Understanding Wall Street, Fifth Edition (GENERAL FINANCE & INVESTING) - Softcover

Little, Jeffrey B.

Softcover

ISBN 10: 0071633227 ISBN 13: 9780071633222

Publisher: McGraw Hill, 2009

Synopsis

A fully revised edition of theINVESTING CLASSIC

For over 30 years this comprehensive, easy-to-read guide has served well as thedefinitive reference for successful investing. Now in its fifth edition and completelyupdated, Understanding Wall Street helps investors prosper in today’s challengingeconomy―whether you’re just beginning or among the millions soon to retire.

Understanding Wall Street, Fifth Edition, has new sections and information on theissues most important to today’s investors, including:

• How to use the Internet as an investing tool
• The shift to exchange traded funds (ETFs)
• The link between Wall Street and Main Street
• The Risks and rewards of the global economy

Praise for previous editions of Understanding Wall Street:

“Recommended. An excellent introduction to stock market intricacies.” ―Booklist

“A lucid guide to those downtown mysteries.” ―Newsday

“Remarkable . . . it remains as useful as ever . . . Experience may be the bestteacher, but this manual runs a close second.” American Library Book Review

About this title

About the Author

McGraw-Hill authors represent the leading experts in their fields and are dedicated to improving the lives, careers, and interests of readers worldwide

Excerpt. © Reprinted by permission. All rights reserved.

UNDERSTANDING WALL STREET

By Jeffrey B. Little Lucien Rhodes

The McGraw-Hill Companies, Inc.

Copyright © 2010 Jeffrey B. Little
All right reserved.
ISBN: 978-0-07-163322-2

Contents

Chapter One

What Is a Share of Stock?

Introduction

Every business day, billions of shares of stock are bought and sold. How did these shares originate, and how are their prices determined? For shares to be traded from one person to another, a company must be created. How does it begin? Where does the money come from?

In this chapter, The NewBrite Lighting Company is born and its officers confront the problems that all successful corporations must solve. Directors are elected, shares are issued, profits are reinvested in the business, and dividends are declared. In the process, the reader will see capitalism at work and will gain an appreciation for a great system that has produced the most advanced economy in the world.

The NewBrite Lighting Company

Johnston W. "Jack" Campbell, a young inventor, has just created a brighter, more efficient LED lighting fixture with a superior design. Encouraged by his family and friends, he decides to turn his hobby of improving lights into a full-time business rather than sell his patents to a large lighting company.

Although Jack has savings that could be put into the venture, the amount is far short of the total capital necessary. He estimates that the total cost for the factory, machinery, and initial money required for product inventory to be approximately $2 million.

These "assets" (the factory, machinery, inventory, and remaining capital) would be used to produce the units and maintain the new business. The more fixtures Jack can produce using these assets, the more profitable the business would be.

Jack has calculated that if he could make and sell at least 100,000 units annually, it would cost about $20 to manufacture each unit. In addition, he estimates the sales and marketing expenses for each fixture to be roughly $10.

Since each new lighting fixture would be sold to his customers at the competitive price of $35, his profit (before paying federal, state, and local taxes) would be exactly $5 per unit.

Jack believes that his new enterprise would be beneficial in several ways. Thousands would enjoy using the lights, many people in his community would be earning a living by making and selling the fixtures, and the company would contribute to the welfare of his community, state, and country through the payment of taxes. If Jack could, indeed, manufacture and sell 100,000 light fixtures, this activity would no longer be a hobby; it would be a sizable business.

Now Jack faces a major problem. Where will he get almost $2 million for the factory, machinery, and working capital? He is unable to borrow such a large amount without collateral.

Jack decides to find other investors, frequently called "venture capitalists," who might also see the potential for his idea and be willing to risk some capital to get the venture started.

To interest others, Jack must divide his new business into smaller pieces to give the investors some ownership. Jack realizes, too, that relinquishing some ownership means that he would no longer be entitled to all the profits. However, he is willing to do this to secure the help of others.

