Thursday, June 05, 2008

Investing Basics: Stocks

The following is a guest post by Dan Carleton, who is not officially a blogger yet, but is thinking about starting a personal finance blog focused on the very basics of finance. I am always looking for new guest writers, so if you are interested in writing a guest post for Money and Such, take a look at these guidelines and drop me a line with your proposed post. And now, without further delay, the actual post:


Investing Basics: Stocks

This is the first post in what will hopefully become a series of helpful and simple articles that will decode finance babble. I’m of the thinking that most things in finance and investing can be explained with basic terminology. My general approach is to assume my reader knows little to nothing about the topic of the day. The goal, then, is to provide a base knowledge from which one can work.

Everyone should know enough about finance to ensure that they’re not getting ripped off. If you went to a mechanic, and he told you that your burned-out headlight would cost $250 to replace because he needed to disassemble the front end to get at it, you should know enough to have some red flags go up.

Investing is no different.

Today, let’s talk about stocks.

Definition

A stock is a security that gives financial ownership in a corporation.

Explanation

If you watch any business-oriented television shows, you would think that stocks were the pieces in a complicated game where neurotic and fickle investors slowly morph into bipolar disasters (BIAS ALERT: I think that day trading is a waste of time and energy, but I’ll save that for another post). Surprisingly, stocks are much simpler than you’d think.

There are two major types of stocks: common and preferred. Common is the type that you care about. Those are the stocks that everyone talks about, and they will be our focus. Pretend like preferred stocks don’t even exist. Most investors already shun them like the Puritans shunned Hester in The Scarlet Letter. So, don’t feel bad for doing the same.

Only corporations that have chosen to “go public” and have cleared all the legal hurdles can issue stock. Going public means that a company is selling ownership via stocks to whomever feels like buying it. Unless you’re a finance junkie, save yourself the time and energy and don’t dive into this idea any deeper. Your head will start hurting very quickly.

Corporations choose to issue stock for one basic reason: they want your cash, and they want it now. They have some project that they want to fund, and want you to be the wealthy benefactor. These projects might include expanding production facilities, buying a competitor, or giving a CEO a really nice year-end bonus.

If you’re wondering why a company would issue stock as opposed to borrowing money through bonds, you’re thinking along the lines of every single CEO out there. And, to be terribly honest, some of them aren’t even sure which is better.

Here’s the simple answer: sometimes stocks are better, and sometimes bonds are better. It depends on market conditions, the company’s current state of affairs, and to some extent, personal preferences. There is no across-the-board correct answer on this one, just like most things in finance.

Macroeconomic Ties

The economy’s main effect on a stock is on the price. Any economic news that has any direct or indirect relation to the corporation in question will probably affect the stock price.

Think of it this way: if a company is expected to perform better in the future for any reason, then the stock price should generally go up. Better future performance can happen for a lot of reasons: the company could, for example, be selling more of its products; they could be bringing out new technology that makes them bigger, better, faster, and/or stronger than their competition; or, the economic gods could be smiling on them.

Let’s use a few well-known companies to illustrate this. Ford Motor is losing vast amounts of money. Just hemorrhaging their cash. They aren’t selling cars, other companies are taking their place in the market, the benefits they owe to retirees are killing them, and they are having problems borrowing money because they are a big risk.

Their stock price is plummeting, down 75% in the last 10 years.

Guess what Toyota’s stock has done over that same time period. If you said that it’s gone up 98%, you are correct.

There are plenty of other reasons why stocks move. Think of oil companies. With the price of oil increasing, oil company stocks have generally gone up, as well. Why? Because with little effort of their own, a company’s products can now be sold at a ridiculously higher price than in the past (thanks to supply and demand). Higher prices mean more money coming in to the company, which means more profits for the owners, which, you guessed it, means that the stock price goes up.

Get it? Company doing well for whatever reason or economic gods being happy means stock goes up; company doing badly or economy working against company means stock price goes down.

No one consistently and accurately predicts all of the possible movements in a stock’s price. Not even the supposed experts. Use their opinions as guidance, not sacred scripture.

Comments are always welcome.


Editor’s Note: for the sake of clarification, all companies issue stock to their share holders. The main difference between a privately held company and a publicly traded company is that the shares of a publicly traded company can be offered to the public at large and may be bought and sold with few restrictions.

Companies go public for many other reasons in addition to raising cash. Three other common reasons are: (i) providing an “exit” or liquidity event for their original investors, shareholders and employees; (ii) the “prestige” or becoming publicly traded assists companies in obtaining more business; and (iii) publicly traded stock is “currency” with which companies are able to acquire other companies without spending actual cash. There are many other reasons for companies to go public.

1 comment:

debt consolidation unsecured said...

My cousin was invited to particpate as shareholder after a company was sold but he was unable to understand the basics. I'm sharnig with him this article. Thanks.