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An introduction to the stock market
Have you always wanted to know how to understand a company's
annual report and
financial statements? In this series of lessons, we set out to
teach you how to take the financialstatements of a company and
carefully analyze them to determine what the stock is truly"worth".
This allows you make better investin decisions by helpin to avoid
the costlymistake of purchasin a company when its share price is
too hih.
!ventually, by readin, printin, and studyin these lessons, you
will be able to pickup a balance sheet and truly understand what
the numbers mean. t the end of each lessonthere is a #uiz to test
your understandin of what you learned.
In this first installment, we are oin to look at why the stock
market e$ists ande$plain how a business oes from bein a small,
family%owned company to a corporation with
publicly traded stock.Financial Terms
Earnings per Share& The amount of profit to which each share
is entitled.Going Public& lan for when a company is plannin an
I().IPO& hort for Initial (ublic )fferin. n I() is when a
company sells stock in itself for thefirst time.Market Cap& The
amount of money you would have to pay if you bouht ever share of
stockin a company. *To calculate market cap, multiply the number of
shares by the price per share.+hort for arket
-apitalization.Share& share represents an investor's ownership
in a "share" of the profits, losses, and assetsof a company. It is
created when a business carves itself into pieces and sells them
toinvestors in e$chane for cash.Ticker Symbol& short roup of
letters that represents a particular stock *e.., "-oca -ola"is
referred to as ")".+ /nderwriter& The financial institution or
investment bank that is doinall of the paperwork and orchestratin a
company's I().
Introduction
The stock market can be a reat source of confusion for many
people. The averaeperson enerally falls into one of two cateories.
The first believe investin is a form ofamblin0 they are certain
that if you invest, you will more than likely end up losin
yourmoney. )ften these fears are driven by the personal e$periences
of family members andfriends who suffered similar fates or lived
throuh the 1reat 2epression. These feelins arenot round in facts
and are the result of personal e$perience. omeone who believes
alonthis line of thinkin simply does not understand what the stock
market is or why it e$ists.
The second cateory consists of those who know they should invest
for the lon%run, butdon3t know where to bein. any feel like
investin is some sort of black%maic that only afew people hold the
key to. ore often than not, they leave their financial decisions up
to
professionals, and cannot tell you why they own a particular
stock or mutual fund. Theirinvestment style is blind faith or
limited to 4this stock is oin up. 5e should buy it.6 Thisroup is in
far more daner than the first. They invest like the masses and then
wonder whytheir results are mediocre *or in some cases,
devastatin+.
In this series of lessons, I set out to prove that the averae
investor can evaluate thebalance sheet of a company, and followin a
few relatively simple calculations, arrive at whatthey believe is
the 4real6, or intrinsic value of the company. This will allow a
person to lookat a stock and know that it is worth, for instance,
789 per share. This ives each investor the
freedom to know when a security is undervalued, increasin their
lon%term returnssubstantially.
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:efore we e$amine how to value a company, it is important to
understand the natureof businesses and the stock market. This is
the cornerstone of learnin to invest well.
:usiness is the cornerstone of every economy. lmost every lare
corporation startedout as a small, mom%and%pop operation and throuh
rowth, became financial iants. 5al%art, 2ell -omputer, and
c2onald3s had combined profits of 7;9.actors such as these often
provoke owners of small
businesses to issue stock. In e$chane for ivin up a tiny
fraction of control, they are ivencash to e$pand the business. In
addition to money that doesn3t have to be paid back, 4oin
public6 as its called when a company sells stock in itself for
the first time@, ives the businessmanaers and owners a new
tool& instead of payin cash for an ac#uisition, they can use
theirown stock.
To better understand how issuin stock works, let3s look at a
fictional company 4:->urniture, Inc.
fter ettin married, a youn couple decided to start a business.
It would allow themto work for themselves, as well as arrane their
hours around their family. :oth husband andwife have always had a
stron interest in furniture, so they decide to open a store in
theirhometown. fter borrowin money from the bank, they name their
company 4:->urniture6 and o into business. The first few years,
the company makes little profit becausethe earnins are plowed back
into the store, buyin additional inventory and addin onto the
buildin to accommodate the increasin level of merchandise.Ten
years later, the business has rown rapidly. The couple has manaed
to pay off the
company3s debt, and profits are over 7A99,999 per year.