After exploring the advantages and disadvantages of the various legal forms of business, he decides to establish a "corporation." The principal reason for choosing a corporation rather than a partnership or any other form is financial liability. Jack learned that no matter which legal structure is used, creditors always have first claim on the assets if the business fails. However, a corporation, as a legal entity, limits the financial risk of the owners to the amount of capital invested. In other words, stockholders owning shares in a corporation are not liable for more than they invest.

Jack forms the corporation under the laws of his state, names it "The NewBrite Lighting Company," and selects a few individuals to act as the board of directors until the first annual meeting of stockholders. At that time, the board of directors will be formally elected by the stockholders.

The directors decide to "issue" 250,000 shares of stock of the 400,000 total possible shares authorized by the company's founding charter (when the company was organized, this number was determined to be the most appropriate for the company's needs). The 250,000 shares are divided between Jack and the venture capitalists in proportion to their agreedupon ownership, determined by the contributions of each. Jack still owns a meaningful amount because of his importance to the company, his fixture patents, and his initial capital. Now it can be said that he and the venture capitalists are, indeed, "stockholders in common."

Each stockholder is a part owner of the company, with the extent of ownership depending upon the number of shares held (someone who holds 50 of the total 250,000 shares issued owns 1/5,000 of the entire company, whereas a person who owns 10,000 shares owns 1/25 of the company). The remaining 150,000 shares could be issued by the directors at a later date if the company finds it necessary. However, at the present time, the ownership of the company is divided into 250,000 pieces. In other words, there are 250,000 shares outstanding of 400,000 shares authorized.

The members of the board of directors, including Jack, are elected by all the stockholders to oversee the affairs of the company. Each share outstanding, according to the company's charter, is entitled to an equal vote in the annual election of the directors.

The NewBrite Lighting Company is now a "private" corporation owned solely by its small group of founders. However, later they might allow the public to participate. If so, stock would be sold to these new investors through the company's "Initial Public Offering" (or "IPO"). But, first, the company needs to establish a "track record" before "going public."

Most of the initial $2 million has been contributed in the form of "equity capital" by the venture capitalists. To raise the remaining capital, the company decides to go into debt. If the corporation were to borrow this money, expecting to repay it in a relatively short period of time, a bank could be approached for a loan. If it needs the money for a longer time period, a few years or more, the company might consider selling bonds.

The NewBrite Lighting Company, being a young, unproven business, would probably be unable to issue bonds backed solely by its word or good name (bonds of this type are called "debentures"). Lenders are usually reluctant to loan money to a new firm without security. Consequently, the company might be asked to put up some property as collateral (bonds of this type are often called "mortgage bonds").

Although The NewBrite Lighting Company would have to pay interest on the money it borrows, present holders would not have to give up any of their ownership, as Jack did when the new stock was issued for equity capital.

On the other hand, the lenders (the bondholders) do have first claim on the company's property if the company fails to repay the debt (such a failure is called a "default").

The Importance of Profits Why would Jack and his associates risk their personal savings to build a factory to manufacture the lights? They could have deposited their money into a bank account rather than investing in the new enterprise. The money would have been safe, and the bank would have paid them interest. Why would anybody be willing to risk money—let alone $2 million—to start The NewBrite Lighting Company? The answer is simple: profits.

Jack and his associates saw an opportunity to make a good profit on each fixture manufactured if the company met its business objectives. The stockholders also saw the possibility of increasing their profits in later years if more light fixtures could be manufactured and sold. In short, Jack and his associates figured that they could achieve a much better return on their money by investing in the new venture than by receiving interest from the bank.

Now time has passed; Jack's projections were accurate, and the venture has been successful. According to the statement of income in its recent Annual Report to stockholders, The NewBrite Lighting Company sold 100,000 units last year, resulting in a net profit, also called earnings, of $260,000—just as Jack had anticipated. The stockholders of the company are now entitled to divide this money among themselves. Since there are 250,000 shares outstanding, dividing the earnings of $260,000 equally means that, for every share held, a stockholder would be entitled to $1.04 ($260,000 divided by 250,000 shares). This calculation is called "earnings per share."

