IF YOU ARE TERRIFIED OF BUYING STOCKS, READ THIS (PART 1)
All corporations have one common goal: Making money by creating new wealth. Corporations create and sell products and services that upgrade the standard of living of its customers. Often, the risks faced by companies in this honorable quest of advancing the lives of millions or if not billions of people, are very high. It is a path fraught with danger; not just money or things could be lost, even lives too. It is not easy to create a successful, profitable company. According to various statistics, up to 90% of all new businesses would fail within five years. The odds are high that 9 out of 10 of the newly formed companies you are seeing out there every day, that just opened for business such as services stores, retail outlets or just plain restaurants, would not be there five years from now.
Companies face challenges from all corners. The challenge of securing cheap and sustainable raw materials supply, human resources capital, ever changing and tightening regulations, competitors, time and certainly money as well, are among the major challenges. Overcoming each and every challenge is critical in determining whether a business fails or succeed. A business could fail on any of the mentioned front, resulting in a failure much like a collapsing wall of a water tank. Even if only one front fails, the business would fail. The stakes are always high. The amount of money to start a business can be large, thus typically, more than one individual would pool their money in order to start one. To reduce the risk of catastrophic failure which could result in the loss of one’s life saving for instance, a group of people can pool their resources and they would have a better chance of succeeding. They can share not just the money part, but knowledge and expertise as well. With broader support plus larger and more tentacles for networking, the odds for surviving would be higher.
A smart individual with a great idea, who wants to change the world and assist millions of people to upgrade their collective lives, is better served if he or she founded a new company. But for lack of experience and especially capital, the person could never do it on his own. A partnership is a better route in solving this crippling problem. This is one of the pillars of capitalism, where a group of people bands together in order to create something of value. More can be created, than one person alone ever could. As it turns out, there is no limit as to how many “owners” a company can have. The more, the merrier it would get. However when there are many owners, the complexity of managing the “owners” would grow as well. For instance, there will be a need to manage owners that wanted to leave. A new owner can be brought in, or simply, the existing owners acquire the departing owner’s stake. Thus a share exchange program can be instituted to manage this process continuously.
When a company’s prospect for making large sums of money in the future is bright, or when it is already raking in those big profits, the amount of money a new owner would have to pay, in order to join the existing owners’ group, would go up. Since the potential of making more money in the future is very bright, the value of share each of the owners is holding would go up as well. We explained this phenomenon in our previous article where we touched on the origin and calculations of Price to Earnings Ratio.
Money extended by the shareholders (the owners) to the company is free of any interest charges and therefore constitute as the cheapest source of capital a company could ever find. In fact, the best part of all is that if the company fails and loses all of the extended money, there is no need for the company or anyone else to pay it back. However if profit is generated, the shareholders would share the profit according to their shareholding in the company. This was one of the critical attribute that enables a big rise in capitalism the world over several hundred years ago.
Each shareholder is free to give away his or her share to another person, at any time. Almost always, for the right price. The share exchange program allows for instant exchange between an existing owner and a would-be owner. An individual can become an owner, and stays as an owner for several years, or for several months, or days. Heck, even minutes is possible, it really does not matter at all to the shareholding and the company itself.
When an existing owner decides to leave, especially for the fear of losing the value of his investment, a new owner could come in. This new owner is apparently willing to extend his own money for the company to use despite the risks involved, therefore supporting the company in its long and tedious quest of making the world a better place. The existing owners of the company could issue new shares to get even more owners to join, acquiring fresh capital for use in the process. As we have said, the more the merrier.
An initial public offering or IPO is a notable step for a company. During the IPO, the company would obtain fresh capital, and the amount would be “locked in stone”, i.e. after the IPO is completed and the shares started to be traded among the owners, the changes in the value of the share would not affect the company much, anymore. The reason this is so is because even if the share price drops to zero during the post-IPO period, the company would have already obtained the proceeds and expended the money. As an example, during an IPO, a company may obtain fresh capital worth 100 million dollars for use in its business, yet if the price of the share subsequently drops by 50%, the company would not be impacted much because the money has already been utilized. The drop of 50% is only on the value of the shares being held by the owners themselves. Therefore companies (and its owners) would go to great length to ensure maximum capital is acquired during their IPOs.
Each owner extended their support for the company by giving away their money in the hope of good returns. Since each share is given a certain percentage of the company’s profit in equal proportion, then each person holding that specific share would be rewarded on that specific share depending on the length of time and ‘events’ during their ownership holding period. For example, a company that continuously makes a million a day of profit from its operations would generate a total of 365 million dollars of profit in a year. A person holding a one percent share for the entire year could be given the profit according to that shareholding, which is 365 mil X 1% = 3.65 mil dollars. If however the person is holding it for half of the time, then he will only receives half of the profit, and the ‘other’ holder receives the other half. There is no limit to this division and every time, the division is fair for each shareholder. In reality, companies typically distribute their profits quarterly, and sometimes, yearly (and certainly not all profits are distributed, some are reinvested into the business for the company’s future expansions and also for rainy days). Indeed, it is wise for an owner to hold the share at the right time or the profit payout will be missed.
In the example above, the company was making a steady stream of profit of one million dollars a day. At this level, the value of the share each owner is holding would be rather steady. What would happen if the company is suddenly able to generate more, say 1.5 million a day, i.e. fifty percent more? Undoubtedly, the value of the share would go up as well. The increase in value would correspond to the increase in profits of the company. But what if the company is expected to quadruple its profit potential in the next few years, but is still making the same profit today, right now? Interestingly, the higher the probability this elevated profit could occur, the higher the price the share would fetch. Each potential new owner must assess this probability and put away his money if it suits him. This potential future profit would push the price for all of the outstanding shares upward, until it stops at a new equilibrium. Depending on the investors’ risks appetite, this Price to Earnings Ratio can be between 10 to 30, with the average typically around the middle.
The following video presentation depicts the concept of share ownership of a corporation by the public.
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The purchase of a company’s stock, to assist the company in achieving its noble goal of making the world a better place, can be a very rewarding undertaking. Historically, the stock market is a place where surplus capital of the economy is consciously directed (by the capital owners themselves), and from it (the stock market) fresh profits are generated and distributed out. Trading stocks is an art of directing precious and limited capital, to a company that needs it most, with the greatest potential for making plenty of profit. As difficult as it may sound, in practice, it is actually not very difficult. After all, almost everybody can direct their limited precious energy to do the things that benefit them the most in their everyday lives. Just like shopping in the mall, spotting sales deals is an art that is mastered by many. The trick is to buy high quality products, with the highest upgrade for one’s potential or wealth, at the lowest possible price.
Countless stories of individuals who made their fortune from the stock market by buying good companies can be found out there. If you bought the share of Apple as it was collapsing back in the late 90s and hold it until today, you will earn a very good return. An article by Kim Peterson, “What if you had bought Apple stock in 1997?” calculates that buying just 100 of Apple shares then, would yield a return in excess of 6,700% (earning you a cool $150,000, give or take). There are many such stocks to buy in the stock market, everyday of the week. If you have surplus capital that you cannot make the best use yourself right now, the stock market is the place to put it, letting others use it and share their profits with you.
However, one need to be prepared to ride the up and down of the stock market. Many good financial advisors gave the advice that an investor should only put into the stock market money that is not needed for at least ten years from the date of the investment. We shall show how true this advice is by doing a deep analysis of the Dow Jones Industrial Average movement over decades.
One thing we can be certain from analyzing DJIA 15,000+ session data is that you are guaranteed to make money if you put your money in the stock market by buying good companies’ stocks. We will back this up with data in part 2.