Stock Market Terminology
The first step to understanding the stock market is to know the terms used. Here are some commonly used words and phrases:
- Earnings per Share: The total earnings of the company divided by the number of shares outstanding.
- Going Public: A colloquial term referring to when a company plans to issue its shares for the first time.
- Initial Public Offering: Short for “Initial Public Offering of stock,” when a company sells its shares for the first time.
- Market Capitalization: Short for “market capitalization,” it is the amount you would have to pay if you wanted to buy every share of the company. To calculate market capitalization, multiply the number of shares by the share price.
- Share: A single unit of ownership for an investor in the company’s earnings, losses, and assets. A company issues shares when it divides itself into parts and sells them to investors for cash.
- Stock Symbol: A short set of letters that represent a specific stock as listed on the stock market. For example, Coca-Cola has the stock symbol KO, and Johnson & Johnson has the stock symbol JNJ.
- Underwriter: The financial institution or investment bank that manages all the securities and organizes the stock issuance for the company.
Introduction to the Stock Market
The stock market can be confusing. Some people believe that investing is a form of gambling and think that if they invest, they are likely to lose their money.
These fears may stem from individuals’ experiences among family and friends who have faced similar misfortunes or from living through the Great Depression. These feelings are understandable but are not based on facts. A person who believes this behavior may not have a deep understanding of the stock market, why it exists, and how it works.
Investing by Following the Crowd
Others believe they should invest for the long term but do not know where to start. Before learning how the stock market works, they view investing as a form of magic known only to a select few. Often, they leave their financial decisions to professionals and cannot tell you why they own a particular stock or mutual fund.
This investment style could be termed blind faith, or perhaps limited to feelings like “this stock is rising – we should buy it.” Although it may not seem so on the surface, this group is at much greater risk than the first. They tend to invest by following the crowd and then wonder why they achieve average results or, in some cases, devastating results.
Learning to Invest
After learning some techniques, the average investor can evaluate a company’s balance sheet, and after some simple calculations, they can arrive at their own interpretation of the company’s true value and its stock.
This practice allows the investor to look at a stock and know that it is worth, for example, $40 per share. It gives each investor the freedom to determine when the market has valued stocks at less than their true worth, significantly increasing long-term investment returns, or has valued them at more than their true worth, making them a poor investment candidate.
Why Do Companies Sell Stocks?
When you learn how to evaluate a company, it helps to understand the nature of business and the stock market. Almost every large company started as a small family business and became a financial giant through growth.
Think of Walmart, Amazon, and McDonald’s. Walmart was originally a single business in Arkansas. Amazon started as an online bookstore in a garage. McDonald’s was a small restaurant unheard of outside San Bernardino, California. How did these small companies grow from small local ventures to three of the largest companies in the U.S. economy? They raised capital by selling stocks.
The Need
To Financing
As the company grows, it continues to face the hurdle of raising enough money to fund ongoing expansion. Owners typically have two options to overcome this challenge: either they borrow money from a bank or venture capital, or they sell a portion of the company to investors and use the money to finance growth. Companies often obtain bank loans, as they are easy to secure and very beneficial, to some extent.
Banks will not always lend money to businesses, and ambitious managers may sometimes try to borrow more than they should, adding a lot of debt to the company’s financial sheet and affecting its performance metrics. Such factors drive these growing small businesses to borrow by issuing shares. In exchange for giving up a small portion of control over ownership, they receive cash to expand the business.
Going public provides the company with money that does not need to be repaid. It also gives business managers and owners a new tool. Instead of paying cash for certain transactions, such as acquiring another company or a line of business, they can use their own shares.
How Are Shares Issued?
To understand how shares are issued, let’s take ABC Furniture, Inc. as a fictional company. After getting married, a young couple decided to start a business. It allows them to work for themselves and arrange their working hours around their family. The husband and wife had a strong, longstanding interest in furniture, so they decided to open a store in their hometown.
After borrowing from the bank, they named their business ABC Furniture, Inc. and began operating. During the first few years, the company did not make much profit, as the owners reinvested the profits back into the store, purchasing more inventory, redesigning, and expanding the building to accommodate the increasing level of products.
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