If, next year or the year after, the company increases its production and earns, for example, $500,000, the calculation would be $2.00 per share ($500,000 divided by 250,000 shares outstanding).

Each year, the directors of the company must decide what to do with the earnings. If the company were to distribute part or all of last year's $260,000 earnings to its stockholders, this cash payment would be called a "dividend." The size of the dividend declared by the directors each year would most likely be determined by the amount of profits available. However, regardless of the total amount declared, each share would receive an equal dividend. A stockholder owning a larger number of shares would, of course, receive a larger dividend check from the company.

The directors of The NewBrite Lighting Company might declare only a small dividend, or maybe none at all. If most or all of the $260,000 net profit is used to increase the size of the factory, hire more people, or add to the company's research program to design better fixtures, the stockholders might enjoy higher earnings and bigger dividends in later years without having to invest any additional capital. This growth process is called "internal financing."

At the board meeting, the directors declare a dividend of $0.26 per share, or a total of $65,000 (one-fourth of the earnings). In effect, the $0.26 per share dividend represents a 25% payout of the $1.04 earnings per share. The remaining $195,000 that is not paid out will be reinvested in the business. These "retained earnings" will also enhance the financial condition of the company, expressed by reports that are released to shareholders periodically.

FINANCIAL REPORTS

The NewBrite Lighting Company, like most companies, will regularly provide financial reports to its shareholders and other people who might be interested, including lenders and potential investors. Financial reports will be discussed in detail later.

However, for the purposes of this discussion, generally speaking, two important reports are always included in the company's year-end Annual Report to shareholders:

1. The Balance Sheet shows what the company owns, what it owes, and the value of the remaining amount, called "stockholders' equity" (i.e., the net worth of the stockholders' ownership), at the end of the year.

2. The Statement of Income indicates The NewBrite Lighting Company's sales, costs, and profits earned during the year.

Obviously the stockholders will be watching the company's earnings progress closely. As they examine the profitability of the business, they will be asking two basic questions:

1. How much profit was produced by each sales dollar?

2. How much profit was produced by each dollar of stockholders' equity?

A typical U.S. company today earns only 7%, or approximately 7 cents profit, after taxes, from each sales dollar. This profit also represents about 14 to 15% of each dollar of stockholders' equity.

Clearly, profits are important to everyone in our economic system. Without profits to spur individual initiative and encourage investment, factories would not be built, people would not be using better products, and many more workers would be looking for employment.

The Stock Price Once a company's stock has been issued and is outstanding, how is the market price determined? To answer this question, there is an old Wall Street saying: "A stock is worth only what someone is willing to pay." Although the saying is somewhat shortsighted, there is some truth to it. A stockholder wanting to sell shares in The NewBrite Lighting Company, for example, could sell them for no more than the price someone else would be willing to pay.

Stock is rarely sold back to the company, since the company's financial resources are tied up in the business. If the firm is prospering and the outlook is bright, there could be many eager investors ready to buy the shares at the asking price, or maybe higher. A large demand to buy could lead to higher bids for the stock. On the other hand, if the business outlook is unfavorable, anxious buyers might be scarce. Perhaps the asking price would have to be reduced to attract buyers. The price is determined simply by the supply/demand situation at that moment.

There are many factors to consider when estimating a value for the stock. However, an investor is most interested in the company's earnings outlook, dividend prospects, and financial condition. The stock price revolves around these three fundamental factors as investors compare the stock to all other investment opportunities.

Two Wall Street terms that are used frequently to appraise stocks are "price/earnings ratio" and "dividend yield." They are not as complicated as they sound.

PRICE/EARNINGS RATIO

The "P/E ratio," or "P/E multiple," as it is also called, simply describes the relationship between the stock price and the earnings per share. It is easily calculated by dividing the price of the stock by the earnings per share figure. For example, if the price of the stock happens to be $30 and the annual earnings per share is $1.50, the P/E ratio is 20 ($30 divided by $1.50 per share).

