Introduction to Stock Markets
For anyone who grew up playing the board game Stock Ticker, investing in the stock markets can feel a lot like gambling. You put all your chips on red or black and hope for the best. Or, maybe you think you need some inside information to get ahead, a hot stock tip from someone in-the-know.
It is unfortunate that this investment vehicle has gotten this reputation with the public, but it is not surprising when you consider how complex the system really is. Even though it is complex, you can understand parts of it and get involved in the parts you feel you are comfortable working with.
Before you start to throw money at the stock market, it is important to first understand how it can earn you money. You don’t need to view the stock market as a place to make bets and see if they pan out. There are just a few things that you need to know so that you can go from making bets to making investments.
A share of stock is just a way of saying a part owner of a company. When you own a share of stock in a company, you literally own a small fraction of the total assets and earnings of the company. The assets of the company are everything the company owns, buildings, patents, equipment and intellectual property. The earnings are all of the money that the company brings in from selling products and services.
A company will usually issue shares of stock for one basic reason: they need the money. If a company wants to expand its business, buy new equipment or purchase assets to improve its business processes it needs extra money, capital, to do so.
There are only 3 ways a company can raise money:
– Save the profits from earnings that are coming in. This is a slow process that takes time to build year after year. If the company wants to raise a lot of money fast, this will not provide enough capital in a short period of time. — Borrow money from banks or investors (debt financing). This can be an effective way to get money, but the money must be paid back with interest, and the investment doesn’t pan out, it can lead to heavy debt burdens that may take years to recover from.
– Sell shares of the company (equity financing) — By selling part ownership of the company, the company is able to get capital with fewer strings attached and they have no obligation to pay back the money. They can also spread out the risk of running the business among more people (stockholders).
Let’s say that you want to start up a company that makes and sells furniture. You do your research and find that you can rent a small warehouse and buy the equipment you need. You will need to raise $500,000 to purchase the equipment, and you calculate that your annual expenses for supplies, employee salaries, and utilities would be $250,000. Once you do that, you will have annual earnings of $325,000, so you would make $75,000 in profit each year. It seems like the perfect plan. Now you just need $750,000.
You could go to the bank for a loan. But if you are not able to earn the full $325,000 each year, you could find yourself burdened under debt for years, or worse, in bankruptcy court.
Or you could look for investors who are willing to give you money in exchange for partial ownership of the business. In this case, your investors would put in $750,000 and see a return of $75,000 each year — a 10% return. Plus, they could sell those shares later on and get back their initial investments.
But you could also say that you value the company higher than the necessary $750,000. If you said that the company would be worth $1,500,000 in a year and that you were selling the shares based on that value, investors would still be able to expect 5% return.
Knowing the value of the company and the earnings that it expects is key to any investment that you are going to make. The first rule of thumb for any investor is that if you don’t know the value of the company and how much it is earning, you should not be investing in it!
So, now you want to sell the shares of your company to the public to raise these funds for your enterprise. If you don’t have a group of friends who want to invest in your company, you can go to a stock exchange to offer shares to the public.
There are several of these stock exchanges. The New York Stock Exchange (NYSE), American Stock Exchange (AMEX) and the National Association of Securities Dealers (NASDAQ) are places where people come to buy and sell shares of various stocks. To save you the trouble of going to New York and learning how to exchange yourself, you can call a stock broker to do that for you and just tell him what you which stock you want to buy or sell and for what price.
Because the price of a share of stock is not set, it will change slightly with each purchase and sale. They change with the free-market forces.
In our example with our furniture company, we had an initial investment of $750,000. If we issued 100,000 shares, that would mean that each share would be worth $7.50. But after a year, your company will have an extra $75,000, so you believe it will be worth $8.25 soon.
If investors were earning less than 10% on their investment, they might sell their bad investment and decided to buy stock in your company. You don’t want to sell your stock for $7.50 because you think that it will be worth $8.25 soon so you instead offer to sell it for $7.75 right now, expecting that it will be worth even more soon.
The new investor does the math to see what the return on the investment (ROI) would be. (estimated future market value — present market value)/present market value)
The investor sees that they will still be able to earn a 6.5% return on his investment and agrees to the purchase price. When you complete this transaction, the market price changes from $7.50 to $7.75. If there are more people that think that company will be higher in the future, the price will continue to climb. On the other hand, if there are more people who think that the price will be lower in the future, the price of the stock will go down.
Because there are thousands of the trades happening every second in the larger stock exchanges, prices of stocks are constantly fluctuating. Investors are always looking for indications on how the company is doing and what its future will be, which is why the stock’s price will react quickly to news from the company, media reports, national economic news and dozens of other factors.
In order to be traded on any major exchange, a company needs to be incorporated (made into a corporation) and publicly report all of its key financial information including its earnings every quarter (every 3 months). Even though you are not able to track all of the factors that will influence the price of any given stock, you can look at the key statistics of a company before you invest (current price and expected earnings). This will let you take most of the guesswork out of investing, avoid the financial bubbles and help you make solid investment decisions.
Featured image credit: RAUMROT