Chapter 2
What Are Stocks?

When a company wants to raise money to expand, it can do so a number of ways. It can raise private equity, where investors give money to the company in return for an equity position. It can bring in more partners, too. A company can raise money by issuing bonds, too, where in return for $1000, for example, the company will pay you interest over a period of time and then return your money. In effect, you've loaned the company money, just like a bank would.

The company can get a loan through the Small Business Administration as well.

Many companies, however, have chosen to go public. The most recent “IPO” (or Initial Public Offering) that made giant headlines was Google (GOOG), which made waves by gaining over 500 percent in a few short years.

Google, and the thousands of other companies that have issued shares of stock to the public, did so to fund new initiatives, expand their marketing campaigns, do more research and development, develop products and services, or a host and/or combination of these and many other things in return for giving up some equity, or ownership, in the company.

That's right, when you buy a single share of a public company that has 1,000,000 outstanding shares, you own 1/1,000,000 of that company! You get to go to shareholder meetings. You are entitled to quarterly and annual reports. You, my friend, get dividends, when and if the company decides to issue them.

You own a piece of Google! Congratulations. In years past, you even got a stock certificate, a piece of paper, suitable for framing, that showed you owned one share of the company. Nowadays, however, you will not get that certificate; you'll have to ask for it and it comes at a pretty stiff price (as in, your $10 stock – not Google, by the way – may cost you $75).

In short, owning shares of stock in a company means that you are an owner of that company. In theory, you have a say on how the company is run. But that's just in theory. All it really means is that you'll get dividends if they're doled out and you get to enjoy the fruits of management's labor in terms of capital appreciation.

There, we've hit on the two – and ONLY TWO – components of stock market performance: Dividends and capital appreciation. If you want to measure the performance of your portfolio in a given year (assuming you buy a stock on January 1 and still own it on December 31 of that same year), you take the difference between the price you it's worth at the end of the year minus the price you paid for it, minus any commissions you paid plus your dividends all divided by the price you paid for it. In equation for, it looks like this:

(Ending price – Beginning price – commission + dividends)/Beginning price

Keep in mind, you'll have to convert these figures to per share values (you generally pay a flat commission – or nearly flat – no matter how many shares you buy).

Things get complicated because there are different classes of stocks: Common stock, preferred, convertible, etc. Even within each of these, there may be different classes (common type A, versus common type B).

Suffice it to say, except for very specific circumstances, we'll be talking about common stocks.

Things aren't all rosy, either, when you're an owner in a public company. If the company loses money, it may reduce its dividend or cut it out altogether. The stock price can decline, too, based upon company-specific fundamentals (more on this later), industry news, or general economic trends. At the end of the year, your stock may be worth less than you paid for it.

In general, stocks of good companies rise over time and stocks of bad companies fall or stay flat, over time. Stock prices really are a good indicator of how the “market” interprets the present and future profitability of any given company.

Take Google again. The stock rose so fast in price due to two overwhelming factors: First, when it had no earnings (another word for “profit”), the market thought that its future earnings had outstanding prospects. Then, when the market was proven right, the future became the present, and the present profitability coupled with the accelerating future expected profitability caused the stock price to rise even more rapidly.

As you may guess, things work in the opposite way, too. Let's look at Enron, THE case study for how to run a company – and its stock – into the ground.

In the late '90s, Enron was one of a few business school case studies for how to run a company. Profits, growth, and future earnings seemed limitless. Nothing could go wrong (this is always the first hint that things are about to go very, VERY, VERY wrong), until the bottom fell out. Enron defrauded everybody. Enron management, along with management from MCI Worldcom and others, basically created false hope of future profitability by booking future revenue in the present and removing current liabilities from present the balance sheet. In short, they put really good lipstick on a really hideously ugly pig.

Here's a telling graphic of the rise and fall of Enron.

But companies can do everything on the up and up and still fail. It all depends on management, the industry, execution, luck, and timing, among many other things. Some companies rise quickly and fall just as quickly. Some slowly rise and slowly fall as they fail to innovate.

It's your job as a potential owner, to pick the right ones and let others pick the wrong ones.

Want this delivered to your inbox? Subscribe to my feed.

Draft of eBook download