What You Should Know About The Stock Market

Everyone’s heard of the stock market — but few know why it works. Were you aware that each stock has two prices? That you can’t buy and sell for the same amount? That a “stock market” works better and is more open than a “stock store”?

This is a companion discussion topic for the original entry at http://betterexplained.com/articles/what-you-should-know-about-the-stock-market/

I enjoyed this. Thank you!

Thanks Joe, glad you found it useful.

[…] What You Should Know About The Stock Market | BetterExplained Everyone’s heard of the stock market — but few know why it works. Were you aware that each stock has two prices? That you can’t buy and sell for the same amount? That a “stock market” works better and is more open than a “stock store”? (tags: stocks money finance introduction tutorial) […]

One thing I’ve always wanted to know is what’s the incentive in buying stocks? What is the inherent value that I’m getting? Like with an iPod I’m getting a valuable item that can play my music but stocks seems like an abstract concept. I’m not getting anything other than a percentage of the company but not all companies pay their shareholders dividends.

Hi dasickis, that’s a great question (could be a post on its own :slight_smile: ). Basically, a share gives you a percent ownership of a company. If you own all the shares, then you own the entire company. So what can you do?

  1. If you’re a large organization, you can buy another company buy purchasing all its shares (or purchasing 51% so you have majority voting in all decisions). Some companies have precautions against this and have different “classes” of shares with different voting rights. They may never sell the shares with the most rights.

  2. You can earn a dividend, as you mention. Some companies are very stable and pay out dividends for shareholders each quarter. GE stock costs about $40 and pays out a $1.12 dividend each year (28 cents per quarter).

  3. You can invest for growth. This might be called “speculative” investing, but certain companies get more valuable over time. Google keeps coming up with new products. Facebook looks like it’s going to be large. Amazon expanded into new markets (Books -> Electronics -> Music).

As companies grow, they become more valuable, so a given share becomes more valuable too. Like a comic book collector, you hope you can sell your share to another investor who thinks the price will go up even more.

This is called “growth” vs “value” investing, but you hope to have a piece of a growing pie, and sell it off later. Of course growth stocks have inherent assets, but it’s not the primary reason you invest – it’s for the future potential. As time goes on, the growth company slows down and becomes a boring “value” company, where it returns profits to shareholders in the form of dividends. [The Board of Directors, elected by shareholders, can influence the direction of the company: does it reinvest profits into itself to grow faster, or hand out profits as dividends?].

Hope this helps – great question! (There may be other reasons to invest as well; invest internationally to get a “share” of that country’s expanding economy if your own is stagnating).

Hey Kalid,

Thank you for the excellent answer. I understood the incentives in the first two reasons. I, however, am still having trouble figuring the incentive in the third reason. Now that I know that a company will grow in the future why does that make the stock more valuable? What tangible result will I achieve because CompanyX will grow?

If CompanyX’s profits grow from $100 to $200 does that get split among all the owners (I thought those to be dividends)?

Hi dasickis, no problem. This is a great question because “stocks are good” is something people often assume without thinking about it (myself included). I may turn this into an article after all :).

To simplify things, imagine a company as a “machine” that makes money each year. Turn the crank, money comes out. [In some broken machines, turn the crank and it costs you money… but let’s ignore that :slight_smile: ].

Let’s say the machine spits out $1 million each year (after tax, expenses, polishing, etc.). How much would you be willing to pay to own this machine?

Whatever price you pick, there’s a Price-to-Earnings ratio (called PE or P/E). This is the multiple of earnings you pay for an investment. So, while you could pay any amount, you’d likely pay around 10x, or 10 million dollars. That means you paid $10M to get $1M annually, which is a solid 10% investment. The owner may find that price fair, and you’re both happy.

But $10M is a lot. If you can’t afford the entire machine, the owner could split it into a million pieces [shares]. In this case, you’d be willing to pay $10 per share, assuming all earnings are paid out as dividends [$1 per share]. But dividends are “boring”.

Suppose the owner says this: I’ll sell half my machine for $5 million, and keep the other shares to myself. Using this money and the yearly earnings, I’ll do advanced research and development for improvements. By my estimates, in 3 years the improved machine will be spitting out $100 million per year, instead of $1 million.

