Monday, April 11, 2011

The Basics of Stocks - Part I: What Are Stocks And Why Do They Exist?

We've all heard of Stocks. When we hear the word "Stocks", most of us think about those guys in suits on the NYSE (New York Stock Exchange) floor yelling and bartering with other traders. But what exactly are stocks and how do you invest in them? In this part of my mini-series on Stocks, I will discuss why stocks exist and how they are useful to a company and an investor.

To put it simply, a stock is almost like a piece of a company. When you purchase stock, you're buying a portion of that company--so you in turn become a partial owner of the company. But why and how did the stock even get there? Let's step back for a bit and understand why a stock is even in existence.

The NYSE (New York Stock Exchange) is one of the world's major stock exchanges where stocks and other financial instruments are traded.

Let's look at a hypothetical example where you are the owner of a private company and would like to expand to meet your rising demand. To do this, you realize that you would have to purchase an entire plot of land, build a factory on that land, and then purchase equipment and hire employees to work in the new factory. Now all of this requires money, and lots of it. If you don't have the capital to start this new expansion, then what can you do? Presuming that the cost of the new land and building is a large sum, getting a loan would be too pricey and too risky. The next logical step for a private company in this situation would be to issue stock.

When the company issues stock, what it is doing in layman's terms is giving up its private ownership for public ownership. This means that instead of one person (or a few people) owning the private company, the company is now owned by the public in the form of stock shares. What does this mean for the company and its owner? Firstly, the owner no longer has the same power that he or she once had over the company. In fact, a Board of Directors is usually set up by the shareholders to keep the company's boss(es) in check. This means that if you founded the company and start doing sneaky and fraudulent business, and the shareholders find out, you can easily be fired from your position and replaced by a new CEO.

Once a company goes public, shares of stock are purchased by the public. Stock Certificates were once used to show ownership of these shares, but in modern times they are rarely requested for printing.

So what can possibly be the benefit of this public ownership? Remember the plot of land, factory, equipment, and employee costs? All of those can now be covered because of the large influx of money coming in from the shareholders! Since the company is now divided into millions of shares which are then bought by the public--they get partial ownership of your company (along with a potential profit which I will cover in my later post), and in turn your company gets their investment for purchasing this share of your company. So in a way, your company is saved from the daunting interest, payments, and risk of long-term debt and is simply made public to receive that extra cash. Who exactly makes the stock valuation (called an IPO or Initial Public Offering)? It is usually an Investment Banking Firm such as JPMorgan or Goldman Sachs which does the stock valuation and does all of the calculations for a successful stock offering in the market (more on this in future posts).

There are clearly sacrifices made for this switch from a private company to a public one. Since your company is no longer private, you must now answer to the shareholders. This means that if the shareholders aren't satisfied with your company--chances are they will sell your stock and the value of your company will take a dive. This is why we often hear "XYZ Company must answer to the shareholders" when we flip on the news. The company's main priorities change, and they must satisfy their shareholders with progress and innovation, a good earnings report, and dividends (again, more on this in later posts).

Stocks can appreciate over time, increasing the value of the company--and profits to the investors. Above, Google's stock during 2009.
Source: Google Finance

The good news is that your company now gets a tremendous amount of capital to use for investing in future growth (such as the plot of land and equipment), research and development (we see a lot of R&D costs in technology companies), and for simply keeping a good cushion for your company in the case of natural disasters and other problems which may halt progress. There are also changes to the structure of the company as well as the transparency code which the company undertakes which can be a double-edged sword depending on your actions (BP anyone?).

So in short, stocks in layman's terms are used to transform a private company into a public one--the company is then available for purchase via stock shares; the company acquires a large amount of capital through this process, while sacrificing its private ownership for public ownership.


So now that midterms are over and my head has cleared a little bit, I thought "It's time to get back to posting!"

I wanted to write something about finance today (after having gone through two grueling Finance midterm exams last week, why not remind myself more about it?), and so here is your finance article!

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