Yet, most people first being introduced to stocks and stock options have very little knowledge of even what a stock is. This brief overview of stocks will provide you with enough working knowledge needed to make learning options easy. If you want more information on stocks, you can go to our website at RandomWalkTrading.com and learn more.
A stock is simply a unit of ownership in a company.
If you were a kid and started a lemonade stand with a friend (his name is âCheapyâ as for reasons understood shortly), you could issue stock to keep things fair. Suppose that the start-up cost of the lemonade stand was $100 for the cost of wood, paint, lemons, water, sugar, ice, etc. You put up $60 and your friend put up $40, and you agreed to split the time working the stand somewhat evenly. If the stand only took in $100 before you got bored of it and shut it down, it would not be fair to divide the proceeds evenly. Thus you decide to issue stock in the venture and call the company John Lemon’s Lemonade.
You and your friend decide to form a quasi-company that issues 100 shares of stock, each costing $1. Because you put in $60 towards the start-up of the company, you will receive 60 shares, and your friend who put in $40 will receive 40 shares. Neither of you mind that you are receiving more shares than your friend, âCheapyâ, because you both know that this is going to be the most profitable lemonade stand in history. Forty, fifty, or sixty percent of $10 million â what’s the difference?
Now as time passes past the first euphoric days in business where you both are envisioning millions, conflicts and differences in opinions may occur. You feel that adding a second, more premium line of pink lemonade, as well as cookies, will increase sales. Yet Cheapy doesn’t want to take a portion of the sales and reinvest it in the company. Cheapy has his eye on the newest series of PokĂ©monâą cards and feels cookies, even if they will bring in more profits, are a waste.
As you can imagine, disagreements like this could arise, and that is why it was good that Cheapy and you started a company. Like all friendships, partnerships and marriages, the relationship can come to an abrupt end in these tenuous situations. Fortunately companies take a vote on major issues, and it is a majority vote that wins. Each share has 1 vote.
Since you have 60 shares, you have 60 votes on pink lemonade and cookies, and Cheapy has 40 votes against the major expansion plans. Fortunately, you two didn’t open your lemonade stand like neophytes, and started it as a company. Your 60 votes mean that, despite Cheapy’s wishes to speculate on the future value of PokĂ©monâą cards, you will be investing in a less volatile product â cookies.
From this point on, as profits are made, the division of that money will be paid out on a per share basis. If the company spends $200 in start-up costs, cookies, and more lemonade, and takes in $500 in sales, the profit is $300. At this point, the company could be liquidated because winter is coming, or the two of you could elect to just pay out the $300 in profit to the shareholders (you and Cheapy).
Supposing that you want to continue running the business but pay out the $300 in profits, the math is straightforward. What you do is declare a dividend (the payout) to the two shareholders. (Dividends will be covered in more detail shortly.) The math literally consists of just dividing the profits ($300) by the number of shares (100) to come up with a dividend payout of $3 per share ($300 / 100). To figure out what each of you is owed, all you have to do is multiply the number of shares each shareholder has by the dividend amount ($3 per/share).
Now if you have friends or business partners like some people have had in the past, the first thing you are going to hear from Cheapy is that he didn’t want to sell pink lemonade, sell cookies, and now is getting ripped off. Of course, Cheapy is going to whine about everything that he brought to the lemonade business and how he is entitled to half ($150) of the $300 profit â not $120. Yet it is totally fair and that is how stock works in corporations. The fact is that you invested more money than Cheapy did (50% more) in the company. Had the two of you been shut down by the health department and had a total loss, you would have been out more money than Cheapy. It all comes down to risk and reward. You put up more risk capital and are entitled to more of the spoils of victory.
The price of a company’s stock is based on the net value of the company (assets minus liabilities) PLUS some amount over or under the net value. There are dozens of statistical formulas to assist in calculating what a stock is worth. For example, the âP/E ratioâ is one of the more familiar terms you will hear when talking about stocks. This is simply the price of the stock (say $50) divided by its earnings per share (say $2.90) â or how much the company makes.
Example: Say a company has a P/E of 17.2. Analysts will then use this number and compare it to other companies in a similar industry to evaluate if the stock is over-priced or under-priced. There are many fundamental flaws and misleading assumptions that can be made when trying to evaluate a company’s real value, and entire business libraries can be filled with texts praising the benefits of stock evaluation. As a matter of fact there are three main schools of thought regarding stock evaluation:
- Technical Analysis
- Fundamental Analysis
- Random Walk Theory
A) Technical Analysis Technical analysis is the study of charts and past price movement of stocks in the attempt to glean a forward looking guidance to future stock movement.
B) Fundamental Analysis Fundamental analysis is the more scientific method of determining future stock prices via the use of ratios and statistics as illustrated in Figure 1.3 ratios.
