How Stocks and the Stock Market Work

How Stocks and the Stock Market Work

The stock market appears in the news every day. You hear about it any time it reaches a new high or a new low, and you also hear about it daily in statements like "The Dow Jones Industrial Average rose 2 percent today, with advances leading declines by a margin of..."
Obviously, stocks and the stock market are important, but you may find that you know very little about them. What is a stock? What is a stock market? Why do we need a stock market? Where does the stock come from to begin with, and why do people want to buy and sell it? If you have questions like these, then this edition will open your eyes to a whole new world

A Simple Example

A Simple Example

Let's say that you want to start a business, and you decide to open a restaurant. You go out and buy a building, buy all the kitchen equipment, tables and chairs that you need, buy your supplies and hire your cooks, servers, etc. You advertise and open your doors.

Let's say that:

You spend $500,000 buying the building and the equipment.
In the first year, you spend $250,000 on supplies, food and the payroll for your employees.
At the end of your first year, you add up all of the money you have received from customers and find that your total income is $300,000.
Since you have made $300,000 and paid out the $250,000 for expenses, your net profit is:

$300,000 (income) - $250,000 (expense) = $50,000 (profit)
At the end of the second year, you bring in $325,000 and your expenses remain the same, for a net profit of $75,000. At this point, you decide that you want to sell the business. What is it worth?

One way to look at it is to say that the business is "worth" $500,000. If you close the restaurant, you can sell the building, the equipment and everything else and get $500,000. This is a simplification, of course -- the building probably went up in value, and the equipment went down because it is now used. Let's just say that things balance out to $500,000. This is the asset value, or book value, of the business -- the value of all of the business's assets if you sold them outright today.

However, if you keep it going, it will probably make at least $75,000 this year -- you know that from your history with the business. Therefore, you can think of the restaurant as an investment that will pay out something like $75,000 in interest every year. Looking at it that way, someone might be willing to pay $750,000 for the restaurant, as a $75,000 return per year on a $750,000 investment represents a 10-percent rate of return. Someone might even be willing to pay $1,500,000, which represents a 5-percent rate of return, or more if he or she thought that the restaurant's income would grow and increase earnings over time at a rate faster than the rate of inflation.

The restaurant's owner, therefore, will set the price accordingly. You might price the restaurant at $1,500,000. What if 10 people come to you and say, "Wow, I would like to buy your restaurant but I don't have $1,500,000." You might want to somehow divide your restaurant into 10 equal pieces and sell each piece for $150,000. In other words, you might sell shares in the restaurant. Then, each person who bought a share would receive one-tenth of the profits at the end of the year, and each person would have one out of 10 votes in any business decisions. Or, you might divide ownership up into 1,500 shares and sell each share for $1,000 to make the price something that more people could afford. Or, you might divide ownership up into 3,000 shares, keep 1,500 for yourself, and sell the remaining shares for $500 each. That way, you retain a majority of the shares (and therefore the votes) and remain in control of the restaurant while sharing the profit with other people. In the meantime, you get to put $750,000 in the bank when you sell the 1,500 shares to other people.

Stock, at its core, is really that simple. It represents ownership of a company's assets and profits. A dividend on a share of stock represents that share's portion of the company's profits, generally dispersed yearly. If the restaurant has 10 owners, each owning one share of stock, and the restaurant makes $75,000 in profit during the year, then each owner gets a dividend of $7,500. A large company like IBM has millions of shares of stock outstanding -- around 1.1 billion in October, 1999 (see this page for details). In this case, the total profits of the company are divided by 1.1 billion and sent to the shareholders as dividends.

One measure of the value of a company, at least as far as investors are concerned, is the product of the number of outstanding shares multiplied by the share price. This value is called the capitalization of the company.



