Stocks 101

Pretend that you own a business.  If you were to divide that business into many small pieces and sell each piece- those pieces are basically "stock".  The definition of stock is 'ownership in a company"; people can all own small bits of businesses just by purchasing the stock of that business.

Some businesses start offering stock as a way to raise money.  Money raised from selling stock is typically put back into the business- paying down old debt, buying new companies, or building new departments or facilities for business operations.  The business owner will want to keep a minimum of 51% of the company stock in order to maintain the control of the business, and have the say over day to day activities.  The person or business that owns the majority of a company's stock is considered the "controlling shareholder' and they can control the business, fire the CEO and make all business decisions.

Why the Stock Market Exists

Businesses play an important role in the state of our economy.  How do you think businesses like McDonalds, Walmart and Dell Computer started?  Each of these giant businesses began with a single establishment in a small town, and grew to rank among the largest company's within America by selling stock. 

As companies are ready to grow and expand, they often don't have enough working capital to meet the financial needs required for the growth.  The business owner has limited options for obtaining additional capital to reach those growth goals; they can borrow money or sell part of the business (stock).

Banks will loan money to businesses with strong financial histories and the means to pay back the loan.  Some businesses may request too much money too soon, and get denied.  These companies often turn to selling stock in order to raise the necessary funds for expansion.  The money from the sale of stocks can be reinvested into the business, and best of all- does not need to be paid back like a loan does!  When a company sells stock for the first time, they are labeled as "going public", and give up a tiny fraction of control each time stock is purchased.

Buy Low, Sell High: The Value of Stock

Even non-investors are likely to have heard the famous saying, "buy low, sell high!"  The saying is used to simplify a stock market strategy to optimize your return on investment.  But how do stocks get value?  How do you know if a stock is "high" or "low"?

For example, when a business is doing well and the owner decides to open a new location- the owner will get the business valued by underwriters like JP Morgan.  Underwriters will add the amount of after-tax profits to the book value of a business (land, building, assets) and subtract business debts.  Then, they will determine what the average stock within the same industry is selling for- if they're selling for 15-20% over the value, the underwriters will multiply the business after-tax profit amount by that percentage and then add the book value in order to determine the total value of the business.

Once the total value is determined, the owner decides what percentage of the business to sell as stock- typically it will be 40% or less in order to keep control of the business with the current owner, and the money from the sale of stock is used to open the second location!

The second location will turn a profit (if business goes as planned!) and suddenly, even though the owner had to sell stock to raise the funds to open the location, their business is expanding rapidly and earning more money than before.  The value of the business stock will increase as the business is now worth more, and when the owner wants to get out of the business, they can just sell their stock!