This information is for people who know little or nothing about stocks and bonds. It is basic education on what stocks and bonds are and not for people who already know how to trade stocks and bonds. If you want to know what stocks to buy or sell look elsewhere. It is my intent to cover the academic basics of stock and bond investing in this blog. I am not a financial planner and will not give advice on what to invest in or what not to invest in. I have Masters degrees in Management, Business, and Human Resource Development and have taught university level (grad and undergrad) courses in all these subjects for the last 11 years. In my finance courses I teach the basics about stocks and bonds, investing, and retirement planning. This is simply basic academic information about what stocks and bonds are, what a 401K is, what an IRA is and other financial information that anyone might need to know. The examples are very simplified intended to educate not to include every detail, real life is always different than a simple example can show.
Today I want to discuss common stock. What is a common stock? When a company grows to the point where they need additional money to continue operations they may issue common stock to raise needed funds. Let us use a simplified example to explain this. You have a computer manufacturing company you run out of your garage. You become successful and get orders for thousands of units. You cannot build thousands of units in your garage so you go to an investment bank and work with them to take your business public. Then you will do an initial public offering or IPO which means you work with the banker to determine a value for your company and then issue shares of common stock that can be bought by the public. Let us say you issue 10,000,000 shares at a cost of $10.00 a share. You and your company retain 51% of the stock so that you will maintain control of your company. (Each share of stock is a voting share and you want 51% of the votes to maintain control). Then 30% of your stock is offered for sale to the public or 3,000,000 shares (3 mil X 10$ a share =30 Million dollars). Every person that buys a share of your stock is now a part owner of your company! Only when you buy common stock do you become a part owner of a company. You have retained 1,900,000 shares of stock that you may choose to sell later if your company needs to raise more money.
(5,100,000 shares belong to you, 1,900,000 shares belong to your company and can be sold later, and 3,000,000 shares now are in the hands of the public). Now you have the funds to build a small manufacturing facility and hire some workers who will build and ship your computers to your customers.
A company only makes money on the initial public offering. Every time a share of your stock is bought or sold after the IPO, only the buyers and sellers make or lose money on the stock. That is called the secondary market. The secondary market is what you see and hear discussed on the news and on financial shows such as CNBC, Mad Money, etc.
After the IPO is complete you now are running a public company and you are now responsible for producing the balance sheet, cash flow statement, and income statement every quarter and for publishing an annual report to your stockholders. You are now under the laws and rules of the Securities and Exchange Commission and you must follow these rules or risk fines and jail time. If you run the company well it is likely that the price of the stock will rise. If your company does not make money the price of the stock will be expected to fall. To see whether a stock is making or losing money one place to look is at the EPS or earnings per share which is available at many places on the Internet and in your quarterly and annual reports. In general the more money your company makes per share the better you are doing and the happier your stockholders will be. Negative numbers are never good and would most likely cause holders of the stock to consider selling their shares.
What makes the price of a common stock go up or down?
It is simply the law of supply and demand. If there are more buyers that sellers then the price will go up. If there are more sellers than buyers the price will go down. For example, if your new stock is still selling at $10.00 a share in the secondary market (the stock market) and I want to sell 1,000 shares of your stock, I may offer 1,000 shares for sale at $10.50 a share, if someone buys it at that price, the new price of the stock is $10.50 a share. That price is only good until the next trade which may be very different. If however, I offer the stock at $10.50 a share and no one buys it, I might then lower the price to $10.25, if still no takers I might try $10.00 and then $9.75, and lower until I hit a price where someone thinks the stock is a good buy at that price and buys my 1,000 shares. If I end up selling at $9.50 then the price of the stock is now $9.50 a share at least until the next trade. The more buyers for a stock means the supply of stock for sale is used up quickly and then they have to offer more to get someone to sell some of the stock to them, if no one wants to buy the stock the price must go lower until a buyer is found who is willing to buy the stock at that price. It is as simple as that, if there are more buyers than sellers the price of a stock goes up, if more sellers than buyers then the price of a stock goes down.
What makes people want to pay more or less for a stock? That may depend on news of a big new contract which might make more people want to buy the stock betting that they will make money when the stock goes up or if news of a law suit comes out that might mean the company might have to pay out a large sum of money then that may have the potential to drive the price of the stock down as investors sell to avoid possible losses should the law suit go against the company. There is a lot of psychology to the market and to buying and selling. As of this writing the market is being moved up and down based on employment reports (if good the market goes up which means people start buying stocks and if bad the market goes down as people sell their stocks.) Another market mover today is any positive or negative news coming out of Europe, if it looks like they are going to save Greece from default the market goes up, if it looks like they won't it goes down. If it looks like the countries in the EU are going to fund their banks if they start to fail the market goes up if not it goes down and so on.
In addition, there are stock analysts and rating agencies that rate stocks (and bonds) and a change in their ratings may influence stock holders to buy or sell a particular stock.
Dividend and Growth Stocks: Some stocks pay a dividend which means you get a check (or deposit to your account) every 3 months for 1/4 of that years dividend. Let us say our sample stock pays $0.40 per year per share of stock you hold. In that case every 3 months you would earn 10 cents for each share of stock you hold. If you bought 100 shares you would receive (10 cents X 100 = $10.00) every three months. Initially your yield for this stock would be 4% (40 cents is 4% of $10.00). The yield changes as the price of the stock goes up or down but we will cover yield in a future post.
Other stocks are called growth stocks and they do not pay a dividend as all profits are plowed back into the company to enhance the growth of the company. In this case the stock holder makes money by the eventual price of the stock going up and the money is made when the stock holder sells at a higher price than the price they bought the stock for.
Stocks are simply a way for companies to sell part of their company to the public in order to raise money to make more product, build more facilities, expand, hire more people, or market their product more effectively.
This concludes our basic lesson on what is a common stock. In future posts we will cover corporate bonds, preferred stocks, municipal bonds, government bonds, 401K's IRA's, Roth IRA's and other general topics relating to personal finance. I will never recommend a stock or bond or course of action for you to take, I advise everyone to get a good certified financial planner who sells nothing but financial information for all your personal investment planning. This blog is for educational purposes only.
Copyright 2011 all rights reserved - Greg High
