Explain Stocks Like I’m 5 Years Old

We may never know how the washing machine manages to eat our socks.

We may never totally get how Pluto was a planet but isn’t anymore.

But as for the stock market, how and why stocks are issued…it’s really not as complicated as people make it out to be. Let’s take a closer look.

Once upon a time, there was a company…

Everything is better in a story. Here’s a typical example of how and why a stock would be issued:

Here’s Julie. Julie’s a baker, known for her famous (and delicious) croissants. She’s just out of university, sitting on a mountain of debts and working out of a small shop. Lately, however, the demand for her croissants is so high that she knows it’s time to expand her operations.

Julie is smart. She did the math. She knows she’ll need $100,000 for a bigger space, extra staff and inventory. Only problem: Julie only has $10,000 in the bank. Taking a loan is out of the question – she has only just started paying down her student debt.

So…what is Julie to do?

Julie decides to issue stocks to friends and family – in return for cash. Stocks represent ownership in Julie’s Bakery. Julie finds 9 people to invest $10,000 each. She also invests her own $10,000. Because 10 people (Julie and her 9 friends) invest equally, they all own 10% of Julie’s bakery. Cool beans.

Julie was able to raise the money she needs to expand, and her 9 friends now own part of her booming business.

And they all lived (financially independently) ever after…..The End.

Need More Cash?

Ever heard the expression, “it takes money to make money”? Well, at a certain point, every business will need money to propel it’s growth. In Julie’s case, she needed to hire workers, expand her shop and buy inventory. Oftentimes, companies will issue stock either privately (like Julie), or publicly (on the stock market) to raise the cash they need to invest in their growth.

The pro: Companies are able to raise money without being required to pay anybody back (like they would if it was a bank loan)

The Con: The company gives some ownership. In Julie’s case, after raising money, she only owns 10% of her company.

How do you issue shares?

In Julie’s case, issuing shares was pretty straight-forward (though this is not always the case) Issuing: 9 investors paid an equal amount for equal ownership. But in the real world, companies issue shares to millions of people, and those people purchase different amounts. That would be more than a little overwhelming for someone like Julie. Enter the banks. But not just any bank. The kind of bank that can arrange this type of deal can only be an investment bank, like Bank of America Merril Lynch (ML), Goldman Sachs (GS) and Morgan Stanley (MS), for example.

What do these banks do?

After the company and the bank sit down together and discuss their intentions, the bank starts to gather information on the company; financial statements, interviews with suppliers, and creditors and all other company info. Their analysts sift through all this information very carefully to come up with a precise value for the company.

How is the price of the first shares determined?

This value is used to divide up the company into many, many shares of stock depending on the price that they want each share to have. Imagine the value of a company is $1,000,000. Now…imagine that the bank does its homework and finds that the stock is most likely to sell at a price of $10. This leads them to come up with a number for the amount of shares, in this case, 100,000 shares.

The Sale

The bank then takes these 100,000 shares and can do at least two things with it.

  1. Offer to buy it all from the company for a discount (like 9$ instead of $10), and then turn around and sell it into the stock market (pocketing the difference). This is called the bought deal method.

  2. Sell it into the stock market for the company as best as they can. In return, they’ll get a commission for the overall sale. This is called the best-efforts method.

And finally, the market

It’s done. The private stock that belonged to only a few is now a public stock available to everyone. The money that came from the sale of stock is used for whatever purposes the original owners needed it for. The stock trades on the public stock exchange increasing in price if the company does well, and decreasing if it does badly. In return, the company has to show their financial statements to the public and answer to shareholders who own the stock.

How you can profit?

1. Check the NASDAQ and the NYSE for scheduled public offering

2. Trade them on Wall Street Survivor on the day they go public!

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