Wow! Now what would you pay? Probably a lot more than $10 [current value], since there’s the expectation the machine will be cranking out $100 per share in the future. You might pay $40, $100 or $500, depending on how likely you think the prediction is to happen.

After 3 years, and $100M per year [no dividends have been paid yet – all income goes to research], the owner comes to you again. Hey, with even more improvements we can grow to $1 billion dollars per year. Yowza! What do you value it now? $1000 per share? $5000? $10,000?

There’s two forces at play. First, there is the raw dividend: for growth companies a dividend is a bad sign. It means “Hey, I can’t improve the machine any more. Here’s your money.”.

Second, there is the value other people will pay. Shares in a growth stock, to some extend, are only as valuable as what someone else will pay. It’s a little bit like an old comic book; if nobody cares about it, it’s not worth anything [Coconut-man]. But the first issue of Spider-man is quite valuable as a lot of people care.

Shares of a value stock are inherently useful since they return a dividend. Shares of a growth stock depend, on some extent, to being able to sell to someone else down the road. [If it’s a poorly priced stock this is known as the “Greater Fool” theory. I may be a fool for buying at this price, but I can sell to an even Greater Fool later.]

Now, the person you sell to down the road may in fact be a value investor. But if you bought a growth stock for $10, you get to sell it to the value investor for $1000, since the company machine is now churning out that much more money [and the board of directors has decided to start paying dividends].

So, to answer your direct question: Value companies may pay out a large fraction of their earnings in dividends [but it’s unlikely for them to grow from $100 to $200 because they aren’t improving the machine]. For growth stocks, an improvement in profit would raise the stock price [“Yes, the machine is making more! It can sell for higher down the road!”] but not the dividend for the individual investor.

Wow, hope that made sense :slight_smile:

Hi Kalid & Dasickis,

thanks for posting your article, questions and answers, which I have found useful. Further to dasickis queries. I have another question, kinda related.

Aren’t stocks and shares that most of us normal ppl will encounter. (home trading etc) Are in the secondary market… where after the initial offering share price, the current price fluctuation is driven purely by speculation? i.e Google announces Android and they share prices hit the roof… as everyone wants a piece of the action.

So in reference of dasickis question “What tangible result will I achieve because CompanyX will grow?”. Thus if you hold google shares then you get the profit if you sold them now. I think alot of companies who issue shares that are traded in stock markets (secondary market) do not pay dividends and instead reinvest… it depends on the company. So you are only buying those shares, in the view that the company will do things (launch new products, programs etc) that will effect it’s share price (in a postive way).

Please correct me if I’m wrong :slight_smile:

Hey Alan and Kalid,

Thank you both for your great responses. I’ve learned more about stocks and this issue has been pressing me for a while. I’m starting to see the incentive structure in growth stocks and when you relate it to comic books it makes a little more sense.

Can you suggest some resources that helped you understand these concepts?

Hi dasickis, you’re more than welcome. Yes, it takes a while, and to be honest, for many stocks the primary reason for investment is speculation (i.e. I think I can sell it to someone else) vs. intrinsic value.

On recommendations, Warren Buffett is considered the best investor of all time, and his “strategy” was to find stocks that were undervalued and invest for the long term. So I’d recommend anything by him, or “The Intelligent Investor” by his mentor Ben Graham. Also, “A Random Walk Down Wall Street” is very good as well. This book is more about investing strategies (namely: don’t try to beat the market, buy a diverse “index fund” and hold for the long term).

To be honest, I haven’t found a clear, simple explanation of the mechanics of the stock market – I’ve mostly pieced it together from various sources online (investopedia, wikipedia and others).

@Alan: I think that’s basically right. For most companies you buy shares hoping the company will launch new products, grow into new markets, and become more valuable. Then you can sell your stake in the company for a higher amount (dividends are rarely a factor).

[…] Don’t undertand the stock market? read this November 16th 2007 Posted in General A very informative article, he boils it down to the important bits and makes it very easy to understand:What You Should Know About The Stock Market[found via news.ycombinator] […]

Hi again - I am in the same situation as Kalid only read stuff from web and had things explained to me by friends! Hence I am not 100% sure. If you do find a good resource then please do share it!

