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What are stocks and how do they work?

Investing in the stock market made simple

Stocks, also known as equities or shares, give you part-ownership of a company and the potential to make a profit if the company does well.

Companies issue and sell stocks to raise money, which they typically use to invest in growing the business. Stocks are listed on stock exchanges around the world – such as the Toronto Stock Exchange – where they’re bought and sold. Stock prices are constantly moving up or down, depending on demand.

Stocks have the potential to provide higher returns than other investments, such as cash and bonds, but they’re also higher risk.  

There are two main types of stocks: common stock and preferred stock. Common stocks, as the name suggests, are more common, and in general are most likely referred to as ‘stocks’.

One major difference is that the owners of common stocks often have voting rights – although only large stockholders have any real influence on the running of a company, whereas preferred stocks usually don’t come with the same voting rights.

What are the benefits of investing in stocks?

Investment returns

The most obvious benefit is the potential to make money, particularly in the long term. You can do this in two ways:

Capital growth

You may be able to sell stocks for a higher price than you bought them if the company does well, and its stocks go up in value.

Dividends

Some companies share profits directly with investors through dividends. These are payments, expressed as a certain amount per stock, which companies tend to announce as part of their full or half year financial results. Dividend payments are more common among large, stable companies than smaller or newer companies which may be more likely to reinvest any profits in growing the business.

Easy access

Stocks are easy to buy online, either yourself or through a broker, and you can start with a small amount. You can also sell them at any time at the market price, which may be more or less than what you had bought it for. This enables quick access to your money should you need it.

What are the risks?

Losing money

The biggest risk is losing your money. Stock prices can go down, as well as up, which means you might not get back what you invest.

That’s why it’s important to understand what you’re investing in. Selecting individual stocks requires extensive research, as well as close monitoring once you’ve invested – and it’s easy to underestimate the emotional rollercoaster of watching the market.

Many people fall prey to the temptation of buying a rising stock at a high price and panic selling when its value falls. You ideally want to buy a stock on a dip and sell it on a high or at a target price you set to maximize your returns. In practice, even experienced traders can struggle to time the market and end up with losses. So, it pays to stay calm and take a long-term view.

And don’t forget the age-old maxim: only invest what you can afford to lose.

Additional costs

It’s important to check the costs of investing, including any trading fees – when you buy and sell stocks – and other ongoing charges. These can make a real difference to your overall returns in the long run. Stocks may also be subject to dividend income tax.

The pros and cons of investing in stocks

Pros Cons
  • Tend to outperform inflation
  • Easy access
  • Profits from growth and dividends
  • Sell when you decide
  • Riskier than other investments
  • Research and market knowledge needed
  • Taxes on profits (Expect for TFSAs)
  • Risk of investment loss if company goes bust

The pros and cons of investing in stocks

Pros
  • Tend to outperform inflation
  • Easy access
  • Profits from growth and dividends
  • Sell when you decide
  • Tend to outperform inflation
  • Easy access
  • Profits from growth and dividends
  • Sell when you decide
Cons
  • Riskier than other investments
  • Research and market knowledge needed
  • Taxes on profits (Expect for TFSAs)
  • Risk of investment loss if company goes bust
  • Riskier than other investments
  • Research and market knowledge needed
  • Taxes on profits (Expect for TFSAs)
  • Risk of investment loss if company goes bust

What affects a stock’s price?

Broadly speaking, if a company consistently grows its earnings and profits, its stock price is likely to rise over the long term. But prices move up and down often, according to supply and demand. The higher the demand for a stock, the more its price is likely to rise; the lower the demand, the more it's likely to fall.

So, what drives supply and demand?

Company performance and outlook

Past financial results are an important measure of progress, which is why investors pay a lot of attention to company announcements when they disclose their earnings, costs and profits at least twice a year.

What investors care about most is a company’s ability to generate profits in the future. So, any news or insights that might affect this can impact a company’s stock price. This could be the acquisition or sale of a business, for example, or a new contract, strategy or competitor – any other news that could affect the company’s position in the market.

The economy

Wider economic and geopolitical factors also impact stock prices. This includes changing interest or inflation rates, as well as GDP or unemployment figures. All of these can affect consumer sentiment and demand, which impact the ability of companies to make money and grow.

How to assess stock prices

Looking at a company’s financial performance and longer-term prospects is a good place to start when considering an investment. If you want to get a better idea of the stock’s current valuation and investment potential, here are some other ‘fundamental’ metrics that can help build a picture.

52-week high and low

This shows the range of a stock price’s fluctuations over a year – the highest and the lowest. You can look at shorter or longer timeframes too. While it’s no indicator of future returns, it can help put a stock’s current price in perspective.

Earnings-per-share (EPS)

EPS is a measure of profits attributed to each stock, which can help you track earnings growth over time. It’s worked out by dividing a company’s net profit after tax by the number of ordinary stocks it has on issue.

Although there can be various factors behind a rising or falling EPS – including one-off events – it’s generally a good sign if it’s growing.

Price-earnings (PE) ratio

A PE ratio tells us how much investors are currently willing to pay for a stock, relative to the company’s earnings. It’s calculated by dividing the current stock price by the company’s EPS.

If a company’s stocks are trading at $10 and its EPS is $1, its PE ratio would be 10.

A high PE ratio suggests a consensus view that a company has strong growth potential, while a lower PE ratio may indicate the opposite. On the other hand, a lower PE ratio can be seen as better value, so long as a company has the potential to grow.

PE ratios vary from industry to industry: tech companies’ PE ratios tend to be higher, while companies in traditional industries such as manufacturing and raw materials usually have lower figures. So, PE ratios are mainly used to compare stocks within the same sector or with similar businesses.

Price-to-book ratio (P/B) ratio

Price-to-book ratio is another good indicator of stock value, comparing the value of a company’s assets – anything it could sell if it were to go bust – to its market value.

It’s calculated by taking the stock price and dividing it by the net asset value per share (NAVPS).

If a company’s price-to-book ratio is below 1, it means its market price is lower than its book value, and potentially undervalued.

On the other hand, a ratio above 1 means a company’s market price is higher than its book value. For example, if a company’s stock price is at CAD20 with a NAVPS at CAD10, it means the market is buying the company’s assets at twice its net value.

Learn about HSBC InvestDirect

HSBC InvestDirect is a division of HSBC Securities (Canada) Inc., a wholly owned subsidiary of, but separate entity from, HSBC Bank Canada.  HSBC Securities (Canada) Inc. is a Member of the Canadian Investor Protection Fund.  HSBC InvestDirect does not provide investment advice or recommendations regarding any investment decisions or securities transactions.