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How Stocks Work

It all starts when a company wants to raise money to invest in something they think will be profitable such as a new manufacturing process more production capacity or a new product.  The company can do this a number of ways but the two most popular are to borrow the money or sell part of the company.  Borrowing the money is usually done by issuing a "bond" which is a promise to repay the borrowed money with interest.

The next most popular way for a company to get money is to sell "stock" in the company.  This is essentially selling a bit of the company and sometimes it carries a promise of getting a split of the profits when there are profits to split.  Stocks are also called "equity" because the owner of the stock has equity or part ownership of the company.

When a company is formed or incorporated it sets up a certain amount of stock which is worth about as much as the paper it is printed on--stock in its infancy carries no real value outside of the company.  When the original owners of the company need to raise money they have to find good natured people who are willing to invest in small but risky companies and sell this stock person by person one person at a time. A share of stock signifies the holder owns some fraction of the company and possibly allows the owner to enjoy part of the profits of the company.   The stock may have a "face value" given to it when the company was formed but you couldn't walk into a grocery store with $10 worth of this stock and buy a loaf of bread. 

As the company becomes even larger and needs to raise even more money (usually several hundred million dollars) even more stock will be offered on the open market. This is when it gets interesting.  An initial public offering is made of so many shares of stock at a predetermined price say $15 a share.  People who invest in the stock market usually read the Wall Street Journal looking for initial public offerings or IPO's.  At the moment the stock is sold to a shareholder during the IPO it is worth its selling price of $15 a share.   Now at this point you can turn around and sell it for $15 dollars to someone else and then go buy a loaf of bread if someone is willing to pay you $15 dollars for it.  The stock has now gone from being held by a few investors and owners of the company (or closely held) who would have a hard time selling it to being publicly held by thousands of owners who could sell it more easily because it is now being traded through stock exchanges such as the New York Stock Exchange or via the NASDAQ.

Soon after trading hands a few times the people buying the stock now determine the value of the stock by what they are willing to pay for it.  Sometimes the price of a stock that sold for $15 a share at its initial public offering will drop like a rock.  Other times it will skyrocket.  The value of the stock is set by many many people trading it in an free open market.   And even though a person buying a share of stock may be a hundred times removed from the person originally buying the stock from the company at the IPO that person still owns some teeny tiny fraction of the company.  I don't know how they do it but the company keeps track of all their stockholders.

Sometimes the value of a share of stock is determined by crazes such as the internet which tends to drive the price up quickly but the price may also fall just as quickly when the craze looses it "newness".  More often than not the price of stock is set by how much profit the owner will receive or dividend or by the company's current earnings and their prospects for future earnings.  A company with little hope for the future will be frowned upon by the people wanting to buy their stock and the buyer will not pay very much for it (its price usually doesn't drop to $0 right away as there are optimists and opportunists who will take a chance on disfavored stocks and will keep the price from falling to nothingness over night).

It's just like trading baseball cards.  When stock is traded on the open market the only reason it is worth so much is because there is someone out there willing to pay that much for it.  No magic no mystery.

How do you buy stock and start to live a part of The American Dream?  This part is continued on the next page.

How To Buy Stock

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