Explaining corporate stock trading is made easier by glancing first at some forms of business that do not have shares of stock (so that it is clear when you do have stock what it is stock of)..

In the simplest type of business organization, one and the same man is sole owner, proprietor, manager, boss, and worker; he is "the whole works." In occupation he may be, for example, a farmer, a plumber, or a grocer. Or he could be a professional man, such as a physician or a lawyer. Probably he thinks of himself more as a worker than as an owner. But he is in quite a different position from an em­ployee who works for somebody else. Nobody pays him a salary or wages. If his income is not large enough to cover his expenses, including what he takes out for personal and family needs, then he must either cut his expenses or in­crease his income by finding more customers or selling more per customer or raising prices, or else he must go out of business. When he wants a new machine to do better or more work, he must find the capital to pay for it. These are the responsibilities of an equity owner of any independent, private business, who is not trading stock, no matter how small or large the organiza­tion is.

A successful one-man business is likely to grow in size. An owner-manager hires employees, thus turning himself into an employer. To meet his need for more capital than he alone is able to furnish, maybe he borrows money. The lender has no responsibility in the business, except that he may interfere if he does not receive his interest or principal on time. After payment of all expenses, including interest on the loan, if the business shows a profit it all belongs to the original owner, who is still the sole equity owner who is not trading stock. Or if the gross income is smaller than the expenses, then, the loss is all his.

Expansion of a business may take this form: The original owner arranges for one or more people to join him as part­ners. Normally a partner contributes work and skill as well as money, but we are concerned here with only the investment aspect. Each partner shares in the profits or losses of the business; but first the firm must pay all of its expenses. On borrowed money it must make the agreed payments to the lender before it pays profit to a partner when not trading stock.

A partnership is an ancient method of organizing busi­ness, and is still used extensively. It is a highly personal form of organization. Obviously it has a better chance of working satisfactorily in a business that does not need more than two or three equity owners. A large number of partners is a clumsy arrangement.

What Is a Corporation?

Another way of owning a business is to organize a cor­poration, and that brings us closer back to the subject of this chap­ter. The equity ownership of a corporation is divided into shares of stock, which can be divided among a great many owners, and one or more shares can be transferred from one owner to another without disturbing the other sharehold­ers in a limited way of trading stock. A stockholder need not have any personal acquaintance or contact with the management or with other owners. This permits a corporation to be larger and more flexible and permanent than a single proprietorship or a partnership can be..

A corporation is a sort of "person" created by law, with an existence separate from its owners, who are "natural per­sons." To start a corporation in the United States, the owners must obtain a charter from a state government, or possibly from the Federal Government, and must submit to govern­ment regulation. An American business enterprise that uses a good deal of capital is pretty sure to be a corporation. An outfit that wants to distribute portions of its ownership among more than a handful of people is practically obliged to in­corporate. All of the business concerns whose stocks or bonds are sold to the public through the stock markets are corpo­rations or the practical equivalent.

A corporation is managed by officers who, technically at least, are selected by a board of directors, and the board in turn are selected by a vote of the shareholders. Each share is entitled to one vote, so that a stockholder has as many votes as the number of shares he holds. In practice, the vot­ing right of an ordinary stockholder is of little consequence. When the management needs stockholder approval, each owner receives by mail a proxy, which he is requested to sign and return. His choice is limited to voting "yes" or "no" on the management's proposals. Even if a small stockholder bothers to attend an annual meeting, voting against the "inside crowd" is useless except on the rare occasions when the opposition is well organized and powerful.

This sounds like a decidedly undemocratic way to run things. But a small stockholder is not powerless. Provided the stock is readily marketable, he is free to express his disap­proval of the management by trading stock and selling out. Ready marketability is a point for a cautious investor to check before he buys. For a corporate shareholder, it is far more important than voting rights.

In the long run, the easiest and safest way for a corpora­tion officer to increase both his personal income and his prestige is to be in charge of a company that is making mon­ey for its stockholders and is growing. He cannot do this unless his company's management is as skillful as its com­petitors' are. The continued success of the company means a great deal more to an officer than it does to the average stockholder.

Corporations are often in need of additional capital for ex­pansion. Traditionally they have raised the capital by trading stock by selling it or bonds to wealthy families. But as the years pass, they find it necessary to induce an ever-increasing number of peo­ple to become stockholders. This causes corporation officers to be more respectful of the "little guy." Much still needs to be done in this direction, but there is a trend toward making it more practical and attractive for a small investor to be­come a shareholder.

Roughly, and over a long period of time, the interests of corporation heads and of small stockholders are likely to agree. But this does not mean that an investor can trustingly assume that all American corporations are well run, or that it matters not whose stock he owns.

What Are Dividends?

Corporate profits that are passed on to stockholders are called "dividends." A corporation does not ordinarily pay a dividend until two conditions have been met. First, the gross receipts must be larger than is required to meet all expenses, including taxes and paying interest on borrowed money. The remainder is the corporation's net income or net profit, some­times called "earnings." Second, the management must decide how much of the profits is needed for such things as expan­sion of the business or as a cushion for possible bad years in the future, and how much of the net income can be spared for dividends to stockholders. Sometimes, when current income is poor, dividends are paid from the undistributed profits of previous good years.