The Basic Idea
If I am a private citizen who owns a restaurant, and I am selling my restaurant stock to other private citizens in the community, I might do the whole transaction by word-of-mouth, or by placing an ad in the newspaper. This makes selling the stock easy for me. However, it creates a problem down the line for investors who want to sell their stock in the restaurant. The seller has to go out and find a buyer, which can be hard. A "stock market" solves this problem.

Stocks in publicly traded companies are bought and sold at a stock market (also known as a stock exchange). The New York Stock Exchange (NYSE) is an example of such a market. In your neighborhood, you have a "supermarket" that sells food. The reason you go the supermarket is because you can go to one place and buy all of the different types of food that you need in one stop -- it's a lot more convenient than driving around to the butcher, the dairy farmer, the baker, etc. The NYSE is a supermarket for stocks. The NYSE can be thought of as a big room where everyone who wants to buy and sell shares of stocks can go to do their buying and selling.

The exchange makes buying and selling easy. You don't have to actually travel to New York to visit the New York Stock Exchange -- you can call a stock broker who does business with the NYSE, and he or she will go to the NYSE on your behalf to buy or sell your stock. If the exchange did not exist, buying or selling stock would be a lot harder. You would have to place a classified ad in the newspaper, wait for a call and haggle on a price whenever you wanted to sell stock. With an exchange in place, you can buy and sell shares instantly.

The stock exchange has an interesting side effect. Because all the buying and selling is concentrated in one place, it allows the price of a stock to be known every second of the day. Therefore, investors can watch as a stock's price fluctuates based on news from the company, media reports, national economic news and lots of other factors. Buyers and sellers take all of these factors into account. So, for example, when the FAA (Federal Aviation Administration) shut down the company ValuJet for a month in June 1996, the value of the stock plummeted. Investors could not be sure that the airline represented a "going concern" and began selling, driving the price down. The asset value of the company acted as a floor on the share price.

The price of a stock also reflects the dividend that the stock pays, the projected earnings of the company in the future, the price of tea in China (especially Lipton stock) and so on.

The Basic Idea

The Basic Idea

If I am a private citizen who owns a restaurant, and I am selling my restaurant stock to other private citizens in the community, I might do the whole transaction by word-of-mouth, or by placing an ad in the newspaper. This makes selling the stock easy for me. However, it creates a problem down the line for investors who want to sell their stock in the restaurant. The seller has to go out and find a buyer, which can be hard. A "stock market" solves this problem.

Stocks in publicly traded companies are bought and sold at a stock market (also known as a stock exchange). The New York Stock Exchange (NYSE) is an example of such a market. In your neighborhood, you have a "supermarket" that sells food. The reason you go the supermarket is because you can go to one place and buy all of the different types of food that you need in one stop -- it's a lot more convenient than driving around to the butcher, the dairy farmer, the baker, etc. The NYSE is a supermarket for stocks. The NYSE can be thought of as a big room where everyone who wants to buy and sell shares of stocks can go to do their buying and selling.

The exchange makes buying and selling easy. You don't have to actually travel to New York to visit the New York Stock Exchange -- you can call a stock broker who does business with the NYSE, and he or she will go to the NYSE on your behalf to buy or sell your stock. If the exchange did not exist, buying or selling stock would be a lot harder. You would have to place a classified ad in the newspaper, wait for a call and haggle on a price whenever you wanted to sell stock. With an exchange in place, you can buy and sell shares instantly.

The stock exchange has an interesting side effect. Because all the buying and selling is concentrated in one place, it allows the price of a stock to be known every second of the day. Therefore, investors can watch as a stock's price fluctuates based on news from the company, media reports, national economic news and lots of other factors. Buyers and sellers take all of these factors into account. So, for example, when the FAA (Federal Aviation Administration) shut down the company ValuJet for a month in June 1996, the value of the stock plummeted. Investors could not be sure that the airline represented a "going concern" and began selling, driving the price down. The asset value of the company acted as a floor on the share price.

The price of a stock also reflects the dividend that the stock pays, the projected earnings of the company in the future, the price of tea in China (especially Lipton stock) and so on.

