Sunday, March 27, 2011

Stock Market 101: Understand How Stocks Get Started

You buy shares from a certain stock and when the stock price goes up, you sell and earn money out of it. That is probably the main reason for all of us to invest in stock.  But do you know why stocks exist at the first place? Is it for you to invest and earn money out of it? Yeah, that’s true. But then why the company want to issue a share for your benefits? Don’t forget that economy is always win-win

Why stocks exist at the first place?

Stocks exist at the first place because companies want to raise capital (i.e. get more cash) for their business. Why companies want to increase their capital? Because they want to make their business big and eventually make even more money! Assuming a company wants to increase its capital to $1000K, the company will issue shares that worth for $1000K for investors to buy. Let’s say 100K shares are issued, 1 share will cost $1000K/100K = $10. When investors buy all these 100K shares, the company will able raise it cash or capital to $1000K. 

You may also wonder why don’t the companies raise their capital from bank by taking loan. That is because taking loan has its limitation and you usually can borrow up to certain limit. Also, when you’re in debt you need to pay for the interest too. In order to get more money than what you can borrow from bank and most importantly without debt, the most effective way is to make your company listed  in stock exchange by issuing shares to the public or in other words make your company a public company.

When your company is listed or became public, everyone can own part of your company by just buying shares from your company. For instant let's use the example above, you buy 1000 shares, you basically own 1K/100k = 1% of the company. If you buy 10K shares, then you own 10% of the company. Cool isn’t it?

How to determine the initial stock price?

Of course, the owners of a company decide what should be the initial stock price and how many shares they want to issue. However to determine the stock price, they must look from investors perspective. Let’s assuming you own this company and the annual net earning (i.e. net income – expenses) of this company is $100K.  How much do you think your company worth? Let’s say you price your company worth for $1000K, this means that if I’m a investor and I invest $1000K. I will get back $100K annually as my return of investment – ROI which is $100/$1000K = 10% (assuming the earning is constant in the coming years). If you price your company for $500K, then the ROI from investors is 20%. The technical term for this ROI is called “Dividend”.

So do you think investors will invest for 10% ROI or 20% ROI? Of course, 20% right? But keep in mind that you only get the capital of $500K from a company perspective. What if you offer 10% ROI, do you think investors will invest? If yes, then you will get the capital of $1000K which is 2 times more than $500K. You get more money by offering 10% ROI as compared to 20% ROI. So, should you price your company $500K or $1000K? Well, that depends how good your judgement on what are the investors' need and to get the optimum capital that you want. :D

If you issue 1 share for $1000K (which is unlikely in reality because after you sell your share, your company no longer belongs to you!) , then 1 share will cost $1000K. If you issue 100K shares, then 1 share will cost $1000K/100K = $10. If you issue 1000K shares, 1 share will cost $1000K/1000K = $1.  Do you think the public or investors have enough money to buy 1 share? So the quantity of the share decide how cheap is unit price per share that affordable by majority of investors. This is up to you to make a call too, if you’re the owner of the company.

Once you have decided to price your company for $1000K and issue 100K shares, your initial stock price will be $1000K/100K = $10 per share. So you make this offer to the public which is also called “Initial Public Offering (IPO)” with $10 per share.


Well, I summarized a lot of stuff here and in reality the process is a lot more complicated than what I have explained. I think it is always important to understand the basic fundamental especially from a company and investor perspective before we start investing in stock.

This article explains how stocks gets started in the first place. Feel free to comments and provide feedback if anything is not clear and you would like to discuss further. Happy investing!


Alvin Lim said...

I'm blur :P actually got a lot of calculations to determine if a company's IPO is 'okay' or overpriced. Even normal stocks (non-IPO), there are so many different ways to calculate if a stock is undervalued or overpriced.

Sadly, i donno any of these complex calculations. Been 'guessing' based on my observation all the time. Relying on my instincts than some complex math that I don't understand.

ChampDog said...

Honestly, I don't know those calculations too. If those formulas tell you overpriced, then is it really overpriced and vice versa? If overpriced, does that mean we don't buy?

See, those formulas basically are meaningless if we can't make right or accurate decision based on them. Perhaps using the instincts would be a better approach in this case.

For me, I think studying the company background and it's financial stability and look at the future potential should be the right strategy regardless of their IPO is overpriced or under-value. Anyway, this can go down to "instinct" too at the end... lol

Doable Finance said...

I think you have done a good job explaining how stocks work.

ChampDog said...

I hope so... :)

Jason said...

Wow this is great.

Michelle said...

This is great info. I think many just investor just invest because their friend/relative is doing so. Without understanding the fundamental of 'stock investment', investing with 'tembak strategy' will no be beneficial for investors. Great basic understanding of stock investment. Thanks for the sharing :)

ChampDog said...

You're welcome, Yan. That's pretty fundamental about stocks. Hopefully it won't be over fundamental. :D

The younger generation now will probably do more research first before they start to invest as compared to previous generation or maybe still the same?

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