Thursday, April 7, 2011

Taking Stock of Stocks: Introduction

First, MBTN took on bonds.  Next, we conquered insurance.  Now, we plan to tackle a financial weapon which should be in everybody's arsenal:  stocks!  Stocks often are praised when they are going up in value, and maligned when they go down.  People who buy them can get filthy rich or dirt poor.  But what is a stock anyway?

Stock Fundamentals

A stock is an ownership share in a business - nothing more and nothing less.  When you own a share of stock, you are a part owner in whatever business that share represents.  When you own a share of Apple, you are a part owner of Apple.  When you own a share of Exxon, you are a part owner of Exxon.  Don't get too excited, though.  According to over 921,000,000 shares of Apple, so when you own one share, you own less than 0.0000001% of Apple!  That isn't a large ownership percentage, but I guess it is better than 0%.

When you own a business, you get two benefits:

1. You get to make all of the decisions.
2. You get to keep all of the profits.

When you own a share of stock, you get the same benefits.  However, you have to share those benefits with the thousands and thousands of other people who own that stock.  Obviously the more shares of stock you own, the more control you have over decisions, and the more profits you get to keep.

How do thousands of people share in the decision making?  Think of how hard it is for three friends to agree on where to go out to eat.  Imagine how difficult it is for thousands of people to make a decision about how to run a business!  Fortunately, there is a solution.  Every year, the shareholder vote for a people to represent their interests when it comes to running the company.  This group is known collectively as the Board of Directors.  The Board oversees the operations of the company and make sure that the owners' interests are taken into account.  Usually the Board won't handle the day-to-day operations of the company.  They will hire somebody to handle the management tasks, who is usually known as the Chief Executive Officer.

As far the profits go, the company splits some of the profits among all of the shareholders in the form of a dividend.  The size of the dividend depends upon how well the company is doing as well as the number of outstanding shares.  Normally, a company won't return all of the profits in the form of a dividend.  Most companies retain some of the profits so that they can use them for future expansion, acquisitions, or just for a "rainy day".  Some fast growing companies may not pay any dividends.  These companies retain all of the profits so that they can be used to continue to expand the company's business.  The Board of Directors are the ones who decide how much is retained and how much is returned to the shareholders.

Why Does a Company Issue Stock?

Consider a person who starts a business.  When they start their business, they might invest some of their own money to get the business off the ground.  However, the company may reach a point where it needs to raise more money in order to expand.  Perhaps a company needs to purchase a factory to manufacture its product.  Perhaps a company needs to hire more staff in order to increase their sales.  These things require a large investment of money which the founder may not have.  They need some mechanism the raise this money. 

Generally, there are two ways for a company to raise money:  get a loan or bring in partner.  For some companies, getting a loan may not be an option maybe because the interest rate is too high or nobody will lead you the money.  The other downside of a loan is that you have to pay it back at some future point in time.  Instead, a company may look to sell an ownership stake by selling stock.  The company gets some amount of money in return for giving up some ownership to an investor.  This means that the company now has to give up some of its profits and control to the new investor.  However, since this isn't a loan, the investment doesn't have to be paid back if the company goes under, since the investor now shares in the risk and the reward (more on that later).

Buying and Selling Stocks

Just like any business owner, you can decide to sell your ownership stake in a company by selling your stock.  Of course, there needs to be somebody ready, willing, and able to buy it.  Fortunately, a mechanism for buying and selling ownership shares of companies exists.  It is called the stock market.  A stock market is a place where buyers and sellers come together to buy and sell stocks.  The exact mechanisms of how the stock market works is beyond the scope of this article.  In a nutshell, the stock market publishes the price at which buyers are willing the pay for a share of stock, and for which sellers are willing to sell a share of stock.  The important thing is that, for most companies, it is quite easier to buy or sell shares of stock.  The buying and selling price fluctuates from day to day.  The price is based upon a variety of factors, including how people feel the company is doing and how people feel the overall economy is doing.

The Riskiness of Stocks


If you are an owner of a business, if the business takes off, you as the owner benefits from this financially.  The sky is the limit, as they say.  However, there is also a great deal of risk involved as well.  If for whatever reason your business tanks, there is a potential for you to lose all of the money which you invested.  This is he same for owners of stocks. 

When a company goes out of business, usually it will still have some assets:  property, inventory, patents, or other things of value.  However, first you have to use those assets to pay off all of the people to which you owe money.  If after you settle your debts there is something left over, then all of the shareholders split whatever crumbs remain.  In many cases, the value of the assets aren't enough to pay off a company's debts.  In that case, the company declares bankruptcy, a judge splits the assets among the creditors, and the shareholders get nothing!

The fact that creditors get first dibs on a company's assets is why bonds generally are less risky than stocks.  Remember that bonds are loans, so when you buy a bond, you are lending a company money.  When a company goes out of business, a bondholder gets their money before a stockholder, so a bondholder won't lose everything.  On the flip side, if the company does well, a bondholder is only entitled to get the bond's face value and coupon payments.  Therefore, there is less upside potential when you buy a company's bonds.

Conclusion

The main thing to remember is that when you own a stock, you own a piece of a company - a small piece but a piece nonetheless.  As a part owner, you have all of the rights and privileges that comes with being an owner:  a share of control and a share of the profits.

Next time, I will talk more about how a stock is "valued" by the market.  Stay tuned!

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