Directions: Use the following K-W-L chart to assess your knowledge of stocks. Begin by listing all of the information that you do know about stocks in the first column. Next, think about things that you would like to know. Finally, you will be adding new learning under the What I Learned column. Keep this chart handy, as you will be referring to it throughout the entire lesson.
Reading: The Vocabulary of StocksPicture yourself as the owner of a growing company. You operate in a rented office that is so crammed with people and desks and equipment that you have bruises on your thighs from trying to get around the desk corners each day. You know you have to expand—in fact, you need to hire two more people to handle shipping and tracking right now, but there’s no place to put them. You also don’t have the money to rent—or buy—a larger space and to purchase more manufacturing equipment and hire staff. Where can you get money to grow?
You’ve asked family members and friends to invest in the company. Some of them shrink away from you as if you have an infectious disease. Others offer you $1,000 or $5,000. That won’t put a dent in the $500,000 you know you’ll need in the coming year. The bank wants to see stronger profits before they’ll consider a loan. What’s left?
Last year you made the decision to make the company a corporation. Doesn’t this give you the power to sell stock? Yes, you can sell small shares of your company to total strangers and maybe raise the money to make your company the success it is in your vision of its future.
Now you have to decide which kind of stock you’re going to offer: common stock or preferred stock? This calls for a chart of the pros and cons of each.
If you sell common stock, your shareholders (or stockholders) get to vote for the corporation’s board of directors. There’s a very remote risk that if you sell enough stock, someday the shareholders could own enough voting stock to control the board and work against you. On the other hand, although they may expect dividends—a share of the company’s profits paid out to shareholders—you don’t have to guarantee that you’ll pay them a set amount every year. If you sell preferred stock, you are stuck paying shareholders a guaranteed dividend as long as you are making a profit. However, they wouldn’t have any vote when it comes to choosing your board of directors.
What are your choices? Continue operating on a shoestring, crammed in two rooms and a warehouse half the size you need, unable to expand—or taking the risk of letting the public buy shares through an initial public offering (IPO)?
This is called going public, and it applies in more ways than one. Brokers and potential investors will start scrutinizing your operation and balance sheet; you’ll have to register your stock with the Securities and Exchange Commission—the government entity responsible for making sure everything about your company is legal—and your business will be subject to new regulations, including regular audits.
Your company will have to find an investment bank (really, a securities firm, which specializes in this kind of deal) to handle the sale of your IPO, a process called underwriting. The investment bankers will either buy the stock offering outright and then resell it for whatever they can get (a higher price, they hope) or they will sell it and take a commission. Because it is the first offering of your stock, it will be sold in the primary market. (If the first purchasers sell the stock later on, it will be sold in the secondary market.)
Then you, the underwriters, lawyers, and accountants must put together a prospectus, a written document that potential investors will read. It contains a detailed analysis of the company’s finances, its management team, and its products or services. The prospectus also spells out difficulties the company could face in the future, and the risks of investing in the company.
Whew! That’s not all, though. You’ll still have to submit the prospectus to the Securities and Exchange Commission and stock market regulators. One to four months later, you’ll print the prospectus, the underwriters will recommend an opening stock price and number of shares to offer—and you go public.
Directions: Use the following note-taking guide as a way to organize the information from the presentation. This information will help you to complete the writing activity to come.
1. People who purchase shares of a company’s stock become _____________________ of the company.
2. Stocks are sold at one of the many _____________ around the world.
3. A market with generally rising prices is called a ________ market, and a falling market is a ___________ market.
The stock market is an everyday term used to talk about a place where stocks and bonds are traded—meaning they are bought and sold. For many people, that is the first thing that comes to mind for investing. The goal is to buy the stock, hold it for a time, and then sell the stock for more than you paid for it.
Buying stock in a corporation makes you a shareholder (or stockholder).
The board of directors of a company decides how many shares the company will have. (This is the case even with privately held companies, where stock is not offered to the public, but just owned by a few people.) Not all of those shares are offered to the public.
The company may use offers of stock to lure key employees and to reward them for meeting performance goals. In that case, executives would hold some percentage of the outstanding shares. Some companies also let employees buy their stock (called profit sharing) to encourage them to feel more vested in the company’s outcome or as the corporation’s contribution to a retirement plan.
The remainder of the shares may be offered to the public, though not necessarily all at once.
There are stock exchanges in major cities all over the world. The largest in dollar volume is the New York Stock Exchange (NYSE), which has its trading floor at 11 Wall Street. (That is why the US financial markets are sometimes called Wall Street.) The Bombay Stock Exchange in India has the most companies listed; the NYSE is second.
More information about the stock market can be found at
http://en.wikipedia.org/wiki/New_York_Stock_Exchange and
Because stock prices are constantly updated at the exchanges, investors and market traders can watch as they fluctuate with news from the company, media reports, national economic news, and other factors.
• With thousands of stock prices rising and falling at once, it would be hard to get a general sense of how the market was doing without some way to group stocks.
