Ch. 4:  Intro to Stocks

A video.  Never as good as the test, but at least you get to see the shadow of my 82" TV for some reason.

Chapter 4:  Intro to Stocks

4.0 Introduction

            Stashing money away in a savings account, which will likely earn less than 1% interest annually, is a sure-fire way to stunt your monetary growth.[1]  Fortunately, avoiding this pitfall is easy.  For most of us, the primary way to build wealth is to invest savings in the stock market.

            Stocks represent ownership in a company… simple as that.  When a firm wants to raise money to finance new projects, one way to do so is by selling off shares of itself.  As an example, imagine you want to open a restaurant, but need cash.  You might decide to issue 10 shares of stock for your restaurant, with each share representing 10% ownership in your business.  You retain five of these shares (meaning you now own 50% of the company) and sell the other five shares for $20,000 apiece.   You now have $100,000 in cash to build in your fledgling business.  You promise your stockholders that each share will earn 10% of all future profits and 10% of the revenues if your business is ever sold.  While the actual stock market is much more complex than this example, the general principles remain.  Firms issue stock to raise money.  Investors buy stock in hopes of enjoying future profits that the firm generates. 

Historically, the US stock market has grown at an annual compounding interest of about 10%.[2]  While stock market investing is risky, it’s financial suicide for a young person to choose a sure 1% over a risky 10%.  More on this later…

4.1  The birth (and death) of a stock

            When a company first wants to raise money, it has two primary options: (1) It could borrow money with promise to repay fund in the future (issue bonds) or it can create shares of itself available for investors to purchase (issue stock).  If the firm chooses the latter option, this first-time issuance of stock is referred to as an initial public offering (IPO).[3] Chances are, you will never buy shares directly from a newly formed corporation, so there isn’t much reason to dwell on the ins-and-outs of IPOs.  Instead, most stock sales occur on the secondary market with one investor selling shares to another investor.  When you buy or sell Nike stock, for instance, Nike has no role in the transaction.  Rather, you are buying a piece of Nike from some rando in Cleveland, Ohio or something.

            At some time in the future (maybe tomorrow, maybe the year 2,205) the stock share will end.  Occasionally the stock’s value goes to zero and any shares you own become worthless.  This is unlikely; instead, the company you own will likely be sold (an “acquisition”) or merged (a “merger”) with another corporation.  In this case, your ownership will transfer to the new firm.  Some of these concepts can get quite complicated, but we don’t need to bother with the complex details.  We just need to buy stocks strategically to grow our wealth while limiting risk.  Let’s gobble up some stock!

4.2  How stocks provide value

            To understand why stocks offer high returns, it’s important to consider what a stock really represents.  Corporations, big and small, are all desperately scratching and clawing for profits.  Apple is actively developing ad campaigns, creating new products, hiring skilled engineers, etc. all in the name of improving the company’s profitability.  Every employee from the C.E.O. to the newly hired entry-level worker is independently incentivized to work hard and improve the company’s standing—even if the workers don’t care about the company at all, they don’t want to lose their jobs and they would love to get promoted!  When you invest in Apple, you are, effectively, entitled to the profits generated by these workers.  You can just sit on your butt and profit!

            Apple is not alone, there are thousands of motivated corporations exerting enormous energy in the hopes of creating wealth.  All this hard work is profitable for the economy as a whole.  While some firms will flounder, others will grow tremendously rich.  Collectively, the US economy grows almost every single year and the stock market, not surprisingly, follows suit.[4]  Compare that to other investing options; for instance, consider gold.  Gold is a rock.  It does not work hard, it does not try to earn profits… it just sits there living a sedentary sedimentary lifestyle.[5]   

            Now, let’s think about how stocks actually provide profits to the investor.  When do you get the money that stocks pay-out?  Effectively, stocks provide profits in two ways.  Firstly, stock prices tend to increase over time because as US corporations innovate and become more productive.  Thus, the shares that represent those companies also become more profitable.  Secondly, stocks often pay dividends.  Imagine Apple has a good year and is left with $500 million in profits.  Keeping in mind that the stockholders own Apple, this $500 million is divided among the shareholders.[6]  In 2023, Apple made four dividend payments to its shareholders; collectively, these dividends provided $0.95 in payment for each individual share of the company that’s been issued by the firm (“shares outstanding”).  If you held 100 shares of Apple stock, you would have earned $95 in dividend payments.  Because some companies are not (yet) profitable, dividends are generally issued by more established corporations.  So, don’t expect massive dividend payments if you hold Tesla stock, for example.  While dividends and price increases are both good for the investor, the tax ramifications greatly differ (more on this in later chapters).

