of the line or pretty close to the back of the line. While the specific setup will vary depending on the company and the exact financing structure they have in place, common stock holders typically come after senior debt holders, junior debt holders, and preferred stock holders. This means that common stock owners typically receive nothing or close to nothing when a company goes out of business.

So that explains the case where a company’s stock might go from $100 per share to $0 per share. But it doesn’t help to explain why a stock might go from $80 per share to $60 per share, even though there may not be much of a risk of the company dying in the near-term. For the answer to that question, we have to look at the second part of the jargon-fest we saw earlier.

The phrase “claim to the cash flows of the underlying company” is a fancy way of saying that you own a portion of the money the company generates. Let’s say that Company X has 100 shares outstanding. They bring in $100 per year and they spend $80 per year. The company’s cash flow is $20 per year. You own 10 shares of the company, because you’re kind of a big deal. Your 10% stake in the company entitles you to 10% of the cash flow, meaning you’d be entitled to $2 over the course of that year. An important thing to note is that companies are not required to pay this cash flow out to shareholders, and in many cases, they seldom do. So getting a payout equal to the annual cash flow of a company should not be one of the reasons why you try to buy a stock. Companies may pay out a dividend on a quarterly basis, but that is typically less than the cash flow they generate.

In any case, let’s return to the example of Company X having cash flow of $20 per year. Suppose investors say they are willing to pay 20x that company’s cash flow for the shares. The stock would be valued at $400 per share. But let’s say that the company has to spend more. Or maybe they don’t sell as much product next year. Let’s say their cash flow goes down to $19 per share. If investors still valued the company at 20x Company X’s cash flow, the stock would be fairly valued at $380 per share. So investors may sell the stock until the market price reflects that new reality. They also may say that the reduction in cash flow might continue, and so they could value it at a lower multiple than 20x as well, pushing it down further. The opposite could be the case if cash flow exceeds expectations, with the stock price and multiple being pushed higher due to growth.

Now, this simple model looks at a company in a vacuum. In reality, there are a ton of forces – fiscal policy, monetary policy, regulation, and a whole host of others that filter into informing prices. But the goal of this simple model isn’t to tell you how what the exact value of a stock should be on any given day. It’s to inform your understanding regarding what you actually own so you can start to understand how all of those different factors may impact the movement of a stock. Investing isn’t just about finding out answers. It’s about building a process, and that process starts with asking the right questions – questions like, “What on Earth do I actually own?”