What is the stock market?
The stock market is the broader marketplace where shares and other securities are bought and sold. A stock represents an ownership interest in a company. When you purchase shares, you become a shareholder of that business.
Companies issue shares partly to raise capital. Investors, meanwhile, buy shares because they may want to participate in the growth of a business, receive dividends or potentially sell their shares later at a higher price.
If a company has one million shares outstanding and you own 1,000 shares, you own 0.1% of the company, assuming those shares represent the same class of ownership.
Stocks are also called equities. They are different from bonds, where an investor generally lends money to an issuer rather than purchasing an ownership stake.
How does the stock market work?
Public companies can raise capital by issuing shares. Depending on the company and market, shares can subsequently be traded between investors. Stock exchanges provide organised marketplaces and trading infrastructure, while brokers provide investors with access to markets.
The price displayed for a stock reflects the interaction between buyers and sellers. If buyers are willing to pay increasingly higher prices, the market price can rise. If sellers become more aggressive, the price can fall.
Stock prices can respond to factors including:
- Company revenue and earnings
- Future growth expectations
- Interest rates
- Inflation and economic growth
- Industry conditions
- Management decisions
- Competition
- Government policy and regulation
- Corporate announcements
- Investor sentiment
- Supply and demand for the shares
This is why a stock can rise or fall even when there has been no obvious change in the company's current profits: investors are constantly changing their expectations about its future.
What exactly do you own when you buy a stock?
The answer depends on the type of security and share class. Common stock typically represents an ownership interest and may include voting rights and eligibility for dividends when declared.
Preferred shares can have different rights, including preferential treatment with respect to dividends or liquidation proceeds, depending on their terms.
Owning shares does not mean that you personally own the company's buildings, cash or equipment. Instead, you own an equity interest in the legal entity that owns those assets.
How do investors make money from stocks?
1. Capital appreciation
Capital appreciation occurs when the market value of an investment increases. If you buy a share for $50 and later sell it for $70, the gross price difference is $20 per share before fees and taxes.
2. Dividends
Some companies distribute part of their earnings to shareholders through dividends. Dividends can provide an income component for investors, although they are not guaranteed and can be reduced or suspended.
3. Reinvesting dividends
Instead of taking dividends as cash, an investor may sometimes reinvest them by purchasing additional shares. Over long periods, reinvestment can allow returns to compound because future returns are generated on a larger number of shares.
Total return ≈ Price change + Dividends − Costs − TaxesThis simplified formula is useful for understanding why looking only at the stock price can give an incomplete picture of an investment's performance.
Types of stocks
| Type | General characteristic |
|---|---|
| Growth stocks | Companies expected to grow revenue or earnings relatively quickly. |
| Value stocks | Shares that appear inexpensive relative to selected financial measures or perceived business value. |
| Income stocks | Companies often associated with relatively consistent dividend payments. |
| Blue-chip stocks | Established companies with large market presence and long operating histories. |
| Large-cap | Companies with relatively large market capitalisation. |
| Mid-cap | Companies between large-cap and small-cap classifications. |
| Small-cap | Smaller publicly traded companies that can have greater growth potential and higher volatility. |
These labels are useful descriptions rather than guarantees of performance. A growth stock can decline sharply, while a value stock can remain undervalued or decline further.
What is a stock market index?
A stock market index measures the performance of a selected group of stocks. Instead of following one company, an investor can use an index as a broad reference for a market, country, sector or investment theme.
Examples include the S&P 500, Nasdaq-100, FTSE 100 and indices associated with the Nairobi Securities Exchange.
An index is not necessarily an investment itself. However, investors can gain exposure to an index through products such as index funds or exchange-traded funds, depending on what is available in their market.
Fundamental analysis: how investors study companies
Fundamental analysis attempts to understand the financial condition, competitive position and potential value of a company.
Common areas of analysis include:
- Revenue growth
- Profit margins
- Earnings per share (EPS)
- Free cash flow
- Debt and liabilities
- Return on equity (ROE)
- Return on invested capital (ROIC)
- Dividend history
- Competitive advantages
- Management quality
- Industry growth
- Market share
Revenue
Revenue is the money a company generates from its business activities. Consistent revenue growth can be useful evidence that demand for a company's products or services is increasing, although revenue growth by itself does not guarantee profitability.
Profit and profit margin
Profit is what remains after a company's expenses are accounted for. The profit margin shows how much profit a company generates relative to revenue.
Net profit margin = Net income ÷ Revenue × 100Earnings per share
EPS measures earnings attributable to each share under the applicable accounting methodology. Investors often compare EPS across periods to study earnings growth.
Debt
Debt can help a company finance expansion, but excessive debt can increase financial risk, particularly when interest costs rise or cash flows weaken.
How to value a stock
A good company is not automatically a good investment at every price. Valuation asks a different question: what price am I paying relative to the company's earnings, assets, cash flows or growth prospects?
Price-to-earnings ratio (P/E)
The P/E ratio compares a company's share price with its earnings per share. It is commonly used to compare valuations, although comparisons are most meaningful between similar businesses and industries.
P/E = Share price ÷ Earnings per sharePrice-to-book ratio (P/B)
P/B compares a company's market value with its book value. It can be especially useful in certain asset-heavy industries, although accounting values may not perfectly represent economic value.
Price-to-sales ratio (P/S)
P/S compares market value with revenue. It can sometimes help analyse companies that have little or no current profit, but revenue alone does not tell you whether a business is profitable.
Dividend yield
Dividend yield compares annual dividends with the share price.
Dividend yield = Annual dividend per share ÷ Share price × 100A very high dividend yield is not automatically attractive. A falling share price can mechanically increase the yield while the underlying business may be deteriorating.
Technical analysis: reading stock charts
Technical analysis focuses primarily on market data such as price and volume. Traders use charts to study trends, momentum, volatility and potential support and resistance levels.
Common technical indicators
- Moving averages: help smooth price data and identify trends.
- RSI: measures recent price momentum and can help identify extreme conditions.
- MACD: compares moving averages to analyse momentum and trend changes.
- Bollinger Bands: help visualise volatility around a moving average.
- Volume: shows the number of shares traded and can provide context for price movements.
Technical indicators describe historical market behaviour. They can help structure a trading decision, but they cannot guarantee that a future price movement will occur.
Long-term investors may place greater emphasis on business fundamentals, while active traders may focus more heavily on price action, liquidity, volatility and market structure. Some market participants use both.
Market orders vs limit orders
When buying or selling shares through a brokerage platform, the type of order can