Fundamentals of stock: The “What” and “why” of stocks

What is a company

Before delving into the world of stocks, you need to understand the basic definition of a company. At its most fundamental level, a company is an entity whose primary goal is to make money by offering something in exchange, be it a product or a service. That realization is important because, ultimately, the price of a stock is based on this ability to generate a profit.

It is also helpful to understand how companies make money these days and what their business models are. This helps determine if the teachings of earlier finance books are still relevant and how they can be applied today.

For example, how companies do business has shifted over the past decades in the United States. The economy has slowly evolved from a manufacturing to a service economy.

 

This realization helps us put into historical context landmark books that were written about investing.

Here’s an example of what I am talking about when I state we need to have some historical perspective on earlier writings:

The “Intelligent Investor”, originally published in 1949 by Benjamin Graham, is considered by many as the bible of value investing. The central theme of the book is to compare the intrinsic value of a company to the actual price of its stock to find bargains. It reaches these intrinsic value estimates by analyzing balance sheet metrics, such as book value. However, with the change in business models over the past century, companies see today much higher returns on capital than in the early 1900’s. Companies now tend to trade above book value, and balance sheet analysis has become less helpful.  In other words, there is much less use for the book value metric than when the “Intelligent Investor” was originally written.

My hope with this site is to eventually show you what metrics make most sense to consider today and where you can easily look them up.

What is a stock

A stock is NOT simply a 1 to 4 letter ticker that goes randomly up and down throughout the day.

A stock ticker represents something real. Under a stock ticker lies a real company, doing real business with real people.

Owning shares in a company gives you 3 rights:

1. A right to vote at shareholder meetings when decisions need to be made regarding the direction of the company
2. A right to sell your shares to someone else
3. A right to receive dividends
4. The right to receive dividends really means that you have a right on a portion of the profits of the company

 

Why do companies go on the stock market

The main reason for companies to go on the stock market (ie. “going public”) is to raise money outside of the banking system and without the need to take additional debt.

Other advantages include:

• Decreasing the risk of the original owners by spreading ownership over a larger number of stock holders
• Getting more visibility
• Having more leverage when obtaining loans from banks and other financial institutions

Does that mean each time you buy shares on the stock market, the company receives a portion of it? No, companies obtain money only when they issue new shares. Most buying that we do is on the secondary market when shares only exchange hands between the buyer and the seller, and the company does not get any money from these transactions.

 

How do you make money with stocks?

The 2 simplest ways to make money with stocks are:

• Selling shares at a higher price
• Receiving dividends from the companies in which you have invested

Our strategy is based on that second bullet. More on that later.

 

Stock Market vs a Market of Stocks

On the one hand, you often hear or read on the news that the stock market or that major indices like the Dow Jones or the S&P 500 increased or decreased by so many points.

On the other hand, there are people who say “it’s not a stock market but a market of stocks”.

When media talk about how much major indices move, they are referring to the behavior of an collection of companies. This is useful mainly when you are planning to buy exchanged traded funds (ETFs) that represent/follow these indices.

When you are planning to buy individual stocks, then the expression “it’s not a stock market but a market of stocks” applies to you. Individual stocks may or may not follow the trend of the general market. So it does not make any sense to be obsessed by how the general market is doing when your strategy is to buy individual stocks that meet your criteria.

Conclusion

• The primary goal of companies is to make money, and the price of their stock reflects that ability .
• The fundamental business model of companies affects how we should analyze them. It helps put into perspective the teaching of earlier books.
• Stocks represent real companies, not just some tickers that fluctuate randomly.
• Companies decide to go public on the stock market usually to raise money. When you buy shares outside of the period of first issuance, you are buying from the secondary market. Companies do not receive money when you buy their shares from the secondary market.
• To make money from stock investing, you either sell the shares at a higher price or receive dividends from the underlying companies.