-onvinced that :- >urniture coulddo as well in several larer,
neihborin cities, the couple decides they want to open two new
branches. They research their options and find out it is oin to
cost over 78 million dollars toe$pand. Bot wantin to borrow money
and be strapped with interest payments aain, theydecide to sell
stock in the company.
The company approaches an 4underwriter6, such as 1oldman achs or
C( oran,
who determines the value of the business. s mentioned before, :-
>urniture earns7A99,999 after%ta$ profit each year. It also has
a book value of 7< million the value of theland, buildin,
inventory, etc. subtracted by the company3s debt@ The underwriter
researchesand discovers the averae furniture stock is tradin at D9
times earnins a concept we willdiscuss more in%depth later@.
5hat does this mean? imply, you would multiply the earnins of
7A99,999 by D9. In:-3s case, the answer is 7;9 million. dd book
value, and you arrive at 7;< million. Thismeans, in the
underwriter3s opinion, :- >urniture, is worth thirteen million
dollars.)ur youn couple, now in their
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fter discussin it, the couple decides to keep G9F of the company
and sell the other89F to the public as stock. This means that they
will keep 7. million worth of the business.:ecause they own a
maJority of the stock, they will still be in control of the store.@
The other89F they sold to the public is worth 7A.D million. The
underwriters find investors who arewillin to buy the stock, and ive
a check for 7A.D million to the couple.
lthouh they own less of the company, their stake will hopefully
row faster nowthat they have the means to e$pand rapidly. /sin the
money from their public offerin, :->urniture successfully opens
the two new stores and have 7;.D million in cash left overremember
it was oin to cost 78 million for the new stores@. :usiness is even
better in thenew branches, which are in more populated cities. The
two new stores both make around799,999 a year in profit each, with
the old store still makin the same 7A99,999. :etween thethree
stores, :- now makes an annual profit of 7D.; million dollars.
This is reat news because, althouh they don3t have the freedom
to simply close shopanymore, the business is now valued at 7A;
million dollars multiply the new earnins of 7D.;million per year by
D9 and add the book value of 7K million0 there are three stores
now,instead of one@. The couple3s G9F stake is worth 7urniture is
sold to the hihest bidder each day.:ecause of human nature = the
emotions of fear and reed = a company can sell for far moreor less
than its intrinsic value. The ood investor3s Job is to identify
those companies that aresellin below their true worth and buy as
much as they can.
hen a company !ants to issue stock in itsel"# it has an IPO$ hat
is an IPO%a+ Investment (rofit )peration b+ 2ividendc+ eetin with
the 1overnment d+ Initial (ublic )fferinI" a company !anted to
borro! money# but did not !ant to go to a bank# !hat could it
do%
a+ :uy tock b+ Issue :ondsc+ 2eclare a stock split d+ :uy
:onds&ook 'alue is$$$
a+ The size of the company's bank account b+The value of the
company's assets minus debtc+ The current stock price d+nother word
for stock optionsA company that speciali(es in taking other
companies public is called$$$
a+ :ank b+:rokeraec+ /nderwriter d+Lenture -apitalist&esides
raising money# stock is use"ul "or$$$
a+ (ayin for c#uisitions b+ 5ritin down income ta$esc+ Increasin
:ook Lalue d+ Eeducin 2ebtThe "ounders o" A&C Furniture o!ned
)*+ o" the e,uity$ hat is e,uity%
a+ Lotin (ower b+ 2ebtc+ (rice d+ )wnership
At the end o" our e-ample# A&C Furniture !as !orth ./0
million$ hat is another term "or this%
a+ :ook Lalue b+:alance heet
c+ arket -ap d+-ost (er hare
I" A&C Furniture earned ./ million dollars o" pro"it in a
year# and the company had a market
capitali(ation o" .1/ million# !hat is the P2E 3atio%
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a+ ;8 b+ ;
c+ K d+ DD
Assume A&C Furniture has a market cap o" .45 million
dollars# and 6$/5 million shares o" stock issued$
7o! much is each share selling "or%
a+ 7irm d+-ommodities 2ealer
I" an under!riter took a company public at 56 times earnings
;annual pro"it !as .05$)/ million
