This post is Part One of a Beginner’s Guide to Stock Investing series.
Part 1: What is a Stock?
Most people have some familiarity with the stock market. But what is exactly is a stock? Why do people buy stocks?
There are plenty of people who trade stocks. That is, they attempt to forecast the near-term direction of stock prices and buy or sell stocks based on those predictions. That is an activity that I do not engage in and for which I can say very little. My experience is in analyzing and investing in stocks. To me, stocks are pieces of a business.
Understanding how those shares later trade in public markets is the focus of Part Two: What Is the Stock Market?
A Stock Is a Piece of a Business
To see this idea more clearly, let’s work through a simplified scenario.
Suppose that you decide to leave the corporate world and acquire a small business. You find an ice cream shop that is doing rather well, and the owner is set to retire. The business is generating $170,000 in pretax profit (sales minus business expenses). After doing a little research, you see that such businesses generally sell for 3.5 times pretax profit. You offer, and the owner agrees to, a purchase price of $600,000.
The business itself is an asset. Actually, it is a collection of assets. But to keep things simple, we will view the entire business as a single asset. An asset is something that is owned or controlled and is expected to provide economic value in the future. Assets must be financed somehow. Broadly, there are two ways to finance an asset: debt and equity. Debt financing is borrowed money. Equity is the monetary contribution of the owner(s).
Why Corporations Issue Stock
It is a good idea to own the asset (the ice cream shop) through a business entity rather than as an individual. There are two main reasons for this. First, a business entity is separate and distinct from its owners. This grants the owners limited liability, where in the event of a lawsuit or bankruptcy, claimants (generally) can go after the assets of the business entity but not the personal assets of the owners. This is a tricky concept, especially for small businesses where the owners must personally guarantee just about everything. But if the business is large enough, the financial risk taken by the owners is limited to their investment in the business.
The second reason for creating a business entity is that you will need to do so to raise additional capital, either in the form of borrowed money or by bringing in additional owners.
There are two main types of business entities: limited liability companies (LLCs) and corporations.
For our purposes, we are going to assume that you start a corporation, and a specific kind of corporation called a C-corporation. The reason that you are using a C-corporation is that you are no ordinary business owner. You are not satisfied owning one store. You want to own thousands of them across the United States. Baskin Robbins, watch out! But to grow to that size, you will need to bring in lots of additional capital. The C-corporation form allows you to sell shares without the restrictions of other business forms. It is also the business form you will need if you ever want to issue stock on a public exchange.
To start a corporation, you must first choose a state to incorporate in. This may be the state in which your business will be headquartered, or it may be a different state that has more business-friendly laws. Either way, you will need to file a document called the articles of incorporation with the state that you choose to incorporate in (and of course pay a filing fee). This document contains general information about the business, such as a general description of its (planned) operations, the name of the corporation, and its place of business.
Authorized Shares and Ownership
The articles also specify the number of authorized shares. This is the total number of shares a company can issue.
Now, you need to “capitalize” the business, meaning that you have to bring financial capital into the business so it can acquire assets and begin operations. You have to bring in at least $600,000 to acquire the ice cream shop and it’s probably a good idea to have some cash in the bank. Let’s say your total capital needs are $650,000. How are you going to finance this?
Suppose that you get a loan for $450,000. For the other $200,000, you will fund this amount yourself. In other words, $200,000 is your equity contribution. When you put that money into the business, what are you getting in return?
When you put money into the business, the company will issue you shares of stock. Let’s say that the company is authorized to issue up to 10 million shares. You may have the company issue you 1,000 shares, implying a price per share of $200. In other words, the company has sold you 1,000 shares of stock at $200 per share.
The Primary Market: Stock Issued by the Company
This transaction between you and the company occurs in what is called the primary market. In the primary market, the company itself receives the proceeds of the stock sale.
Let’s look at the company’s balance sheet. A balance sheet is a financial statement that shows a company’s assets along with how those assets were financed. This statement is called a balance sheet because the monetary values on both sides of the balance sheet must be equal.
The left side of the balance sheets shows the two assets: the acquired business and cash in the bank. The right side of the balance sheet shows that those two assets were financed by a combination of borrowed funds and funds provided by you, the owner.
In this case, you own 100% of the company because you own all the shares that have been issued. Ownership of a company is based on the number of outstanding shares – the number of shares held outside the company – rather than the number of authorized shares. Because the number of authorized shares is substantially higher than the number of shares issued and outstanding, the company can issue additional shares in the future if it requires additional capital. It can also issue shares as compensation to employees.
Stock Ownership Represents Residual Claims
The value that the ownership gives you is twofold. First, you have a residual claim on the assets of the company. This means that you have a claim on the assets after the claims from creditors. In other words, if the assets were liquidated, the debt would have to be paid off before you can receive any proceeds. The second source of value is that you have a residual claim on the company’s profits. Profits are just the amount of income that is left after expenses have been paid. And profits are really the lifeblood of any business. Without them, the business will not be around very long. The value of the stock is a function of those profits.