• A market index does just that. When you hear that the Dow fell 12 points, it means the total decline of stocks in the Dow Jones Industrial Average (the average of 30 large industrial companies’ stocks) was only 12 points. To put that in perspective, the actual Dow was around 14,000 points in early 2013, so a drop of 12 points would be considered an insignificant change.
• Coca-Cola, IBM, Merck, and Exxon are on the Dow Jones.
• Some other well-known indexes are the S&P 500 (US), FTSE 500 (Britain), CAC (France), Nikkei (Japan), Hang Seng (Hong Kong), and DAX (Germany).
• Other indexes track a sector of the economy, such as high-tech stocks or the auto industry. The Morgan Stanley High Technology 35 Index tracks 35 US technology firms.
Offering stock is an easy way to gather large quantities of investment capitalmoney to make major improvements. The company could ask for a loan from a bank, but eventually it would have to pay the money back. By issuing stock, a company can raise money without going into debt.
When a corporation first sells stock to the public, it makes an Initial Public Offering (IPO). The company might sell one million shares of stock at $20 a share to raise $20 million very quickly (less the brokerage house’s commission). The company then invests the $20 million in equipment and employees. The investors hope that the company will make a bigger profit and pay a dividend. The company will also be worth more and be better rated by analysts.
Of course, if the stock price goes up on the stock market, the shareholder may also choose to sell the stock and pocket the profit.
Investors buy stocks in the hope the company will earn money as it grows. If a company earns money, the stockholder shares the profits.
Historically, investors have earned more from owning stock than from leaving money in the bank, buying bonds, or making other types of investments. This is true even though investments in stocks are not insured the way bank deposits are.
They may also want to have a vote in how the company is run. By buying common stock, they have voting rights when the board of directors is up for election. The board oversees company decisions. Stockholders typically have one vote for each share they own. Every vote counts, but a stockholder with 5,000 shares will have more influence on the company than someone with only one share.
Although we have described the stock exchange as a chain of stores, you don’t need to go to one to buy stocks. You can call a stockbroker at a firm authorized to trade at the exchange, such as Bank of America Merrill Lynch or Morgan Stanley. The broker relays your trade to the exchange floor, and a representative of the firm (or a computer) makes the trade. You pay the broker a commission (generally $10 to $100 per trade).
Brokers provide different levels of service, from full-service brokers, who will call you with stock tips, to online brokers, who offer limited personal assistance. In general, the more service you get, the higher the fees the broker charges.
An experienced investor may use an online broker because of the low fees, while a new or inexperienced investor may want a full-service broker. While the initial fees may be higher, the full-service broker may choose stocks that perform well enough to make up for the initial fees or commission. If you are interested in a company’s initial public offering (IPO), you can research the company by reading its prospectus.
Many investors get their first exposure to the stock market through their employer-sponsored 401(k) plan. This is a program that allows employees to save for retirement throughout their working years. Investments within a 401(k) plan are generally made via mutual funds, which are groups of stocks that are selected and managed by investment managers. Investors buy shares of the mutual fund which owns shares of stocks. This gives investors an inexpensive way to gain exposure to many companies.
When a company has strong earnings, the stock benefits. Buzz about new products and leadership changes can also affect the stock price, up or down.
The price-earnings (P/E) ratio measures share price against the company’s annual net profit per share. A higher P/E ratio means investors are paying more for each unit of income. The higher the ratio, the riskier the investment. For example, if a stock is selling at $120 per share and its net profit per share is $10, the P/E is 12 ($120 / $10). If another stock is selling for $90 per share and its net profit per share is $10, its P/E is 9 ($90 / $10). The investor purchasing the first stock is having to pay $12 for $1 of income versus only $9 per $1 of income for the second stock.
One measure of the value of a company is capitalization—the number of outstanding shares multiplied by the share price.
The stock market operates on supply and demand. Given a limited supply of shares, the more demand people make to buy a particular stock, the higher the price. The more people trying to sell a stock (that is, the bigger the supply), the lower the price. Shortages of commodities (oil, for example) drive up the price of the commodity but can make its stock more valuable.
Disasters may damage certain segments of the economy. For example, after 9/11, passenger planes were grounded for two days, representing tremendous losses to the airline industry. Such losses can depress the value of a stock. High unemployment numbers, gridlock in Washington, D.C. on budget issues, and political or economic upheaval in other countries also causes investors to get nervous and the market to react negatively.
Stocks have strong appeal because of their potential for growth. However, since they also have some risks—your investments are not insured, and the markets are subject to factors beyond your control—they should never be the only type of investment you make. Different investment vehicles—stocks, bonds, CDs, commodities, to name a few—have varying return potentials. Those with the highest return potential come with the highest level of risk.
Even within your stock portfolio, you should have a mix of growth and income stocks. Companies with growth put most of their profit back into the business to make it grow, thereby increasing the company’s value; the price of the shares also rises (capital appreciation). Those with income pay out most of their profit to shareholders, but the share price for an income stock stays flat. The income (dividends) from these stocks can be paid out to the investor or can be reinvested into the company in the form of purchasing more shares (dividend reinvestment plan).
