Stocks and the Stock Market

Stocks and the Stock Market

 

Stocks and the Stock Market

 

For a new investor, the stock market can feel a lot like legalized gambling.

 

"Ladies and gentlemen, place your bets! Randomly choose a stock based on gut instinct and water cooler chatter! If the price of your stock goes up -- and who knows why? -- you win! If it drops, you lose!"

 

Isn't that why so many people got rich during the dot-com boom -- and why so many people lost their shirts (not to mention their retirement savings) in the recent recession?

Not exactly.

But unfortunately, that's how many new investors think of the stock market -- as a short-term investment vehicle that either brings huge monetary gains or devastating losses.

With that attitude, the stock market is as reliable a form of investment as a game of roulette.

But the more you learn about stocks, and the more you understand the true nature of stock market investment, the better and smarter you'll manage your money.

The stock market can be intimidating, but a little information can help ease your fears.

Let's start with some basic definitions.

share of stock is literally a share in the ownership of a company.

When you buy a share of stock, you're entitled to a small fraction of the assets and earnings of that company. 

Assets include everything the company owns (buildings, equipment, trademarks), and earnings are all of the money the company brings in from selling its products and services.

Why would a company want to share its assets and earnings with the general public?

Because it needs the money, of course.

Companies only have two ways to raise money to cover start-up costs or expand the business:

It can either borrow money (a process known as debt financing) or sell stock (also known asequity financing).

The disadvantage of borrowing money is that the company has to pay back the loan with interest.

By selling stock, however, the company gets money with fewer strings attached.

There is no interest to pay and no requirement to even pay the money back at all.

Even better, equity financing distributes the risk of doing business among a large pool of investors (stockholders).

If the company fails, the founders don't lose all of their money; they lose several thousand smaller chunks of other people's money.

Perhaps the best way to explain how stocks and the stock market work is to use an example.

For the remainder of this article, we'll use a hypothetical pizza business to help explain the basic principles behind issuing and buying stock.

We'll start on the next page with the reasons why a restaurant owner would issue stock to the public.

 

Selling Shares

Let's say that you've always dreamed of opening a pizzeria.

You love pizza, and you've done your homework to figure out how much it would cost to launch a new pizza business and how much money you could expect to earn each year in profit.

The building and equipment would cost $500,000 up front, and annual expenses (ingredients, employee salaries, utilities) would cost an additional $250,000. With annual earnings of $325,000, you expect to make a $75,000 profit each year. Not bad.

The only problem is that you don't have $750,000 (building + equipment + expenses) in cash to cover all of those costs.

You could take out a loan, but that accrues interest.

What about finding investors who would give you money in exchange for a share of the ownership of the restaurant?

This is the logic that companies use when they make the decision to issue stock to private or public investors.

They believe that the company will be profitable enough that investors will see a good return. In this case, if investors paid a total of $750,000 for shares in the pizza restaurant, they could expect to earn $75,000 annually.

That's a solid 10 percent return.

As the owner of the pizza restaurant, you can set the initial price of the company, as well as the total number of shares of stock you want to sell.

Interestingly, the price of the pizza business doesn't have to correlate with the actual value of the assets or the company's current profitability.

You can set the price so that it reflects the future value of the investment.

For example, if you set the price at $750,000, investors could expect a 10 percent return.

If you set the price at twice that much, $1,500,000, investors would still get a respectable 5 percent return.

If you issue a lot of shares, that would lower the price of each individual share, perhaps making the stock more attractive to lone investors.

Another consideration is ownership.

Each person who buys a share of stock essentially owns a piece of the company and has a say in how the company is run.

We'll talk more about shareholders in a later section.

But for now, it's important to understand that, as the owner, you may wish to buy a majority of the available shares yourself so that you remain in majority control of the company.

We'll talk more about stock prices later. In the meantime, let's talk about stock exchanges -- the clearinghouses where the world's biggest companies sell shares by the millions each day.

 

A Stock Exchange

Let's get back to our pizzeria example.

If you want to launch one and are interested in recruiting a pool of investors, where would you find these people?

