Investing Lesson 1 - Introduction to the Stock Market
The Nature of the Stock Market and How Stocks are Issued
Have you always wanted to know how to understand a company’s annual report and financial statements? In this series of lessons, I’ll teach you how to take the financial statements of a company and carefully analyze them to determine what the stock is truly "worth". This allows you make better investing decisions by helping to avoid the costly mistake of purchasing a company when its share price is too high.
Eventually, by reading and studying these lessons, it is my hope that you’ll be able to pick up a balance sheet and truly understand what the numbers mean. In this first installment, we’ll discuss why the stock market exists and explain how a business goes from being a small, family-owned company to a corporation with publicly traded stock.
Throughout this article and others here on this site, you’ll come across financial terms with which you may not yet be familiar. I won’t go into great depth here, but the following terms are some of the most common.
- Earnings per Share: The amount of profit to which each share is entitled.
- Going Public: Slang for when a company is planning an IPO.
- IPO: Short for Initial Public Offering. An IPO is when a company sells stock in itself for the first time.
- Market Cap: The amount of money you would have to pay if you bought every single share of stock in a company. (To calculate market cap, multiply the number of shares by the price per share.) Short for Market Capitalization.
- Share: A share, or a single common stock, represents an investor’s ownership in a "share" of the profits, losses, and assets of a company. It is created when a business carves itself into pieces and sells them to investors in exchange for cash.
- Ticker Symbol: A short group of letters that represents a particular stock (e.g., "The Coca-Cola Company" has a ticker symbol of "KO", "Johnson & Johnson" has a ticker symbol of "JNJ")
- Underwriter: The financial institution or investment bank that is doing all of the paperwork and orchestrating a company’s IPO.
Introduction to the Stock Market
The stock market can be a great source of confusion for many people. The average person generally falls into one of two categories. The first believe investing is a form of gambling; they are certain that if you invest, you will more than likely end up losing your money. Often these fears are driven by the personal experiences of family members and friends who suffered similar fates or lived through the Great Depression. These feelings are not grounded in facts. Someone who believes along this line of thinking simply doesn’t understand what the stock market is or why it exists.
The second category consists of those who know they should invest for the long-run, but don’t know where to begin. Many feel like investing is some sort of black-magic that only a few people know how to use. More often than not, they leave their financial decisions up to professionals and cannot tell you why they own a particular stock or mutual fund. Their investment style is blind faith or limited to “This stock is going up... we should buy it." Though it may not seem like it on the surface, this group is in far more danger than the first.
They invest like the masses and then wonder why their results are mediocre (or in some cases, devastating).
In this series of lessons, I set out to prove that the average investor can evaluate the balance sheet of a company, and following a few relatively simple calculations, arrive at what they believe is the “real”, or intrinsic value of the company. This will allow a person to look at a stock and know that it is worth, for instance, $40 per share. This gives each investor the freedom to know when a security is undervalued, increasing their long-term returns substantially, or overvalued.
The Nature of Businesses and Stock Market
Before we examine how to value a company, it is important to understand the nature of businesses and the stock market. This is the cornerstone of learning to invest well.
Almost every large corporation started out as a small, mom-and-pop operation, and through growth, became financial giants. For example, in 2016, Wal-Mart, Amazon.com, and McDonalds had combined profits of roughly $20.7 billion by the end of the year. Wal-Mart was originally a single-store business in Arkansas. Amazon.com began as on online bookseller in a garage. McDonalds was once a small restaurant of which no one outside of San Bernardino, California had ever heard. How did these small companies grow from tiny, hometown enterprises to three of the largest businesses in the American economy? They raised capital by selling stock in themselves.
