Alpine Summit

Friday, July 29, 2005

Investment Crash Course, Part 1

I've had several people ask me about investing on varying levels of understanding. So, I've decided to start my own miniseries where I talk about some of the generalities and what I know personally about investing. This post is going to cover What stocks are, what other securities are out there, and a little on the pricing of stocks and how you can take advantage of it.

First off, what is a stock? To answer this, I need to explain a small bit of business law, first. When someone starts a business in America, they have the option of how that business is defined. The definition of the business determines how finances are to be handled (among other things). The main types of businesses are Sole proprietorships, Partnerships, and Corporations.

Sole proprietorships are the most simple of business organizations because it merely involves a person hanging out their shingle and selling their wares. No special papers need to be filed, and profits from the business are counted as personal income. An example of this would be your kids' lemonade stand. They just go out to a sidewalk corner and sell lemonade and keep all the revenues. However, if the business incurs debt and goes under, creditors can come after the owner's own personal assets. A sole proprietorship dies when the owner dies, or if he/she decides to call it quits.

Partnerships are like sole proprietorships except that it's run by at least two people. There is usually an agreement in the form of a contract that determines who does what and how profits are distributed according to what each parter has contributed to the business. The contract usually outlines what percentage each partner owns, and only partners can manage. Again, liability for the business going under is unlimited, that is, they can come after your home if the business fails. When a parter dies or walks away, the partnership is voided and the business ends. Now, if other partners want to continue the business, they have to draw up a new contract and form a new partnership. The lemonade stand example from before works again, just imagine it's your kid and his/her friends running it together.

Corporations are businesses that have filed papers with the state in which they wish to do business and limits the liability of the owners. Someone who owns a business that has been incorporated has "limited liability" (and you thought this would be hard to understand). This means that if the business goes under, the owner is only liable to pay what he/she invested in the company and the company's creditors cannot take the owners home. One of the rules of a corporation is that the personal finances of the owner and the finances of the company must remain separate. For example, the owner can't use the company as their own personal bank. When you hear people talking about "piercing the corporate veil," they're talking about finding a way to go after the personal finances of an owner of a corporation. The most recent example of this would be the Enron and Worldcom scandals. Corporations are considered a legal entity unto themselves. It's best to think of a corporation as a person or individual, but not in a literal sense. Also, a company cannot go to prison... though it could still break laws. This is why the Sarbanes-Oxley act was passed. It makes the leadership of a corporation either be honest in their dealings, or personally have to break the law. That adds accountability to a company.

ANYWAY, I got off-topic. When a business incorporates, it has to come up with a way to determine ownership. Since personal finances of individuals aren't involved, there has to be a unit of measurement to show ownership of the company. That is what stock is. Stock is one thing a company has and it's broken down into "shares." When incorporating, the owner determines how many shares they want. It basically asks "how many shares equals 100% ownership?" This means you can't sell more than this number of shares. Most will make this number incredibly high (I'll explain this later). All shares belong to the company and the company's total value is divided by the number of shares to determine the price of an individual share.

Other securities that corporations issue are bonds and options. Bonds are debt. A bond is comparable to you going to the bank for a loan. It's a corporation's version of asking for a loan. I may talk more in-depth about these in another post sometime, but that's what bonds are. Options are derivative securities. They are contracts made by two people where one agrees to buy a stock at a certain price, and one agrees to sell a stock at a certain price. The option merely gives you the right to buy/sell a stock at a certain price... you don't actually have ownership of the company if you own an option. Options can be as complicated as you want them to be, and I took an entire class on futures and options, so I may not talk too much about these... or if I do, it'll be its own post... at least.

Getting back to the stocks, the values of a stock vary according to what you're looking at. A public company is a company where its stock is traded publicly in a stock market (NYSE, NASDAQ, AMEX are the big houses in America). Public stock is subject to the whims of the public. If people even think the latest widget is going to make billions of trillions of dollars for the company, the stock price will go up due to basic supply and demand. But, the book value, or strict value of the stock based on a financial audit of the company, can be, and often is, different. This is mainly due to the fact that the public will add value to the stock for its potential, but a financial audit doesn't. So for example, a company won't say "we expect to make this much in the next year from this product, so lets add that into our value."

Stocks on the stock exchanges are the ones most individuals trade. Because stocks are subject to the whims of the public, its price fluxuates daily and the smart investor will be able to buy a number of shares of stock at one price, and hopefully sell it at a higher price level so as to make money. I'll go more into detail on this later. "Buy low, sell high" is the motto of any investor.

Part 2 will cover some strategies and legal issues of investors.

Wikipedia goes more into some detail here if you care to read more.