Raising Capital and Dilution
Fast forward a few years. You now own three profitable stores. But you’re not growing anywhere near what you would like. So, you decide to bring in other investors.
The issuance of stock to additional investors is done through what is called a private placement. Because this represents a sale of stock to outside investors, it will fall under the jurisdiction of the Securities and Exchange Commission (SEC), and they have certain rules that must be followed. And following these rules will require you to hire an attorney knowledgeable in securities law to prepare all the necessary legal forms.
Let’s say that you want to raise $2 million through a stock sale. You now have several questions to ask.
- How much of the company are you willing to give up?
- How should you price the shares so that investors are incentivized to buy them?
- What’s in it for outside investors?
You tell your investors that with their capital, you can grow to 20 stores in ten years. At that point, you estimate that the company will earn $3,500,000 per year in pre-tax operating profits. So, one way to value the company and price the stock is to work backwards. First, as an established and growing company, you estimate that the company will be worth at least 12 times operating earnings, or $42,000,000. You also estimate that the company will have $15 million in debt. The value of the equity is the value of company minus the amount of debt, or $27 million.
Valuing Equity Using Discounting
Now remember that the $27 million in estimated equity value is 10 years in the future. We want to know what the equity is worth today. To calculate the value of the equity in current dollars, we must discount the future amount by the return required by the investors. Suppose that investors in private businesses require a minimum annual return of 18%. We can discount the future equity amount using the following formula:
Present value = Future value / (1 + r)^N, where r is the required rate of return and N is the number of years.
Using this formula, the present value of the equity is:
$27,000,000 / (1.18)^10 = $5,158,741
The $2 million that you are looking to raise is a claim on the $5.159 million in estimated equity value, or 38.7692% of the total. That leaves you, as the founding owner, with 61.2308% of the equity.
You still must put a per-share price on the equity. Remember that you own 1,000 shares. With the proposed capital raise and associated valuation, those 1,000 shares represent 61.2308% of the total equity. That equates to a total number of shares of 1,000 / .6123 = 1,633. In other words, you will need to issue 633 new shares.
To find the price per share, we simply divide the equity value after the capital raise by the total number of shares outstanding after the capital raise:
$5,158,741 / 1633 = $3,158.74
Here is a summary of the numbers we just worked through:
With the additional shares issued, you’ll go from 100% ownership to roughly 61% ownership. In other words, the new share issuance leads to dilution of your ownership stake. Why would you agree to this?
Let’s look at the value of the company without the new equity. You have three stores. Suppose they are collectively generating $450,000 in operating profits. Let’s also assume that the valuation multiple is now four times operating profits. Your equity stake is $1.8 million.
With the new equity issuance, your ownership is worth roughly $3.16 million, despite your ownership being reduced. You now have a smaller share of a larger pie. And that is why entrepreneurs are willing to sell part of their companies to investors: so they can grow a larger company than they could without the additional capital.
If you’d like a deeper walkthrough of present value, discount rates, and the math behind these calculations, you can download my free guide on Compounding and Discounting here.
Key Concepts: What a Stock Represents
In the above example, we had two stock transactions which occurred directly between the company and its investors. From the example, we can conclude the following:
- A stock is an individual unit of ownership (equity) in a corporation.
- The owners of equity have a residual claim on the assets and the profits of the underlying business.
- The value of equity is based on the estimate of future profits, discounted to the present.
- The percentage of ownership is based on the number of outstanding shares.
Looking Ahead: The Stock Market
In Part Two: What Is the Stock Market?, I discuss how companies move from private ownership into public markets and how exchanges function. But for now, I want to pose the following question: should someone buying stock through a stock exchange view things any differently than a sophisticated and informed investor would in buying stock directly from the company? To me, the answer is no. And that is the essence of fundamental investing. By thinking as an investor in the private market would, you can view yourself as a business owner rather than a trader.
Summary:
A stock is not simply a financial instrument that moves up and down on a screen—it is a real ownership interest in an underlying business. When you buy stock, you are purchasing equity, which represents a residual claim on a company’s assets and profits after creditors have been paid.
In this post, we worked through a simplified example of acquiring and expanding a small business to show how shares are issued, how ownership is divided, and why companies raise additional capital through equity financing. We also saw how future profits ultimately determine the value of a business, and how investors must discount those future values back to the present.
Understanding stocks in this way is the foundation of fundamental investing. By viewing stocks as pieces of businesses rather than trading vehicles, investors can approach the stock market with a long-term ownership mindset.
Key Takeaways:
- A stock is an individual unit of ownership (equity) in a corporation.
- Stockholders have a residual claim on the assets of the business after creditors are paid.
- Equity owners also have a residual claim on the future profits of the company.
- The value of stock depends on expected future earnings, discounted back to the present.
- Ownership percentages are determined by outstanding shares, and issuing new shares causes dilution.
- Fundamental investing begins with thinking like a business owner, not a short-term trader.
