Stock market basics: Earnings and other key drivers of share prices

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Stocks: The building blocks of long-term savings.

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When you buy a share of stock, you’re essentially purchasing a partial ownership stake in a company. You get a sliver of the company’s future profits, and you usually get to vote in elections for the board of directors and other company initiatives.

Because these ownership stakes represent slices of “equity” (i.e., value or financial interest) in the company, you may hear stocks referred to as “equities.”

Stocks are different from other types of investments, like bonds, in several important ways. And no two stocks are exactly the same, which is why it’s so important for beginners to start with a solid understanding of the basics.

The stock market is where shares of publicly traded companies are bought and sold—a central meeting place (physical or digital) where investors, traders, and institutions come together to exchange ownership in businesses. It’s a key part of the broader financial markets, which also include bonds and other fixed-income securities, currencies, and commodities. The stock market connects companies looking to raise money (by selling shares) with investors hoping to grow their wealth (by buying those shares). Famous examples include the New York Stock Exchange (NYSE) and the Nasdaq.

But the stock market isn’t just a giant swap meet for stocks—it’s a system that runs on rules, intermediaries, and pricing mechanisms. Market makers help keep trades flowing smoothly, institutional investors including mutual funds and pension funds shape prices with their large trades, and individual investors bring energy (and sometimes emotion) to the mix. Together, they set prices, reflect expectations, and help allocate capital across the economy.

The size of an investor’s ownership stake depends on the size of the corporation and the total number of shares it has issued.

For example, suppose ABC Inc. has 10,000 shares outstanding and you purchase 100 shares. Congratulations! You now own 1% of the company.

The biggest companies have hundreds of millions or even billions of outstanding shares, so as an individual investor, you’d typically hold only a tiny fraction of the overall pie. For example, there are 2.8 billion shares of retail giant Walmart (WMT) outstanding, and Apple (AAPL) has issued more than 16 billion shares.

Nearly all equity trading today is “screen-based,” or conducted over computerized networks. This means buy and sell orders are matched electronically, making trading faster, more efficient, and accessible to investors around the world, virtually in real time.

Exchanges are what’s called a “secondary” market. Before a stock becomes available for trading on an exchange, the company typically holds an initial public offering (IPO), where shares are first sold to outside investors. This is known as going public. Private companies go public for a variety of reasons, but the primary function is for the company to raise capital to invest back in the business or to use the capital toward a merger or acquisition.

Publicly traded companies report earnings a few weeks after the end of each quarter. For example, a company may report its results for the January–March quarter in mid- to late April. Earnings per share (EPS), both actual and expected, are a key performance indicator for most companies and a critical driver of a stock’s price. For this reason, investors should watch EPS numbers closely.

Analysts who follow a company typically release per-share forecasts that collectively shape the market’s expectations for the company. Suppose ABC Inc. is expected to earn $1 per share in its current quarter, but it actually reports earnings of $1.10 per share—an earnings “beat,” in Wall Street parlance. Such a positive surprise could send the stock price higher. Conversely, if the company misses expectations and reports earnings of only 90 cents per share, the stock price may drop sharply.

Stock prices and company earnings are also key inputs for other important fundamental indicators, including the price-to-earnings (P/E) ratio. A company with a low P/E compared to others in its industry may be considered “cheap,” or undervalued by the market. A high P/E may signal that the stock price is overvalued and potentially more risky to hold as an investment.

But note: A high P/E ratio could also indicate high growth expectations down the road. Tech companies frequently begin life with ultra-high P/Es, but as the technology is adopted, products are sold, and profits begin flowing, the P/E tends to fall in line with the general market. In recent years, electric carmaker Tesla (TSLA) saw its P/E compress as its vehicle production rose. The same could be said for Amazon (AMZN), which had a nosebleed-high P/E a generation ago, but as its e-commerce and web services divisions went from conceptual dreams to concrete profitability, the P/E fell steadily.

Stocks of companies with good management and widely or increasingly used products and services can be solid long-term investments that generate stronger returns than bonds, CDs, or savings accounts. Over long periods, the U.S. stock market has outperformed other investment classes. Over the past 140 years, U.S. stocks posted an average annual return of around 9.2%. Some companies may also pay investors a quarterly or annual dividend, which is a proportion of the company’s funds distributed to shareholders.

Individual stocks can perform even better than the broader market—but they can also do worse. If you bought 100 shares of ABC Inc. at $50 for an initial investment of $5,000, and a year later the stock was trading at $60, you’d have a gain of $1,000, or 20%. But if the stock dropped to $40, you’d be down $1,000.

Even if a company is consistently profitable, that doesn’t mean its shares aren’t subject to the whims and emotions of the market or real-world events beyond anyone’s control—recessions, pandemics, geopolitics, and weather, for example. If overall market sentiment turns negative (i.e., “bearish”), it can take any and all stocks down with it very quickly.

Stocks represent public companies great and small—those that power the global economy and those that might someday. The stock market includes the full range of industries—retail, apparel, energy, food and beverage, technology, manufacturing, and everything in between.

But as an old Wall Street adage goes, it’s both a stock market and a “market of stocks.” There are many moving parts, in other words, and wise investors do their homework before jumping into anything.