4.3  Stock prices, shares outstanding, and market cap

            At the moment this was written, the share price of Boeing stock was $209.33 while the price of one share of Apple was $187.15.  A new investor (I’m looking at you Donny Dumbass) might mistakenly think that this indicates that Boeing is a more valuable company than Apple.  This is not the case.  The price of a stock, without context, tells us basically nothing about the firm’s financial standing.  To get a clear picture, we also need to consider the number of shares outstanding.  At present, there are about 15.46 billion outstanding shares of Apple.[7] Given that each share is worth $187.15, we can easily solve for the value of Apple stock, collectively.  By multiplying the share price of $148.66 by the number of shares outstanding (16.53 billion), we find that Apple’s total perceived value is roughly $2.89 trillion.  This perceived valuation is called the market capitalization rate or market cap. 

  Eqn. 4.3.1            Market Cap = Shares Outstanding*Share Price

We can now directly compare Apple and Boeing.  With about 606 million shares outstanding and a share price of $209.33, Boeing’s market cap is about $126.9 billion.  This suggests that Apple is a much more valuable company in the eyes of investors.  However, it is critical to understand that Apple being “bigger” does not mean they are a superior investment to Boeing.  All corporations, big and small, have the potential to generate wealth.

4.4  Large caps, mid caps, and small caps

            Now that we understand the concept of market capitalization, we can categorize corporations by size.  Large Cap stocks are big corporations; while definitions vary, a firm is often considered a “large cap” if its market cap exceeds $10 billion.  As of February 2024, there are 610 “large caps” in the US.[8]  Although these firms make up less than 10% of US corporations, they make up the vast majority of the US stock market’s overall market cap and employ a massive number of employees.  Firms are generally considered mid caps if their market cap is between $2 billion and $10 billion; firms smaller than $2 billion are called small caps.  Although future performance could greatly differ from historical returns, it’s informative to consider the return generated from stocks in each of these asset classes.  Between 1972 and 2020, large-caps returned an average of 10.8% annually.  Mid-caps and small-caps returned 12.1% and 11.9%, respectively.[9] While large-caps have a lower average return, they tend to have fewer dramatic swings in price, resulting in lower overall risk. 

4.4 Valuing the stock market with stock market indexes

            In personal finance, the focus on stock market investing usually leads to considerations of collective stock valuation changes over time, rather than individual firms.  For reasons that will become clear, it’s unlikely that you will invest in just one (or even 1,000) corporations.  So, how do we measure the total value of the stock market… or perhaps one industry?  A stock market index attempts to do just that.  While there are countless stock market indexes, we will focus primarily on the Standard & Poor’s 500 (S&P 500) in this class.  The S&P 500 tracks the collective value of the 500 largest corporations in the United States.  The S&P 500 is value-weighted, meaning that it places more emphasis on firms with larger caps.  This style of indexing is far superior to price-weighting, which emphasizes the price of stocks.  To explore this concept, consider the table below.

Imagine we were to form a price-weighted index of these firms (which would be weird—indexes are normally much larger).  In doing so, we could sum the price of these three firms, discovering that they have a collective price of $760.63.  We can use the following formula to solve for a firm’s relative share price:

Using this formula, we can find that Goldman Sachs would make-up about 53% of the index, despite the fact that it is the smallest company!  This is silly!  Price-weighted indexes arbitrarily over-weight firms that have a high price. Given that firms can basically choose the price of their index at the time of IPO, this is nonsensical method for building an index.  Nonetheless, this is the method used to calculate the value of the well-known Dow Jones Industrial Average (DJIA), which is a price-weighed index of the thirty largest US firms.[10]  When the DJIA was first created, indexing was a novel ideal.  The creator, Charles Dow, simply wondered how much it would cost to buy one share of the thirty largest firms and how would these thirty shares perform?  Unfortunately, Charles Dow’s simplistic index gained popularity and will always be included in discussions about the stock market… it’s a shame really.

            Now, back to the S&P 500.  In sophisticated personal finance circles, you’ll hear way more discussion about the S&P 500, which is a value-weighted index.  In a value-weighted index, a firm’s market cap determines its relative position in the index. 

Consider the firms in Table 4.4.1… the sum of their market caps is about $2.64 trillion.  As such, Microsoft would make up about 87% of the index whereas Goldman Sachs would only be 5% of the index.  This is far more reasonable—Microsoft is a much larger company, with more diversification in production, more employees, more assets, etc. 

            For most investors, investing in an entire index is an excellent way to grow wealth while limiting risk.  Index funds are tradeable assets that mimic the performance of the overall index.  Because value-weighted indexes are more fundamentally sound, almost all index funds are value-weighted.  Index funds offer a simple (and generally smart) way to invest.  For example, you might decide to invest in the Fidelity 500 Index Fund, which literally allows you to invest in all 500 firms in the S&P 500 in one simple purchase.  I love index funds and I bet you will too!  Much more later on…

4.5 Conclusions

            Understanding the general principles of the stock market is crucial in building your personal financial strategies.  But you don’t have to understand it thoroughly!  Pac-Man doesn’t know why he’s eating all those little dots, but he knows the score goes up when he does.  You can gobble-up index funds and get embarrassingly rich without fully comprehending what you’re buying or how the market works.  Investing is easy.  