C) Random Walk Theory Random Walk (RW) theory is the mathematical formalization of successive movements in order to explain stocks, psychology, physics, biology, economics and chemistry. RW theory has also been called âthe drunkard’s walkâ because the markets move in a random fashion and cannot be predicted. Since Princeton Economist Burton Milkiel wrote the text âA Random Walk Down Wall Streetâ in 1973, RW theory has been accepted as fact by many economists and large proprietary trading firms. Random Walk Trading believes that evaluating stocks and trying to predict the future is too slow and difficult of a method for making money in the markets (for all but a select elite group of individuals). It is our belief that winning in the stock market can be best accomplished through superior strategies. More extensive material can be found in any library or bookstore if interested in further reading.
A company that has demonstrated consistent increases in profits from one year to the next will have a premium attached to the stock. There is a fairly commonsensical reason for this. If you are going to invest in a company, would you want to invest in one that demonstrates its health and growth, or one that is dying on the vine? Because the number of shares available to be purchased is limited, there will be more of a demand than the supply can handle which forces the price of the stock higher.
Once in a while a company will be in such bad favor with the public that people rush to sell their shares for fear of losing everything if they continue to own the stock. Images of Enron and other bankrupt companies move to the front of their minds, and they panic. Sometimes the selling is so strong and pronounced that the company will trade for less that its âbreak-up valueâ, which is what the company is worth if all the assets were sold.
- Buying Stock
- Short Selling Stock
Money is made on stock as the price of the stock increases if you own the shares. The formula is very simple. All you have to do is multiply the number of shares by the amount of the move, and this will tell you how much you have made (or lost on the stock).
Suppose that your buddy Cheapy is running out of patience for the lemonade business and decides to sell 10 shares of his stock to a friend, Henry. Henry is an entrepreneur in his own right. At the age of 11 he has a paper route and a lawn cutting business that nets him enough money to invest in sound businesses such as lemonade stands. He decides to let his money work for him, instead of working for his money and buys 10 shares of John Lemon’s Lemonade, Inc. for $5 per share. SinceHenry is buying 10 shares, his investment will cost $50 (10 shares X $5 per share).
The following year is one of the hottest and most humid on record. The pink lemonade is a hit, and your new location across from the park is paying off. Sales soar to $900, well above the $500 from the previous year. Suppose that at the end of the year all the shareholders get together to determine the value of the business, and with the advanced business skills picked up in 6th grade, the group determines that John Lemon’s is worth $900 because that is how much you can net in a year. Since there are 100 shares in the company, each share must be worth $9 ($900 company value / 100 shares).
Henry now wants to know what his investment has done, so he does the math. He knows that he bought his shares for $50 from Cheapy, which equated to costing $5 per share. The 10 shares he bought are now worth $9 each. By simply doing the math, Henry determines that he made $40 in one year on his $50 investment. The formula is as Figure1.5:
This was not bad at all; Henry got an 80% return on his capital. Yet, things could have turned out the other way for this investment. The price of lemons could have gone up so dramatically as to make lemonade too expensive to make. Cheapy could have blown off doing his shift, leaving the lemonade stand alone. A competing stand could have sprung up across the street and dramatically affected sales. Or it could have been a cold and rainy summer. If sales decreased to $200 and you determined that the value of the company was only worth $200, a loss would have occurred for Henry’s passive investment. Recall that Henry has 10 shares that he purchased for $5 per share. Now after one summer, sales declined to $200 and the 100 shares that the three of you have divided are only worth $2 per share. Henry’s loss would look as figure 1.6.
This may sound like a catastrophe to Henry, and it might just well be. Yet, many people make a good deal of money in the stock market by betting that stocks will go down â not up. How does that work?
Money can also be made on selling stocks that you do not own. This sounds almost illegal, but it is not. It is actually done all the time in business. Dell Computer Company was a master of selling you computers that they did not own. Sounds like a scam, doesn’t it?
Dell
Dell used to have a commercial that implied that they cared so much about their clients that they âwere going to build a custom computer to match your needs.â Even though Dell may sound considerate and thoughtful in the advertisements, they were actually keeping their inventory to a minimum. They learned early on that, by the time many computer companies got their products on the shelves, they were already outdated. Michael Dell brilliantly wanted to do something different and take less risk of having an obsolete product going unsold or returned.
- Dell would get the order from a customer and Sell the computer without even having it in stock.
- Dell would then order the parts.
- Dell would then assemble the computer.
- Dell would send the computer to the customer.
- Customer Receives the Computer. Transaction closed.
Often times in this world, things are sold before they are even created. Ordering a car with custom seats, paint, wheels, etc. often requires you to purchase the vehicle before it is even manufactured. Suppose someone wanted a car with an aquamarine exterior, seats made out of pink dyed elephant skin, and interior carpet and trim that was bright fuchsia mother of pearl.