Corporations

Corporations

Any business that wants to sell shares of stock to a number of different people does so by turning itself into a corporation. The process of turning a business into a corporation is called incorporating.

If you start a restaurant by taking your own money to buy the building and the equipment, then what you have done is formed a sole proprietorship. You own the entire restaurant yourself -- you get to make all of the decisions and you keep all of the profit. If three people pool their money together and start a restaurant as a team, what they have done is formed a partnership. The three people own the restaurant themselves, sharing the profit and decision-making.

A corporation is different, and it is a pretty interesting concept. A corporation is a "virtual person". That is, a corporation is registered with the government, it has a social security number (known as a federal tax ID number), it can own property, it can go to court to sue people, it can be sued and it can make contracts. By definition, a corporation has stock that can be bought and sold, and all of the owners of the corporation hold shares of stock in the corporation to represent their ownership. One incredibly interesting characteristic of this "virtual person" is that it has an indefinite and potentially infinite life span.

There is a whole body of law that controls corporations -- these laws are in place to protect the shareholders and the public. These laws control a number of things about how a corporation operates and is organized. For example, every corporation has a board of directors (if all of the shares of a corporation are owned by one person, then that one person can decide that there will only be one person on the board of directors, but there is still a board). The shareholders in the company meet every year to vote on the people for the board. The board of directors makes the decisions for the company. It hires the officers (the president and other major officers of the company), makes the company's decisions and sets the company's policies. The board of directors can be thought of as the "brain" of the "virtual person."

From this description, you can see that a corporation has a group of owners -- the shareholders. The owners elect a board of directors to make the company's major decisions. The owners of a corporation become owners by buying shares of stock in the corporation. The board of directors decides how many total shares there will be. For example, a company might have one million shares of stock. The company can either be privately held or publicly held. In a privately held company, the shares of stock are owned by a small number of people who probably all know one another. They buy and sell their shares amongst themselves. A publicly held company is owned by thousands of people who trade their shares on a public stock exchange.

One of the big reasons why corporations exist is to create a structure for collecting lots of investment dollars in a business. Let's say that you would like to start your own airline. Most people cannot do this, because an airplane costs millions of dollars. An airline needs a whole fleet of planes and other equipment, plus it has to hire a lot of employees. A person who wants to start an airline will therefore form a corporation and sell stock in order to collect the money needed to get started.

A corporation is an easy way to gather large quantities of investment capital -- money from investors. When a corporation first sells stock to the public, it does so in an IPO (Initial Public Offering). The company might sell one million shares of stock at $20 a share to raise $20 million very quickly (that is a simplification -- the brokerage house in charge of the IPO will extract its fee from the $20 million, but let's ignore that here). The company then invests the $20 million in equipment and employees. The investors (the shareholders who bought the $20 million in stock) hope that with the equipment and employees, the company will make a profit and pay a dividend.

Another reason that corporations exist is to limit the liability of the owners to some extent. If the corporation gets sued, it is the corporation that pays the settlement. The corporation may go out of business, but that is the worst that can happen. If you are a sole proprietor who owns a restaurant and the restaurant gets sued, you are the one who is being sued. "You" and "the restaurant" are the same thing. If you lose the suit then you, personally, can lose everything you own in the process.

Stock Prices

Stock Prices

Let's say that a new corporation is created and in its IPO it raises $20 million by selling one million shares for $20 a share. The corporation buys its equipment and hires its employees with that money. In the first year, when all the income and expenses are added up, the company makes a profit of $1 million. The board of directors of the company can decide to do a number of things with that $1 million:

It could put it in the bank and save it for a rainy day.
It could decide to give all of the profits to its shareholders, so it would declare a dividend of $1 per share.
It could use the money to buy more equipment and hire more employees to expand the company.
It could pick some combination of these three options.
If a company traditionally pays out most its profits to its shareholders, it is generally called an income stock. The shareholders get income from the company's profits. If the company puts most of the money back into the business, it is called a growth stock. The company is trying to grow larger by increasing the amount of equipment and the number of people who run it.
The price of an income stock tends to stay fairly flat. That is, from year to year, the price of the stock tends to remain about the same unless profits (and therefore dividends) go up. People are getting their money each year and the business is not growing. This would be the case for stock in a single restaurant that distributes all of its profits to the shareholders each year.

