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STOCK MARKET BASICS FOR NEWBIES – 4

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WHY SHOULD I INVEST IN THE STOCK MARKET?

Why would someone invest in the stock market? This is an excellent question, and the answer is to get your money working for you. There are a couple of very important ways that you make money with owning common shares. First is the potential for a capital gain if the shares go up and you sell them for a profit. Second, is the possibility that the company will pay out a dividend to its shareholders. Companies can share their profits with their owners, and many senior companies do that every quarter or sometimes monthly. They announce the amount and payment date of their dividend payout in advance, which brings us to the topic of “yield.”

Yield is the amount of money you earn each year by owning the stock of a company. We always express a dividend in terms of dollars and cents per share. You can easily calculate your “yield” as a percentage using the dividend amount and the price you paid for the stock. Please remember that a company can raise or lower the dividend amount as financial conditions change for them. Your yield is determined by the price you paid, not what the stock is currently trading for on the market. Let’s look at our company Orange and see how this works. We assume you bought the stock initially for 10.00 per share and let’s pretend that the company announces a dividend of .50 per share annually. It doesn’t take a lot of math to figure out that the “yield or earning” on your shares is 5%. If someone else bought the stock on the market for a higher price, then naturally their yield would be less.

Let’s return to the opening line of this article- “why would someone invest in the stock market?” We will introduce something here that may be of interest–the Rule of 72. Many people do not want to take the time and effort to learn a few basic investment procedures and tell others it is too complicated or too risky, etc. Let’s add some reality to that argument. Suppose that someone has $10,000.00 available to put away for retirement and they are only comfortable putting it into a savings account at their financial institution. What is the current rate for savings accounts? At the time of writing, it is around 1%. The Rule of 72 states that if you divide 72 by the rate of return (in this case, 1%) the result is the number of years it will take to double your initial investment. SARCASM ALERT: For the safety conscious non-risker takers, add 72 to your current age and you will have turned your $10,000.00 into $20,000.00. Fantastic! You have doubled your money. By the way, we have not considered the ravages of inflation or taxes, but in only 72 years you will have twice as much money assuming you withdraw nothing during that time.

Let’s go back to our example of Orange in which we determined that if you bought the stock at 10.00 and receive a .50 dividend each year for a return of 5% how would we fare with the Rule of 72? We divide 72 by 5 and learn that if we do not withdraw any of the earnings, our money will double in 14.4 years. You can do the calculations yourself for different scenarios. That alone is reason to give serious consideration to investing in stocks. This process also works if you only consider the growth in the stock market itself if you own the right investments. We will cover some of those types of investments later but consider this: The 25-year average annualized return for the S&P 500 from 1994 through 2018 was 8.52%. If you had invested in an index fund that tracks the S&P 500 in 1994 and you never withdrew the money, you would have average returns of 8.52% per year. At that rate, expect to double your money about every 8.45 years. For those people who already follow the market a bit–this includes the fact that it had many swings in value both up and down during that period.

OK, enough math for today–your head hurts and this was precisely the stuff you wanted to avoid – right? Common stocks are not the only investment available on the market, and we have already alluded to at least one other. We will move on to some of these possibilities next time.

If this is your first exposure to this series, you might find it helpful to start at the beginning with our bite-sized lessons about investing and the stock market. You can also share this with friends and on any social media platforms if you want to.

STOCK MARKET BASICS FOR NEWBIES – 3

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In our previous instalment, we looked at what a stock market or stock exchange is and its role in the world of investments. “The entire purpose of the stock exchange is to facilitate the exchange of shares from the seller to the buyer at a price that is agreeable.” We will now move forward and look at one product that is available to you on the stock exchange-common shares.

COMMON SHARES

Common shares are the fundamental investing tool used by individuals, institutions and investment funds to create savings, growth and income in most economies around the world. A common share is evidence of a person’s ownership in a company. The holders of common shares have several “rights” because of this ownership position, which we will explore. Let’s begin by dismissing one very glaring exception to your “rights.” As a public shareholder, you do not have the right to walk into our company, Orange, and talk to the manufacturing manager and tell him to change the colour of our widgets. Common shareholders may be owners, but they do not have day-to-day management rights or obligations. However, you do have some very important rights.

As a share owner, you may attend the annual general meeting where you may ask questions of management and the board of directors. You can vote on any motions put forward, including the election of directors. You may also put your name forward to become a member of the board. You will be eligible to receive any profits that the board may decide to share with stockholders. They call these “dividends,” and may be a very important reason to become a shareholder. Dividends can provide an excellent source of income from your investing efforts.

Let’s come back to a real life example of something else connected with holding common shares in a company. Suppose, for a moment, that Orange was not a public company, and you were its founder. You start in your garage, begin building and selling widgets, and something goes wrong. Let’s suppose that some technological innovation renders your widget obsolete. In the meantime, you have been buying raw materials, paying for employees, marketing, shipping, etc. But it all crashes to a close. You have outstanding obligations to suppliers, employees, banks and much more. As the sole owner, you are on the hook for any outstanding obligations.