This color combination is obviously limited to a select few individuals with the most sophisticated sense of aesthetics. Unless Liberace miraculously shows up, this ultimate color palette of a car is unlikely to sell. A better idea would be to sell the car first, and then build it, and deliver it.
The same exact process can be done with stocks.
Often people with little or no knowledge of stocks and/or options have a strong suspicion that a certain stock may decline in price by a large amount. You hear, for example, that there may be an accounting irregularity at a firm called Enron. Despite the superior reputation for excellence, brilliance and ethics that Enron has, you know what devastation even false rumors can have on the price of a stock. Certainly there must be a way to profit from the inevitable decline in the price of the stock before these false rumors are cleared in the next few months and this wonderful stock bounces?
Typically, people buy a stock and then sell it after it goes higher. Here we are going to do the same thing, just in the reverse order. We will sell a stock when it is high and close the transaction when buying it back at a lower price. This is called âshort sellingâ.
As stated, the process works the exact same way that buying a stock to sell at a higher price works, just in reverse. Technically, though you need not concern yourself with the details, you have to âborrow the stockâ from someone in order to sell it. Once borrowed, the stock is then sold and you can buy it back anytime you want. At the time you buy back the stock to close the transaction, you then deliver the shares back to the person you borrowed it from and the transaction is closed. The difference between where you sold it and bought it back is the profit (or loss).
Suppose that you believe that a stock trading for $10 per share is going to drop in price. You go out and sell 1,000 shares (or whatever amount you are comfortable with) at $10 and take in $10,000 in cash ($10 per share X 1,000 shares). A week later the stock does in fact drop to $8 per share! You decide that it is not going any lower and want to take your profit. You go to your broker’s website and buy the stock for $8. This will cost you $8,000 ($8 per share X 1,000 shares) which you get from the $10,000 you took in earlier. The difference from where you sold the shares ($10) and where you bought the shares ($8) is a $2 profit. Multiply the $2 per share profit you made by the 1,000 shares you sold and bought back and you will have a $2,000 profit.Â
What if you are wrong?
Just like if you bought a stock and it went down, if you sell a stock and it goes up in price, you will lose money. Selling the stock at $10 and watching it go to $8 is fun, but often the stock will not do as you want (which is why you will be learning options as a hedging tool shortly). Suppose the stock went up to $13 instead. In this case you would have lost $3 per share, or -$3000
Dividends are covered here simply because they will affect the price of stock options when the dividend date approaches.
When a company makes money, it has a couple of choices on what to do with it. If the company is growing, the profits are usually reinvested (called retained earnings) in order to create an even larger and more profitable company. If, however, the company’s growth is stagnating and the CEO doesn’t feel that he can reinvest the profits and get a return greater than the current interest rates, he will often issue a dividend.
In the simplest and most common form, a dividend is a cash payout to the shareholders and is calculated on a per share basis. A company that is paying $0.20 per share dividend pays the shareholders $0.20 for every share outstanding. If you own 1,000 shares of stock in the company, you will receive a check for $200 ($0.20 per share X 1,000 shares). It is that simple as far as a shareholder is concerned.
Yet, what does this do to the company paying out all that money?
As you can reasonably suspect, when the company pays out a good amount of its profits back to the shareholders, it dilutes the value of the company. Let’s see what happens to John Lemon’s.
After years of hard work, you, Cheapy and Henry built up the lemonade stand and actually rented a small roadside storefront turning the company into a $2 million business. Because Henry is just a passive investor and is tired of his profits on his initial $50 being reinvested in the company, he wants a payout without liquidating his stock ownership. You all agree to distribute the next 3 months profits in the form of a dividend.
You and the team come up with a brilliant marketing idea â a free doughnut with every cup of lemonade purchased! And people line up!
At the end of three months, the company has a profit of $200,000. Since there were originally 100 shares of stock created and you have $200,000 to pay out to the shareholders, a special dividend of $2,000 per share ($200,000 profit / 100 shares) will be allocated. Individual’s payouts look as Figure 1.12:
Youâll see John Lemon’s started the quarter worth $2 million dollars, and then made a $200,000 profit after 3 months. Technically the company would be worth $2.2 million now, except that the shareholders agreed on paying out a dividend. This brought the company back down to a $2 million dollar company. The problem with the dividend is that it will be taxed, while the stock shares are not taxed until sold. This is why many people prefer to have high growth stocks that do not pay a dividend rather than low growth stocks that do pay one.
The Figure 1.13 example is the most common form of stock, and is known as âcommon stockâ. There are other forms of stock, such as âpreferred sharesâ that typically don’t have voting rights, yet they do have a claim against company assets should the company go into bankruptcy. Whenever people buy stock they are almost always purchasing âcommon stockâ. You have to go out of your way to invest in preferred shares, so don’t be worried that you are buying the wrong thing.