I used to know a guy who managed a team designing stock market software. When I asked him about it he told me,
“The stock market was not designed for the common man”.

@Alan: I’ll reply back here if I find anything :slight_smile: (As always, if anyone finds a good resource feel free to share).

@Nick: I think part of the mystique is that the stock market is a “rich man’s game” and most people don’t experiment with it until their first 401(k) or a few years of work.

It takes money to make money… and the average joe may not have much. But, I have hope – I think investing in an index fund is a simple, effective strategy in the long run [and for those who don’t want to monkey around with individual trades].

I’m a recovering stockbroker, having worked for UBS which is a very big Swiss bank that has a brokerage arm in the U.S. One of the many things I had to master in order to succeed was how the stock market works. People hand over their life savings to a stockbroker, and the SEC (securities and exchange commission) pays close attention to protecting the public from crooks and scam artists. So a broker has to know how the market works, and what all the rules are, in order to avoid running into trouble with the law, and also to avoid making a mistake that would cost his customer money.

Your article about how the market works is very well written, and kind of elegant in it’s clarity and simplicity. What I would add is the world of investing can be a dangerous place for a novice investor who trusts that the system is fair and transparent. I know that sounds cynical, but bear in mind that we’re talking about the heart of our capitalist way of life, and the amounts of money being traded every day are so huge that there is a pretty big incentive to “cheat” by trying to gain an unfair advantage over other investors.

I learned the hard way, just like all brokers, that the only way to survive and prosper in such a hyper-competitive environment is to question absolutely everything that you’re told- especially when it comes to listening to someone who is trying to get you to give them your money to invest for you. I was fortunate to have a mentor who looked after me and helped me dodge some big bullets along the way. He taught me to do my own research rather than rely on “street” research, which is usually biased. He also taught me to go against the crowd when it looked like the crowd was absolutely convinced that the market was going to go in a certain direction. The crowd is famously wrong most of the time.

I also learned quite a lot about the tricks, traps, and outright lies that many brokers use in order to bring in more customers. You see, the problem with stockbrokers, or financial advisors, or whatever you want to call them, is that their incentives are all wrong. They are rewarded for gathering assets, and their pay is directly based on how much money they bring in the door. There is no reward for providing skillful and profitable advice to clients. A skilled and honest broker will keep his clients longer on average than an incompetent broker, but the incompetent or dishonest broker who happens to have great sales skills will out earn the good guy by a mile.

I could go on for quite a while about this subject, because it’s always been my passion in life. Learning how the market works from the “inside” was a wonderful experience, and it has allowed me to see through the thick layers of b.s. that, unfortunately, are part of the investment landscape.

Keep writing like you do, and I’m sure your success will continue to grow.

To continue what Erik is talking about with cheating. I have learned from very reliable sources that work at large investment firms that insider trading happens all the time at major firms.

Large firms have a private equity branch and hedge fund branch. Even though the two branches are barred from communicating according to SEC, information travels freely between the groups. My source told me that when the private equity branches are trying to buy a company they let their hedge fund branch buy it and then when the private equity branch announces to buy the company, the stock increases thus they get huge returns.

That was just one example, there are supposedly many multi-billion dollar firms that engage in illegal activity to give them the edge.

Now I have taken my source’s word with a grain of salt. I’m very skeptical because I would like to believe that the SEC observes these companies very closely (supposedly they don’t have enough power to stop these billion dollar deals). I just wanted to bring it out there. Please comment if anyone else has observed this behavior.

Hi Kalid,

The thing that attracted me to your site was the article on pythag. Maybe you can help me understand how to use it in my daily work. I designed a multi-factor model for stock investing that identifies the attributes of a stock- such as price/earnings ratio, price/book value, earnings growth, etc. and I subjectively assign weights to each of the factors based on experience and reasoning. If I understood the pythag article, there’s probably a way to write a formula that would tell me which factors are more important and which are less important when it comes to predicting how much the stock’s price is likely to rise in the future. Being thick-headed, I can’t seem to figure this out for myself. Can you shed some light on it for me?


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[…] Accountants try to quantify items like this with intangible terms like “Goodwill”, but it’s not easy. In reality, most companies are worth several times their reported assets; Google’s market cap is over 10x the book value (but read more about stocks to see why market cap is not quite right). […]