Let's say that the single restaurant decides, for several years, to save its profits, and eventually it opens a second restaurant. That is the behavior of a growth company. The value of the stock rises because, when the second restaurant opens, there is twice as much equipment and twice as much profit being earned by the company. In a growth stock, the shareholders do not get a yearly dividend, but they own a company whose value is increasing. Therefore, the shareholders can get more money when they sell their shares -- someone buying the stock would see the increasing book value of the company (the value of the buildings, equipment, etc.) and the increasing profit that the company is earning and, based on these factors, pay a higher price for the stock.

In a publicly traded company, all of the financial information about the company is public. The Securities and Exchange Commission (SEC) is in charge of collecting this information and making it available to investors. Shareholders also use a number of other indicators to determine how much a stock is worth. One simple indicator is the price/earnings ratio. This is the price of the stock divided by the earnings per share. There are all sorts of indicators like these, as well as a great deal of other financial information available on any stock. You can look up all of it on the Web in thousands of different places -- see the links at the end of this article for details.

Stock Averages

Stock Averages

Every day on the news you hear about the Dow Jones Industrial Average, and other averages like the S&P 500 or The Russel 2000. These are broad market averages designed to tell you how companies traded on the stock market are doing in general. For example, the Dow Jones Industrial Average is simply the average value of 30 large, industrial stocks. Big companies like General Motors, Goodyear, IBM and Exxon are the companies that make up this index (this page tells you which companies are currently in the Dow Jones average). The S&P 500 is the average value of 500 large companies. The Russel 2000 index averages the values of 2,000 smaller companies.

Wall Street's bronze bull, by Arturo De Modica, located at the northern tip of Bowling Green

What these averages tell you is the general health of stock prices as a whole. If the economy is "doing well," then the prices of stocks as a group tend to rise in what is referred to as a "bull market." If it is "doing poorly," prices as a group tend to fall in what is called a "bear market." The averages reveal these tendencies in the market as a whole.

Exchanges and Brokers

Exchanges and Brokers

There are three big stock exchanges in the United States:

NYSE - New York Stock Exchange
AMEX - American Stock Exchange
NASDAQ - National Association of Securities Dealers
A company "lists" its stock on an exchange. For example, the NYSE has about 3,000 companies listed. According to the NYSE:
At the end of November, 1998, there were 3,104 companies with stock listed on the NYSE. These companies had over 236 billion shares worth a total of $10.1 trillion available for trading on the Exchange, giving the NYSE the world's largest market capitalization (in global market-value terms, the total global value of the NYSE-listed companies exceeded $12.8 trillion).
Anyone who wants to buy or sell stock in any of these 3,000 or so companies goes to the New York Stock Exchange to do it.
Of course, no one wants to fly to New York to buy or sell their shares. A person therefore calls a stock broker in a firm that is authorized to trade at the exchange. There are dozens of such brokerage houses, including such familiar names as Merrill Lynch, Charles Schwab and Morgan Stanley. When you call up a broker at one of these companies, he or she relays your trade to the floor of the appropriate exchange, and a representative of the company (or, more commonly, a computer representing the company) makes the trade on your behalf. You pay the broker a commission (generally $10 to $100 per trade, depending on the broker) to provide this service to you.

Stocks that are not listed on an exchange are sold Over The Counter (OTC). OTC stocks are generally in smaller, riskier companies. Usually, an OTC stock is stock in a company that does not meet the requirements of an exchange.