When a corporation's gross receipts are smaller than its ex­penses, so that there is no profit, its stockholders suffer by receiving no dividends, and the market value of a share drops, possibly to zero. But a stockholder is not assessed, as a part­ner often is, to help pay the firm's debts. There may be some rare exceptions to this statement, so that a cautious investor needs to inquire before he buys.

Every corporation has "common" stock; and in the sim­plest form of equity ownership, a company has only this one class of stock. A company with two classes of stock is likely to call one class "preferred"; or maybe there are a first pre­ferred and a second preferred.
Preferred stock is a compromise between a loan and an equity. A preferred dividend is scheduled at a uniform rate per share, such as five dollars a year, thus resembling inter­est on a bond. But in contrast to bond interest, a corporation pays a preferred dividend only if earnings have been adequate and the management decides to pay. This uncertainty of divi­dends causes more fluctuation in the market price of pre­ferred stock than on bonds issued by corporations, although probably not as much as on the common stock of the same corporations.

When a company's net income goes up, the dividend on a share of preferred stock remains at the scheduled rate, while on a common share the increased profits are probably reflect­ed in a larger dividend, and the market price of a common share rises more than on the preferred. In a prosperous per­iod, both the dividend and market value on a share of com­mon may be higher than on the preferred, thus leaving a preferred stockholder in a state of genteel poverty! When profits are poor, maybe dividends will continue on the pre­ferred but not on the common; or maybe dividend payment will stop on both classes of stock. Usually the only thing sure about preferred stock is that the dividend will not be higher than the scheduled rate!

For an amateur investor, a simple way to meet this con­fusing situation is just not to own any preferreds. And be­cause the presence of a preferred class complicates the normal relation between company earnings and common-stock divi­dends, an amateur had better be skeptical of common stock in a corporation that also has preferred stock. A majority of the large American corporations have only common stock, and the type especially recommended by this book issue only common stock. So in the remainder of these chapters, the dis­cussion of stock is limited to the common class.

Early in this century a corporation customarily sold a new issue of stock at the par value, usually $100 a share, so that par value had some meaning for an investor. But today the par value of a share of common stock indicates neither the original price nor the present selling price. It has become merely a legal technicality, and a number of corporations specify that their stock has "no par value." To an investor, the market price of a share is what matters, and on common stock in a prosperous period this value is likely to be a good deal higher than the par value.

Buying and Selling Stock

In the United States there are several hundred thousand corporations, ranging in size from baby to giant. New ones are constantly being formed. The stock of a corporation may be closely held, perhaps with one man owning a majority, and the remaining shares all held in his family where no-one is trading stock. Or maybe shares are sold on a rather personal basis to selected employees and friends of the man­agement.

When a company is willing to sell some of its shares to anyone who will pay for them, normally it arranges for sale of the shares through one or more stock-dealers. This action puts those shares into the organized stock market. The same thing happens if an old stockholder decides to unload.

A stock-dealer does not work alone, unless on some stock he has both seller and buyer among his own clients. Dealers have systems of notifying one another by long-distance phone and mail as to what stock their clients want to sell or buy, and at what price. Daily newspapers and radio carry quota­tions on the more active and prominent stocks in the realm of trading stock. Some metro­politan newspapers print prices daily on thousands of stocks.

Who sets the price on a corporation's stock? An amateur investor may naturally assume that the price is set by the man­agement of the issuing corporation. But this is true only when the company that issues the stock is doing the selling, and such sales make up only a small percentage of the total volume of stock sold. In the great bulk of transactions, the seller is a stockholder who has his own reasons for wanting to sell some shares. The issuing company knows nothing about these sales until a dealer turns in the old stock certificate, with a request for the company to issue a new certificate in the name of the new owner.

A comparison with the sale of automobiles may help here. An automobile manufacturer sells a new car to a dealer, who in turn sells it to a user. Some time later the user sells this car, now a used car, to a dealer. Most likely the price of the secondhand car becomes part of the user's payment for an­other car, and this complicates the transaction. But the man­ufacturer has no direct part in the selling of a used car. How much a dealer pays for a used car depends mainly on what some other customer will pay the dealer for it. A car may be bought and sold through dealers several times before it is junked.

Some major differences between the sale of a used automo­bile and trading stock are these: First, the price of a "used" share of stock may be either higher or lower than when "new." On the stock of a successful, established com­pany, the price is apt to rise, as the company grows larger and older. A share of stock does not go to the "junk yard" unless the issuing corporation goes out of business.

Second, each share of common stock has the same market value as any other share issued by the same corporation, and a certificate of ownership can be mailed readily over great distances. How far apart a buyer and a seller are physically is of no consequence. The price of stock in trading stock is set by the consensus of opinion of all the people who are either offering or bid­ding for stock of that company at that time. All dealers are likely to quote close to the same price at any one time.

Contrary to the usual conditions discussed above, in some corporations a buyer always receives newly issued stock, and instead of selling he turns in his shares for redemption by the company. The principal group of such corporations are the open-end investment companies, usually called mutual funds. The price of a share in a mutual fund is set automatically by the total market value of all the stocks and other property that the fund owns. This is explained further in later chap­ters on this aspect of trading stock.