When you are young, you can invest more heavily in growth stocks, because if you suffer a loss, you have time in your working years to recoup. As you near retirement, your portfolio should be weighted toward income stocks, which are more stable and less risky. Prior to retirement, you may want to reinvest your dividends to increase the size of your stock portfolio. At retirement, you may want to start receiving the dividends as part of your retirement income.
Investing in the stock market can be a gamble, so be aware of how well you tolerate risk (risk profile).
The IPO DecisionWhy does it make sense for the owner(s) of a private company to sell stock to the public? Think about what an initial public offering (IPO) means. The owner(s) are accepting some number of strangers as partners in their business. Furthermore, there are no restrictions on these new owners’ ability to sell their stock, so these unknown partners can sell to other unknown partners.
The usual reason to go public is the need to expand the business. The company wants to take advantage of some business opportunity but does not have the cash to do so.
Risks of Going PublicGoing public can have its negatives for the company and its owner(s):
Other people will own part of the company and share its profits.
The money from the sale of stock does not go to the original owner(s).
The company’s current owner(s) must give up a lot of control over the way the business is run, because management must consider the needs of public investors.
The company must be managed in a more formal, more deliberate way, which means decisions will take longer.
The federal Securities and Exchange Commission (SEC) will oversee the way management reports financial results, and the company will face significant legal penalties for violations.
Pressure from stockholders to produce a profit every quarter may limit management’s ability to take a long-term view of the business.
Benefits to the Original OwnersThe other side of going public is that it can offer benefits to the company and its original owners. If all goes as expected, the company’s sales will grow with the influx of new capital, and the company will make much more money. With the money it makes, it can pay a healthy dividend on its stock, causing the price of the stock to increase. Even though their ownership in the company has been greatly reduced, the original owners can benefit from stock dividends and the higher value of the stock they do own—and may make considerably more money in the long run.
The IPO ProcessWhen a company decides to issue securities (a certificate of ownership in an investment), it generally hires an investment bank to underwrite the stock offering. Underwriting means the investment bank (or a group of investment banks known collectively as a syndicate) agrees to one of the following:
Firm underwriting: The investment bank or syndicate will buy all the available shares of stock and then resell them to investors at a profit.
Best efforts underwriting: The investment bank or syndicate will sell the stock as the company’s agent, earning a commission on however many shares are sold.
The first sale of securities by a private company to the general public is called an initial public offering (IPO). The underwriter (or lead underwriter in the case of a syndicate) plays a pivotal role in the IPO. The underwriter/lead underwriter handles all the legal and financial details of the sale. It also helps the company:
Prepare a prospectus, a legal document that gives pertinent information about the company offering the shares.
Prepare an advertisement—called a tombstone because of its heavy black border and use of capital letters—for the IPO.
Line up investors or offer the shares to the public.
IPOs are distributed through investment bankers in the primary market. If the underwriters have agreed to buy the stock directly from the company, they sell it to the public for the first time. If their involvement is on a best-efforts basis, they sell the stock as the company’s agent, earning a commission on the shares sold.
Who Buys the Stock?Selling large amounts of stock a little at a time to thousands of investors is costly and time consuming. Underwriters want to conduct the sale as quickly and cheaply as possible, so they prefer to sell to very large investors. Underwriters usually offer IPO stock to pension plans, mutual funds, and very large private investors first, with the hope that it will sell quickly. Later on, these investors will sell smaller blocks to smaller investors.
Who Benefits?When everything goes according to plan, the company raises the needed capital for expansion, debt relief, operating expenses, or whatever reason it specified in the prospectus. The underwriter makes a profit by buying all the new securities at one price and selling them to the public at a higher price (or by collecting a commission on the shares sold). If the company puts the new capital to good use, it becomes much more profitable, and its investors make money.
T-Chart: The Pros and Cons of Going PublicStudent Name:_______________________________________________________ Date:___________
Directions: Using the graphic organizer below, list five positive and five negative effects of issuing stock to finance a company. Remember, you will be using this resource as a guide for the following writing assignment (Student Resource 9.7).
Directions: Imagine that you have an early-stage company in need of funding. Write a summary in which you list the top three reasons why a company should or should not go public.
Make sure your assignment meets or exceeds the following assessment criteria: The summary accurately introduces the topic of going public and includes an explanation of what
an initial public offering means.
It includes a clearly written description of why a business would choose to issue stock to finance a company.
It clearly informs your reader of your position. (For example, “There are several advantages [or disadvantages] to raising financing for a company in a stock market. Among the most important are…”)
It includes three statements that effectively support your position. Remember not to just list your supporting statements one after the other but to include one or two sentences of opinion or fact to help clarify your position to the reader.
It includes transitional words such as first, in addition, furthermore, and finally as a way to connect your ideas.
Your summary is neat and legible and uses proper spelling, grammar, and punctuation.
