A Straight Talk Introduction to Stocks And Their Role in Our Economy
Apple is up 20% today. Google’s down 10. Bob made a fortune on IBM. Steve’s dad owns General Electric. Buy low, sell high? What does all of this mean?
Stocks are all around us. In the news, in the classroom and at dinner parties (ok, maybe not all dinner parties). Stocks are one of the most fundamental pieces of our economy, but the truth is most people don’t fully understand what they are and why they are so important.
So…what is a stock?
In short: stocks are ownership in a company and are represented in shares. They are the most effective way for the average person to build wealth over their lifetime. Similarly, for corporations, stock are the most effective way for to raise money.
How does it work?
(Don’t feel like reading? Watch the video!)
Here is Suzie. Suzie is a master baker, known for her delicious croissants. She has a small shop that she quickly outgrew due to crazy high demand (a nice problem to have!). In order to take her business to the next level, Suzie needs about $100,000 in cash to buy in supplies, hire more workers and move into a bigger shop.
But there is a problem. Suzie is a recent college graduate and although the bakery is doing well, she has a ton of debt and only $10,000 to put into the company. Because she already has to pay back her student loans so she does not want to take on another bank loan.
Suzie decides to issue shares.
Suzie puts in the $10,000 she has in her bank account but is still $90,000 short. Suzie asks her friends and family to invest in the balance. She is able to find 9 people, each investing $10,000.
In this example, Suzie gave up 90% ownership in her company but was able to raise $90,000. There are now 10 shareholders, Suzie and her 9 friends, who each have 1 share worth 10% each.
Each shareholder is a part owner of Suzie’s Bakery. If the bakery increases in value, so to will the value of their shares. If the value of the bakery decreases, the stock value will drop as well.
In the Real World…
Now that you understand how a stock is created, it is easy to relate this principle to the big names like Apple and Google. Google started off as a small idea, not unlike Suzie’s bakery. And after 5 years of operation, Google issued stock in order to raise money. Unlike Suzie’s bakery, however, Google has issued over 19 million shares!
Google now trades on the NASDAQ, one of the world’s biggest stock exchanges. You can buy a share of Google for around $500. And if you did buy a share of Google, you would actually be an owner of Google (albeit a tiny one!)
Why Stocks Are So Important
For the every day person: The majority of American’s are wage earners. This means that the only way for the majority of people to accelerate their wealth is through investing. Because stocks are accessible and liquid (the opposite of investing in real estate, for example) it is the only way for investors to grow their wealth over time.
For companies: Stocks are one of the most effective ways for a company to raise cash and cash is one of the most effective ways to grow a company. Think of Suzie’s bakery. There is no way she could have paid for her supplies and staff, which helped her to grow, without issuing stock. A company could use that cash for any number of reasons that could propel growth including: hiring new employees, investing in machinery, buying inventory, renting a new building…etc.
Some stuff to keep in mind:
- Issuers use stocks to raise money for projects.
- A company owner may be looking to sell their business completely to the public.
- Investors use stocks to profit from a company’s performance.
- Individuals who cannot afford to own a company can now be partial owners.
- Stocks help keep companies honest as they are exposed to more public scrutiny.
- There are two main types of stock: Common Stock and Preferred Stock.
- There are also different classes of stock that have different voting rights.
A stock represents real ownership in a business as you share in the profits AND in the losses of the company. In the example, we showed you what happened when Suzie’s bakery succeeded after 3 months. If she went bankrupt though, all her friends would have lost all of their money.
It is important to research the company and the stock before trading its shares as the stock price contains a lot more than meets the eye. Alternatively, understanding how and why companies issue stocks can give you the upper hand and confidence required when deciding which stocks you are going to invest in.