In order to become a successful investor, one must have a basic understanding of financial instruments and how to use them profitably. Having a firm understanding of these instruments will help you to make wise investment decisions, even as market conditions change. One of the most popular and widely used financial instruments is stocks.

A stock, or share, is a financial instrument that represents partial ownership of a company. Therefore, owning a company’s stock means you are a part-owner or shareholder of a company, entitling you to a portion of the company’s assets and earnings. Being a shareholder also grants you special voting rights which can be used to elect the board of directors at annual general meetings, held by the company. This is to ensure that shareholders have a say in how the company is being run, for after all, they are the owners.

Even though a shareholder is a part-owner of a company, this does not mean they are responsible for liabilities. If a company goes bankrupt and has to default on loans, the shareholders are not liable in any way. However, all money a company obtains by converting assets into cash will be used to repay loans and other debts first; therefore shareholders cannot receive any money until creditors have been paid. Often the shareholders end up with nothing, but this ensures that the most investors can lose is the initial cost of their shares.

Most stocks are traded on a public exchange. For example, the Jamaica Stock Exchange is home to a number of Jamaican stocks which are traded on a daily basis. The role of a stock exchange is to facilitate stock trading by matching buyers with sellers. So if a shareholder of Company A wishes to sell his stock, he uses the stock exchange (through his broker of choice) to find a buyer and settle at an agreeable price. If the price agreed upon is higher than the price at which the shareholder purchased the stock, the shareholder will realise a profit upon completion of the trade. However, if the price is below the stock’s purchase price, the shareholder will realise a loss.

There are a number of factors that affect the price at which a company’s stock will be traded. The more valuable a stock is deemed to be, the greater the demand for it. As the demand for a particular stock increases, buyers are willing to pay higher prices resulting in an appreciation in the price of the stock. This demand is tied to the perceived value of the company, held by investors. Investors consider a number of factors and attributes when valuing a company. A few of these factors are earnings, dividend payments and market capitalisation.

A company’s earnings are very important when determining its value and financial health. Earnings can be defined as the profit a company produces over a specified period of time. Listed companies are required by law to report their earnings on a quarterly basis so as to keep investors informed about the company’s performance. This also aids them in making sound, educated investment decisions. A steady increase in a company’s earnings is a favourable condition for investors as this implies that the company is growing its business and becoming more profitable.

When a company makes a profit, it may choose to pay a portion of this profit to its shareholders. This payment is called a dividend and companies use dividends to reward existing shareholders and to attract new investors. Similar to earnings, a growth in dividends is favourable to investors as this too implies that the company is becoming more profitable. However, if a company decides to suspend or reduce its dividends, it does not automatically imply the company is facing financial troubles. The company may decide to reinvest this additional income to put itself in a more stable cash position. Dividends are often directly related to the company’s cash position, and cash is widely regarded as king, in business.

If Company A has a share price of $1 and Company B has a share price of $2, this does not mean Company B is twice as valuable as Company A. To determine a company’s value, relative to another, we must compare each company’s market capitalisation. The market capitalisation, or market cap for short, is the dollar value of a company based on its current share price.

A company’s market cap is computed by multiplying the company’s share price by the number of outstanding shares. For example, if Company A has 20 shares outstanding while Company B has 5 shares outstanding, Company A will have a market cap of $20 while Company B’s will be $10. Based on this indicator, Company A would be twice as valuable as Company B. When investors are comparing two companies, they tend to prefer the one with a larger market cap as this implies the company is larger and more stable — therefore having a higher chance of staying in business.

Investing in stocks can be very profitable as long as the required effort is put in. As an investor, it is very important to keep up to date with companies that you have invested in, as day to day events can change the fundamentals of a company.

Also, pay special attention to quarterly and annual reports released by the company as these help to keep you informed about how the company is performing. A firm understanding of stocks is a powerful tool, as it enables you to create a more profitable investment portfolio and make solid investment decisions.

Rory DeSilva is a trader at Stocks and Securities Limited.