Companies: The building blocks of the stock market
Before you can attempt to understand the stock market, it’s important to first understand the building blocks behind it: companies.
At its core, a company is nothing more than a team working together towards a specific mission. When the teams achieves this mission, it creates value for the company’s customers.
If customers are willing to pay more for this value than it costs to create, the company earns a profit. And when the company is able to sustain the production of value while growing its customer base, it becomes more profitable over time.
How companies go to the next level
Companies are never born perfect. In fact, nothing and nobody is ever born perfect — unlike what our mothers led us to believe. Sweat, tears, failure and endless learnings go into every successful company. To go from a vulnerable start-up, strapped with nothing but hope and intensity to a goliath multinational corporation takes years.
Companies usually start off as sole proprietorships owned by a single founder or, perhaps, partnerships owned by two or more co-founders. Over time, and as a company grows it may decide it wants to “Go public”.
To go public for the first time, a company must sell pieces of itself to the public for the first time ever. Sounds shady right? It’s not. This process is, surprisingly, called an “Initial Public Offering” (IPO).
Going public puts several layers of responsibility on every IPO’d company. The most important of which include:
- Reveal certain information about the company to the public
- Be listed on a public stock exchange (eg. NASDAQ)
- Sell shares in the company and its earnings to the public
- Publish accounts on a quarterly basis (earnings calls)
What are shareholders?
From the IPO onwards, the company is no longer fully owned by its founders. Every shareholder becomes a partial owner. Imagine that! You can own a piece of any and every public company out there. When you hear about owning “stock”, all that really means is ownership of a piece of a company, represented by a “share”, “stock certificate”, or “stock”.
Having hundreds or thousands of owners means that a company has a responsibility to these owners (also known as shareholders). It has to ensure they make decent returns on their investments (ROI). After all, they’ve invested their hard earned money in the company with the expectation that their investment will be profitable.
A company is also responsible for assigning a board of directors, whose task becomes ensuring shareholder rights are being respected through the company’s operations & dealings.
Why go public?
A company can go public for several reasons:
Maintain healthy growth while raising money: Growing a company requires expanding teams and possibly buying more raw materials. This requires capital. Where better to inject additional capital than from interested investors?
Retain control while raising money for future expansion: Going public doesn’t necessarily mean a founder has to give up his/her majority ownership in a company. This is why owners retain control while funding additional expansion.
Create more liquidity so that you, as owner, can liquidate your shares more easily: When a company is listed on an exchange, it is exposed to willing buyers and willing sellers. This creates what we call “liquidity” where there is one interested buyer for every seller.
What it means to be an investor
As an investor, you lend a company money for a share in the potential future success of the company. When you do this, you are effectively making a statement:
I believe in this company. So much so, that I am prepared to lend it my money, with the hope that in the future, the company will make decent profits. Decent enough that my returns on investment (ROI) will be more attractive than doing anything else with my money.
So, by investing in companies you get equity in them. And, as an equity investor, you typically take on larger risks. And as we discussed in our article about interest, the larger the risk you take the higher you should be compensated for having the Cojones to take it.
The company compensates investors in two ways:
- Profit Sharing: Owners split every dollar that the company earns. As an owner you get to share the profits of the company each month/quarter/year. This profit sharing arrangement is what we call getting paid dividends.
- Capital Appreciation: As the company grows, acquires more assets, machines, etc, it becomes worth more than it did when you bought into it. This organic growth means the value of the company increases and you, as a shareholder, get to see your initial investment grow at the same rate as the company overall.
Rights as an investor
Shareholders have a say in how the company is run. Yes, you become a shot-caller! Fine, if you own 0.01% of Starbucks, you aren’t exactly going to get to name a cup of coffee after your nephew.
However, every shareholder gets to vote in the annual general meeting (AGM) on important issues that affect the company. In fact, when you buy stocks, you get sent emails notifying you of when these meetings are happening.
Finally, it’s important to note that every shareholder’s voice is as strong as the number of shares he or she owns in that company. This is why majority owners (usually the founders) get to run the show.