How do stocks work?

By Craig Verdi, CFP®

Why do good companies increase in value in the long run? The short answer is by increasing the sales, earnings, growth and distributions/dividends of the company. Let’s look at a very simple example of a company you have a chance to invest in. Imagine that a young entrepreneur, Marcus, decides to open a hot dog stand on the corner of the street.

  • The total cost of the business is $1000.
  • There are a hundred shares available at $10.00 per share.
  • You are offered 10 shares for a total investment of $100.
  • You own exactly 10% of the business. You don’t have to work, go buy hot dogs, cook, and collect money, pay sales tax or any of the other chores of the owner.
  • Sales are $500.00 per year. Profits are $200.
  • Next year sales are expected to be $600 with profits at $240.
  • 25 cents per share is paid each year in dividends.

That gives us some good information that we can use to decide if we want to own this equity asset.

  • Market cap is $1000. Market cap is simply number of shares times price per share.
  • The P/E Ratio (price to earnings ratio) of the stock is 5. This is just the price per share over the earnings per share or 10/2.
  • Forward P/E ratio is 4.2. Current price divided by future profit estimates. Or 10/2.40.
  • Price/sales ratio is 2. Price of company 1000/500.
  • The dividend yield is 2.5% which is 25 cents/$10.00.
  • You are an insider because you own 10% of the company.
  • Marcus owns 90% of the company.

Is this a good investment for the long term? If Marcus is going to continue and be successful for decades to come this might be a great investment. The first year you make $2.50 in dividends and your shares produced $20 in earnings. You do not directly receive the earnings. However you may with good reason, estimate that the shares may now be worth $12.00 per share due to the 20% in increased profits.

Shares you own are available for you to sell back to Marcus or any other investor. Offers for your shares are listed daily on media. You have several offers to buy your shares for $10-11.50. You say no. Each time a person makes an offer, the media lists the price of the shares at that price, and because that is the amount a willing buyer would offer you. Later you are offered $14 per share. You also say no. Later someone offers you $5 and you get no other offers for several months. The price in the media is now listed as $5.00 since that has been the price for the last several offers.

No one is willing to pay more than $5.00 for an extended period. You think your shares are worth $12.00, but you start to wonder if there is something other investors know that you don’t know. Thoughts begin to race through you head:

  • Maybe Marcus has a criminal record that you don’t know about.
  • Maybe his hotdogs contain cheap ingredients he is lying about.
  • Maybe he is “cooking the books” and not selling as many hot dogs as he says.

In this case you happen to know all of that is false. There are no good or apparent reasons your shares are so cheap. What could you do?

  1. Panic, feeling that there must be something wrong that you don’t know (even though you are secure in your knowledge of the business) and sell your shares for $5.
  2. Hold your shares and collect the dividends until better offers come in for your shares. By the way your yield as reported in the paper is now 5%. That is .25/5.00. So while your yield is higher the total value of your shares is now only $50.00.
  3. Call Marcus and see if he wants to sell you more shares at the market price of $5.00.

Because of your knowledge of the business, the obvious thing would be to try to purchase more shares. You may or may not have the money available to buy more shares. Assuming that you have the funds, why would you not do the obvious and buy additional shares that you deem to be underpriced? There is another reason. The reason is fear. You are upset, confused and worried that the market offers of $5 must represent a basic weakness in the company, the economy or world affairs. That is all the information about this saga of your investment into the hot dog stand industry.

Welcome to the world of stock investing.

Remember Investments are subject to risk, including the loss of principal. Because investment return and principal value fluctuate, shares may be worth more or less than their original value. There is no guarantee that any investing goal will be met.