Saturday, April 4, 2009

What is stock?

When I don't get questions from my readers, I write posts like this one. I'll describe a financial/economic theory, instrument, or idea. Many of you might already know this stuff, but I'm sure someone out there has no idea.

Today, I'll explain what stock is and how it is created. I'll try to follow up another day with how it is traded and changes in value.

Simply, a share of stock represents ownership of part of a company and the profits that company produces. I'll explain the details with an example.

As many of you know, before I started graduate school in Finance, I was working at a school running the Technology Department. I've continued to do some technology consulting at a couple different places to help pay the bills while I'm in school. For tax purposes, I created a business to do this work. Most of my income is earned actively doing consulting, but I also run a server at home that provides off-site data backup for clients.

So, right now, I own my company, all its assets (the server and other equipment, the cash in the checking account, the name, the license with my town, etc.), and future earnings the company may produce. Let's imagine, though, that the off-site backup services of my business grow significantly. Let's also assume that this is all the company does now; no more consulting. This would require buying more equipment to provide more space and faster service. If I (the company) have enough cash to make this investment without help, I'll just buy the equipment myself, but what do I do if I need to buy $20,000 of stuff and I only have $5,000. Well, I have a couple feasible options to get the extra $15,000 I need.

My first choice would be to go to my bank and get a loan, but let's say they turn me down because they think my expansion plan is too risky. My next option would be to look for an investor. I would ask someone, let's say my friend George (he's a technology guy too), to give me cash in exchange for ownership in the company. This would be a permanent relationship, as opposed to a bank loan where I pay it back eventually. George would own a part (or a share) of the company.

Let's say the non-cash assets of the company before this deal are worth $10,000. I'm also bringing $5,000 cash. George brings another $15,000 cash. So we each bring $15,000 to a deal that creates a business worth $30,000, meaning that we each own half the company. We could incorporate the business, create two shares of stock, and each of us get one share. No matter what happens to the total value of the company in the future, each of us owns half of it. We share good times and bad equally.

Now there is work to be done to keep this business going, and I'm the one who knows how it all works, so I'll probably still be doing that work. The company will need to pay me a salary for that work. After all the costs of running the business, including my salary, there will hopefully be profits. These profits will be shared equally between George and me, because we each own half the stock in the company. When these profits are paid out to us, they are called dividends. Also, decisions that involve spending these profits on the business (say, for future expansion) will need to be approved by both of us.

Again, this arrangement is permanent. There are ways for one or both of us to sell our ownership of the company, but an explanation of this process will be the topic of another post.

Notice how much I've used the word "share" in this post. Shares of stock are named as such for a reason.