DIVIDEND YIELD

The "dividend yield," often just called the "yield," represents the annual percent return that the dividend provides to the investor. Yield is calculated by dividing the annual cash dividend per share by the price of the stock. If a company pays an annual cash dividend of $0.60 per share and the stock price happens to be $30, the annual return, or dividend yield, is 2.0% ($0.60 per share divided by $30).

Although a low P/E ratio is considered desirable, it is a common mistake to assume that a stock with a low P/E ratio is automatically more attractively priced than another stock that has a higher P/E.

A stock with a P/E ratio of 8.0 times earnings, for example, is not necessarily a better value than one with a P/E multiple of, say, 20.0 if the future profits of the first company grow much more slowly or maybe not at all, compared with the second company. A higher P/E ratio implies, but does not necessarily mean, greater investment risk.

The same applies to the dividend yield. A stock paying a dividend that yields a return of, say, 7.0% is not necessarily more attractive than another stock with a lower dividend yield of 2.0%, for example. How secure or safe is the dividend? What is the chance that the dividend will be increased in the future? How much of the company's profit is being paid out as a cash dividend to shareholders rather than being reinvested in the business for future growth? These and other related questions must be considered.

Of course, the P/E ratio and the dividend yield never remain constant. The P/E ratio increases and the dividend yield declines when the stock price moves higher.

Conversely, the P/E ratio declines and the dividend yield increases when the stock price declines. Moreover, the P/E ratio and dividend yield will also vary as the company's earnings and dividends increase or decrease.

Over a period of days, weeks, or months, the price of a stock can fluctuate widely depending upon the direction of the overall stock market or news items affecting the company or its industry. Sometimes a stock will rise or fall at random for no apparent reason. Any number of circumstances or events can influence the confidence of investors and the delicate supply/demand balance of buyers and sellers. However, to repeat, over an extended time period—a few years or longer—the stock price will most likely rise or fall in line with the company's earnings, dividends, and financial condition.

Accountability With the administration and ownership of corporations come many responsibilities and at different levels.

The executives of a company, appointed by the "Board of Directors," have obligations to the firm—to its customers, to its employees, and especially to the "shareholders," who are the owners. In effect, the board members, who are elected by the owners, are "caretakers" of the owners' property—primarily denoted by the Shareholders' Equity on the balance sheet and the good name that goes with it.

This is a democratic system. Shareholders who are unhappy with the management of the company or with its actions can vote for a change. The owners always have the final say. If they do nothing, they have no one else to blame but themselves.

Why Do People Buy Stocks? Where should that extra money go? Into the bank? Bonds? Real estate? Or art? Or will the stock market provide the best possible return? While each individual has a different investment objective, stocks are bought for one primary reason: to make money!

An individual can participate in the stock market in three ways.

INVESTING

This is generally the most successful approach because time can be used to advantage. An investor buys shares to be a part owner of the company and to obtain at least an adequate return on the investment (enough to justify the risk and enable the investor to keep ahead of the rising cost of living). The investment time horizon is usually a few years or longer.

SPECULATING

The speculator is willing to assume great risk for a potentially great reward. Being a part owner is not important to the speculator, since the time horizon is to be no longer than necessary.

(Continues...)

Excerpted from UNDERSTANDING WALL STREETby Jeffrey B. Little Lucien Rhodes Copyright © 2010 by Jeffrey B. Little. Excerpted by permission of The McGraw-Hill Companies, Inc.. All rights reserved. No part of this excerpt may be reproduced or reprinted without permission in writing from the publisher.
Excerpts are provided by Dial-A-Book Inc. solely for the personal use of visitors to this web site.

Edition details

• Publisher: McGraw Hill
• Publication date: 2009
• Language: English
• ISBN 10: 0071633227
• ISBN 13: 9780071633222
• Binding: Paperback
• Edition number: 5
• Number of pages: 384