When a company is growing, the biggest hurdle is often raising enough money to expand. Owners generally have two options to overcome this. They can either borrow the money from a bank or venture capitalist, or sell part of the business to investors and use the money to fund growth. Taking out a loan is common, typically easy to acquire, and very useful - up to a point. Banks will not always lend money to companies, and over-eager managers may try to borrow too much initially, which wreaks havoc on the balance sheet. Factors such as these often provoke owners of small businesses to issue stock. In exchange for giving up a tiny fraction of control, they are given cash to expand the business. In addition to money that doesn’t have to be paid back, “going public” [as its called when a company sells stock in itself for the first time] gives the business managers and owners a new tool: instead of paying cash for an acquisition, they can use their own stock.
How is Stock Issued?
To better understand how issuing stock works, let’s look at a fictional company “ABC Furniture, Inc.“ After getting married, a young couple decided to start a business. It would allow them to work for themselves, as well as arrange their working hours around their family. Both husband and wife have always had a strong interest in furniture, so they decide to open a store in their hometown. After borrowing money from the bank, they name their company “ABC Furniture” and go into business. During the first few years, the company makes little profit because the earnings are plowed back into the store, buying additional inventory and remodeling and expanding the building to accommodate the increasing level of merchandise.
Ten years later, the business has grown rapidly. The couple has managed to pay off the company’s debt, and profits are over $500,000 per year. Convinced that ABC Furniture could do as well in several larger neighboring cities, the couple decides they want to open two new branches. They research their options and find out it is going to cost over $4 million to expand. Not wanting to borrow money and be strapped with interest payments again, they decide to sell stock in the company.
The company approaches an “underwriter”, such as Goldman Sachs or JP Morgan, who pours over their financial statements and determines the value of the business. As mentioned before, ABC Furniture earns $500,000 after-tax profit each year. It also has a book value of $3 million [the value of the land, building, inventory, etc. subtracted by the company’s debt]. The underwriter researches and discovers the average furniture stock is trading at 20 times earnings [a concept we will discuss more in-depth later].
What does this mean? Simply stated, you would multiply the earnings of $500,000 by 20. In ABC’s case, the answer is $10 million. Add in the book value, and you arrive at $13 million. This means, in the underwriter’s opinion, ABC Furniture is worth $13 million.
Our young couple, now in their 30’s, must decide how much of the company they are willing to sell. Right now, they own 100% of the business - it is entirely theirs. The more they sell, the more cash they’ll raise, but they must keep in mind that by selling more, they’ll be giving up a larger part of their ownership. As the company grows, that ownership will be worth more, so a wise entrepreneur would not sell more than he or she had to.
After discussing it, the couple decides to keep 60% of the company and sell the other 40% to the public as stock. [This means that they will keep $7.8 million worth of the business, and because they own a majority of the stock, they will still be in control of the store.] The other 40% they sold to the public is worth $5.2 million. The underwriter finds investors who are willing to buy the stock and give a check for $5.2 million to the couple.
Although they own less of the company, their stake will hopefully grow faster now that they have the means to expand rapidly. Using the money from their public offering, ABC Furniture successfully opens the two new stores and has $1.2 million in cash left over [remember it was going to cost $4 million for the new stores]. Business is even better in the new branches. The two new stores both make around $800,000 a year in profit each, while the old store still makes the same $500,000. Between the three stores, ABC now makes an annual profit of $2.1 million.
This is great news because, although they don’t have the freedom to simply close shop anymore, the business is now valued at $51 million [multiply the new earnings of $2.1 million per year by 20 and add the book value of $9 million (each store has a book value of $3 million)]. The couple’s 60% stake is now worth $30.6 million.
With this example, it’s easy to see how small businesses seem to explode in value when they go public. The original owners of the company are, in a sense, wealthier overnight. Before, the amount they could take out of the business was limited to the profit that was generated. Now, they are free to sell their shares in the company at any time, raising cash quickly.
This process is the basis of Wall Street. The stock market is, at its core, a large auction where ownership in companies just like ABC Furniture is sold to the highest bidder each day. Because of human nature and the emotions of fear and greed, a company can sell for far more or for far less than its intrinsic value. A good investor'’s job is to identify those companies that are selling below their true worth and buy as much as they can.