Stocks are absolutely intrinsic to our entire economic system, yet most of us can barely call ourselves even vaguely familiar with the stock market. To change that, here are some of the basic things you need to know about company stocks before you start investing in the companies of the world.
An Introduction To Companies
Let’s first try to understand what a company is before getting into the details of stocks and shares. Imagine that you want to go into business making Walkmans. You don’t really know much about business, or Walkmans for that matter, so you would do your best to minimize your risk in this endeavor. Therefore, you create a ‘company’, which is a legal entity that is taxed separately and is essentially treated as a different ‘person’. Now, all the losses you incur in that business will not drain away your personal assets or any other company that you might own. Essentially, you are free to go bankrupt by pursuing this ridiculous business of yours!
Imagine that your business starts to boom right away. People really love your product and believe it’s going places. You, obviously excited by the response, want to expand your company. However, you don’t seem to have any funds, leaving you with two options: debt financing or equity financing.
Bonds and Shares
One way you can raise money is by taking out loans, either from a bank or by issuing bonds. When a company issues bonds, it basically means that it is borrowing money in exchange for a bond certificate. If a person has a bond certificate, as long as the company is not going bankrupt, that person is assured to have his/her principal amount back at a future date, along with a specified rate of interest. This is called debt financing.
Now, let’s get back to your fictional Walkman company. You don’t want to issue bonds or loans, as you don’t know if you’re going to continue to make the same amount of profit in the future. Instead, you look into equity financing. In this case, you aren’t technically borrowing money, but rather opening up parts of your company for purchase.
You can either be choosy and invite only strategic partners in on the party, such as a really rich sound engineer who wants to invest enough in your company to have some power in certain decision-making processes. Now, let’s say this sound engineer buys 40,000 of the total 100,000 shares of the company. Congratulations! Now you have someone who owns 40% the company, 40% of the share of profits and losses, and 40% of the voting rights when the company makes decisions.
You’re still not satisfied though, so you make the bold decision of diluting your shareholdings even further and offering new shares to outside financiers. At this point, you decide to list your company on the stock exchange market, where any person in the world can buy or sell stocks of your company!
But Why Stocks?
We’ve already discussed why it is beneficial for the company owner to consort to equity over debt. Issuing stock is advantageous for the company because it does not require the company to pay back the money or make interest payments along the way. However, why would a buyer prefer stocks over bonds when there is no guarantee of receiving your initial investment back? After all, the only thing that shareholders get in return for their money is the hope that those shares will someday be worth more than what they paid for them.
As a stockholder of your company, I would get every bit of the profit that you make, but also riding the woes of the free market right along with you. This is unlike a bondholder, who would be prioritized during the payback process before a stockholder.
In other words, if the company wins, then you win. However, if the company goes bankrupt, then you run the risk of losing your entire investment.
Here is the deal. As a stockholder, I am only liable to lose my initial investment. Stocks are much more flexible than bonds, so I always have the choice to sell my stocks if I see the company losing money.
Therefore, if a new company comes up and creates a Discman that is much more user-friendly than the Walkman, then your popularity in the market will drop. You may start losing money and be well on your way to bankruptcy (sorry). As a stockholder, I notice this, and decide to sell my stocks at a rate lower than what I had bought them for. Let’s say that I had bought a stock at the price of $5, but now decide to sell it at $4 before the price drops even further. I may lose one dollar on each stock, but I deem that to be a better decision than losing all five dollars.
The Walkman company doesn’t give up, however, and you introduce a new product – a portable MP3 player that revolutionizes the music industry! My friend Bob realizes the growth potential of your company very quickly and decides to buy all the stocks that I had sold for $4 each. Now, people begin buying your new product all over the world and your net worth increases significantly. Likewise, the price of your stock also skyrockets to $8. So, while I lost $1 on every stock that I sold, Bob actually doubled his investment! Now he can sell the same stocks that I owned at a much higher rate simply because he was ready to take the risk.
Obviously, Bob knew better.
This is an extremely simplified understanding of the stock market, obviously. There are so many other factors that affect the price of stocks – the earnings of the company, analyst reports, economic trends, business and industry outlook, etc. Unlike bonds, which require you to be a passive receptor of the interest rates on your investments, investing in the stock market demands that you shrewdly take calculated risks. The greater the risks, the greater your returns could be. This is why stocks have always outperformed other investments, such as bonds or savings accounts. Over the long term, an investment in stocks has historically had an average return of roughly 10-12%!
- Stock – Wikipedia
- Joint Stock Company – Wikipedia
- Bond (Finance) – Wikipedia
- Debt Financing – Investopedia
- Equity Financing – Investopedia