When a company needs to raise money to manufacture widgets, rent offices, and hire employees, they generally have two choices. The first option is to borrow the money by issuing bonds. The second option is to sell off a portion of the company – and its future earnings – by issuing common stock.
When a company decides to sells of shares of stock, called “going public,” an Initial Public Offering (IPO) is held in which a specified number of shares, representing a certain percentage of ownership in the company, will be sold. The IPO is handled by one of the large security firms who is responsible for publicizing the IPO and gathering an initial group of investors. Typically the IPO price is set by valuing the company, based on the perceived value of the company as determined by current and potential earnings, and then dividing that value by the number of shares to be offered. Once sold through the IPO, the shares are then traded among individuals and the price will rise or fall depending on future earnings of the company.
Each share of common stock represents a fractional ownership stake in the company. Each holder of common stock therefore has a say in how the company is run and gets a share of the profits. The amount of the say and the size of the share of the profits is determined by how many shares are held. For example, in voting on propositions individuals typically get one vote per share; therefore, if an individual owns a majority of the shares she can control the outcome of the vote and therefore the direction of the company. Likewise, dividends are issued on a per-share basis so the more shares you own the mgreater your share of the profits.
After the IPO, additional shares of the company may be sold in what is called a secondary offering, either from the portion of the company retained by the company (for example, if only 30% of the control of the company was sold during the initial offering, the company could issue shares representing control of another 10%) or by further dividing the value of the company. In this latter situation, the majority of the shareholders must approve of the issuance of further shares since each share will then be worth a smaller percentage of the company after the secondary offering. Because the company receives additional funds which can be used for acquisitions, expansions, and other activities, however, the actual value of each share may not decrease (each share is worth a smaller percentage of the pie but the pie is bigger).
Common stocks are generally more risky than bonds and other investments like bank CDs since the investor is assuming an ownership stake in the company and therefore there is no guarantee of returns. This means that if the company loses money, the value of the ownership, and therefore the value of each share of stock, will decrease. If a company continues to lose money there will be no profits to split. Despite stocks being more risky than many investment options, there are good reasons to hold stocks. Among these:
1) Stocks can beat the rate of inflation, leading to growth in capital. Of the various investment options, stocks are one of the few that provide enough of a return to beat inflation. If you are saving for retirement, the dollars you invest today in money market funds, treasury bonds, and the like will be worth only a fraction of their value when you retire. Real estate (that you buy fully for cash) will on average just track the level of inflation (although there are special situations if you are investing in specific properties and know what you are doing). Common and preferred stocks hold a nice place in the risk curve where you can beat inflation but still put the odds in your favor.
2) Long-term holding of stocks allows compounding through the delay of taxes . Capital gains taxes on stocks do not come due until the stock is sold. This means that investors who hold stocks for long periods of time get to enjoy the benefit of compounding for years without paying taxes on the capital gains until the shares are sold. Warren Buffett and Bill Gates have paid very little in the way of taxes, despite their enormous wealth, because most of their wealth is in stock in their companies. Because they sell only a few shares each year, their tax bill as a percentage of their wealth is very small. Warren Buffett will actually never pay taxes on the bulk of his wealth because he donated it to the Bill and Melinda Gates Foundation.
By contrast, those earning a paycheck see 25-35% of their earnings taken by state and federal income taxes and another 15% taken by payroll taxes before they even see it.
3) Investing in stocks requires much less effort than some other types of investments. Real estate can be a great investment if you know what you’re doing, but you often need to have it as your hobby. If you want to buy, renovate, and resell houses, count on spending many hours at the house doing a lot of the work. Even if you contract the work out, losing much of your profit, you will rarely find someone with as much commitment to the project as you do since it is not their house.
With long-term investing in stocks, you simply need to spend a little time finding stocks to purchase, call a broker or enter trades on a website, and then monitor the stocks once in a while. Because good investing is long-term and based on the business, rather than on the short-term fluctuations in price, it really doesn’t require a big time commitment.
For even less care and feeding, a set of index mutual funds can be purchased. In that case, the only maintenance required is to rebalance the money in the funds once a year. As retirement nears, more and more of the funds are sold to raise the cash needed for living expenses.
While other investments deserve a place in one’s portfolio, common stocks, either bought directly or through mutual funds, definitely deserve a prominent place for money that will not be needed in the next 5-10 years.
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Disclaimer: This blog is not meant to give financial planning or tax advice. It gives general information on investment strategy, picking stocks, and generally managing money to build wealth. It is not a solicitation to buy or sell stocks or any security. Financial planning advice should be sought from a certified financial planner, which the author is not. Tax advice should be sought from a CPA. All investments involve risk and the reader as urged to consider risks carefully and seek the advice of experts if needed before investing.