The question then becomes, as a common shareholder, what obligations do you have in the event the company goes under? The answer is none. You may lose your investment in purchasing the shares, but that is the limit of your losses. Creditors cannot request compensation from you. Some of you smart business people may say, “But if you incorporate your business, they also cannot hold you responsible.” Strictly speaking, that may be true, but practically, the chances of a small, new business getting any kind of credit from banks or suppliers will depend on the owner giving a personal guarantee.

As a common stockholder, it entitles you to your share of any assets left over from the winding up of the business. They would provide this after it pays other debts, and the organization fulfils certain other financial responsibilities. We refer to common stock as “equity” in the company, reflecting your position as an owner. Analysts often use the equity on a balance sheet as a reflection of the company’s financial health. Besides cash flow, there are two other ways of raising money in a company, offering equity or shares and incurring debt. As a shareholder, you are an equity holder.

As previously mentioned, we are not going into great depth about the accounting ramifications and how common stock and equity are involved-this is a simplified introduction to the world of shares and investing. We will connect some dots about dividends, yield, and other types of shares in the next instalment along with some interesting information about how long it will take to double your investment.

STOCK MARKET BASICS FOR NEWBIES – 2

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STOCK EXCHANGE FUNDAMENTALS

In our previous section we learned that inventor Bob created a company to organize, produce and sell his new invention – we’ll call it a widget. He used the facilities of a stock exchange to finance the project and make this happen so that people could participate by buying units of ownership called shares. By the way, the original decision to use the stock exchange and offer shares for sale in order to raise money for the company is called an IPO or Initial Public Offering.

So, in the early days of our enterprise, that we named “Orange,” there may not be a lot of excitement in terms of the stock market. It takes time and a lot of work to build a company and begin to see the values increase. After some basics we will see how the growth of the company affects these common shares that people purchased to help the company get started. The day to day pricing of a common share or stock can be influenced by many factors, some controllable by the company, and some from outside influences.

The words “stock” and “share” are basically interchangeable for our purposes here. The company is required to report to its shareholders on a regular basis and you may be familiar with the terms of quarterly or annual reports. These are a review of the financial results of the company and usually a comment about the management’s plans for the future.

Initially, the company picked a price to sell their shares to the public – in our example this was 10.00 per share and the proceeds went to the company’s bank account. Because the company chose to use a “stock exchange” to raise the capital, the shares must be listed on that exchange so that people can see them. Anyone else, in addition to the original buyers, can buy these shares since they are now public but how and at what price? Remember earlier we said that a stock exchange is simply an auction market. In other words, a person who currently owns the shares could offer them for sale at any time and another person could be willing to buy these shares – the trick is to agree on a price.

In reality, this is not much different than you selling your dining room suite on Kijijii or Marketplace or some other way. You would list it for sale at a price you consider to be fair and a potential buyer would tell you that they are willing to pay that price or perhaps offer you a price below your listing. At some point in time you might agree to an exchange of money for the dining room suite. The stock market is a bit more organized than that and has other rules in place to protect the buyer and seller but the process is basically the same.

Let’s try and put this process into real world terms to see how it works. We will pretend that my name is Bill and I learned about inventor-Bob’s company and attempt to raise capital and was interested and impressed with the potential of his widget. As a result, I bought 100 of the initial shares that were offered at 10.00 each. George, later learned about our company “Orange” from the various PR releases / quarterly reports, etc. from the company and maybe other sources and has been watching their efforts. He thinks they have the potential to be successful and would like to own a piece of it. He is interested in buying some ownership units or shares (same thing – remember). We also need to understand that the company originally sold 500 shares and there are no more company shares available to purchase. In order for George to buy some shares, he will need to buy them from Bill or another share owner.

The stock exchange has hundreds of companies “listed” and one of them is Orange. This means that every day, and during the day, the exchange will show what people are willing to buy a share for and what people are willing to sell a share for – in this case “Orange.” Let’s introduce a couple of new terms here – bid and ask. Just like an auction sale we have one person willing to “bid” on a product at a certain price and someone else who is “asking” or offering to sell shares at a different price. This very closely relates to our efforts to sell the dining room suite on Kijijii at one price (the ask or offer) and someone else who is looking for a dining room suite and is willing to pay (buy or bid) at a slightly different price perhaps.

The whole purpose of the stock exchange is to facilitate the “exchange of shares” from the seller to the buyer at a price that is agreeable. You may have many questions about how they agree on a price and the process of this agreement. For now, the buyer and seller are not required to actually talk to each other or even know the other party. We will cover that soon since there are intermediaries and rules that govern this. However, before getting to that we will continue our conversation about common shares themselves and some of the characteristics and investment opportunities they present. The next section will go into a little more depth to help you understand more about shares. One thing that is very important to remember, the company sold the original 500 shares and received the money for it but those same shares are now owned by investors, not the company. So, any buying or selling of shares from this point on, does not result in money being added to the company’s bank account.

We are intentionally over simplifying some of this information. Our purpose is to help you understand the basics. Trading techniques and philosophies are for a different time and place. We will continue with more basic information in the next section.