You could place an ad in the paper or online, or you could simply contact friends and family.

But what if some of your initial investors decide a year later that they want to sell their shares?

They would each have to go out and find a new buyer, which might prove difficult, especially if the company isn't performing very well.

A stock market solves this problem. Stocks in publicly traded companies are bought and sold at a stock market (also known as a stock exchange).

The New York Stock Exchange (NYSE) is an example of such a market.

In your neighborhood, you have a "supermarket" that sells food.

The reason you go the supermarket is because you can go to one place and buy all of the different types of food that you need in one stop -- it's a lot more convenient than driving around to the butcher, the dairy farmer and the baker.

The NYSE is a supermarket for stocks.

The NYSE can be thought of as a big room where everyone who wants to buy and sell shares of stocks can go to buy and sell.

Modern stock exchanges make buying and selling easy.

You don't have to actually travel to New York to visit the New York Stock Exchange.

You can call a stock broker who does business with the NYSE, or you can buy and sell stocks online for a small fee.

There are three big stock exchanges in the United States:

  • NYSE - New York Stock Exchange
  • AMEX - American Stock Exchange
  • NASDAQ - National Association of Securities Dealers

If these exchanges didn't exist, buying or selling stock would be a lot harder.

You'd have to place a classified ad in the newspaper, wait for a call and haggle on a price whenever you wanted to sell stock.

With an exchange in place, you can buy and sell shares instantly.

Stock exchanges have an interesting side effect.

Because all the buying and selling is concentrated in one place, and since it's all done electronically, we can track the constantly fluctuating price of a stock in real time.

Investors can watch, for example, how a stock's price reacts to news from the company, media reports, national economic news and lots of other factors.

For example, all publicly traded companies need to issue quarterly earnings reports through the Securities and Exchange Commission (SEC).

If those earnings are lackluster, shareholders might decide to sell some of their stock, which would lower the stock price.

But if the newspaper reports an overall increase in the popularity of pizza, more people might buy shares and the price would go back up.

But before we delve too deeply into the intricacies of stock prices, let's talk about corporations. Even if you own your own pizza business, you can't sell stock in the company unless you become a corporation. We'll discuss that on the next page.

 

Corporations

 

 

Any business that wants to sell shares of stock to private or public investors needs to become acorporation first.

The legal process of turning a business into a corporation is called incorporation.

If you start your pizzeria with your own money (even if it's borrowed from the bank), then you've formed asole proprietorship.

You own the entire restaurant yourself, you get to make all of the decisions, and you keep all of the profits. If three people pool their money together and start a restaurant as a team, then they've formed a partnership.

The three people own the restaurant themselves, sharing the profit and decision-making.

A corporation is different, and it's a pretty interesting concept. A corporation is a "virtual person."

That is, a corporation is registered with the government, has its own Social Security number (called a federal tax ID number), can own property, sue and make contracts. (It can also be sued.)

By definition, a corporation has stock that can be bought and sold; all of the owners of the corporation hold shares of stock in the corporation to represent their ownership.

One characteristic of this "virtual person" is that it has an indefinite and potentially infinite life span.

There is a whole body of law that controls corporations.

These laws are in place to dictate how a corporation operates, how it's organized, and how shareholders and the public get protection.

For example, every corporation must have a board of directors.

The shareholders in the company meet every year to vote on the people who will "sit" on the board.

The board of directors makes the decisions for the company.

It hires the officers (the president and other major officers of the company), makes the company's decisions and sets the company's policies.

Consider the board of directors as the virtual person's brain:

Even if a corporation has a single employee who also owns all of the stock in the corporation, it still has to have a board of directors.

Another reason that corporations exist is to limit the liability of the owners to some extent.

If the corporation gets sued, it's the corporation that pays the settlement.

The corporation may go out of business, but that's the worst that can happen.

If you're a sole proprietor who owns a restaurant, and the restaurant gets sued, you're the one being sued.

"You" and "the restaurant" are the same thing.

If you lose the suit, then you can lose everything you own in the process.

 

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