Key Terms

Corporation:  This is kind of a vague term, but usually people use the term “corporation” when discussing a firm that has issued stock.

Dividends:  Profits paid directly to shareholders by corporations.  If you own shares of a well-established firm such as Google, you are likely to be paid dividends, typically at pre-determined time intervals

Initial Public Offering (IPO):  The first issuance of stock in which a corporation directly sells shares of itself

Market Cap:  The total value of a company as reflected by the cumulative value of all shares it has issued.

Large Cap:  A “big” corporation, per its market cap.  Usually defined as having a market cap that exceeds $10.  Or one of those ridiculously large caps that celebrities wear these days.  You know what I’m talking about?

Mid Cap: A medium-sized corporation, per its market cap.  Usually defined as having a market cap that’s between $2B and $10B.

Small Cap:  A “small” corporation, per its market cap.  Usually defined as having a market cap that is less than $2B.

Price-weighted Index:  A form of stock market indexing where a corporations relative share of the index is based on its share price.  If Firm A’s price is 10 times higher than Firm B’s, Firm A will garner 10 times more weight in the index.  This is problematic since share price is largely arbitrary.

Secondary Market:  A market where pre-existing assets are sold.  In the stock market, a transaction on the secondary market means that the buyer is purchasing shares from a stockholder, not the corporation itself

Share Price:  The price of one share of stock (I mean… did I even need to tell you this one?)

Shares Outstanding:  The number of individual stock shares that exist for a given corporation.

Stock:  A financial asset that represents ownership of a company

Stock Market Index:  A collection of stocks that seek to track the overall performance one the entire stock market, or by other means (e.g. tech firms only)

Tax-sheltered accounts:  Investing accounts that have some kind of tax-advantaged feature (i.e. 401k, IRA, HSA, etc.)

Taxable account:  Investing account with no special tax advantages. 

Value-weighted Index:  A form of stock market indexing where a corporations relative share of the index is based on its market cap.  If Firm A is 10 times larger than Firm B, Firm A will garner 10 times more weight in the index.


Endnotes

[1] For this reason, we won’t discuss savings accounts much in this class.  If you have money that you need to spend in the near future, a savings account makes sense.  Otherwise, they are just crappy products offered by banks that earn profits at your expense.

[2] See for yourself:  http://www.moneychimp.com/features/market_cagr.htm

[3] Firms may also issue additional stock in

[4] Although the US stock market is much more volatile than the US economy as a whole.

[5] You could do a lot worse than gold though!  https://www.macrotrends.net/2608/gold-price-vs-stock-market-100-year-chart

[6] Alternatively, Apple executives may choose to “buy-back” some shares of its stock—when it buys shares of stock, it reduces the number of shares outstanding, increasing the value of all remaining shares.  Or… it could reinvest the money in some other way; for example, it might open a new factory. This investment will increase Apple’s expected profitability, increasing its stock price today.  Regardless, shareholders are rewarded!

[7] The number of shares outstanding can change for many reasons.  A company might issue more shares to raise more funds.  Or, it might decide that the shares are getting too expensive for investors and decide to issue a stock split, effectively doubling the number of shares.  None of this is too important for our personal finance purposes.

[8] Source:  https://companiesmarketcap.com/usa/largest-companies-in-the-usa-by-market-cap/?page=7

[9] This growth is based on annualized compounding interest, including the increase in stock prices and dividends paid-out.  This is based on CAGR (don’t know what this is… don’t worry about it).  Source:  https://www.mindfullyinvesting.com/historical-returns-of-small-cap-and-value-stocks/\

[10] There are countless articles, podcasts, etc. about this topic.  Here’s a quick one:  https://www.cbsnews.com/news/the-silliness-of-the-dow-jones-industrial-average/ 

Practice Problems

Theory-based questions  (Note that these questions could have a few different possible answer.  You may not arrive at the exact same answer as someone else in the class, but from reading the chapter, you should be able to provide a reasonable evidence-based answer.  If you are clueless about a question… go back and read the material again!)


Math-based practice problems

 

The following table displays share prices and the market cap for four different firms.  Use this information to answer the remaining questions.

11. How many shares of Plex Fitness stock have been issued?

12. Suppose there is a price-weighted index of these four firms.  Determine what share of the index will be composed of each firm.  (For example, what % of the index will be composed of Hammock Outlet?)

13. Suppose there is a value-weighted index of these four firms.  Determine what share of the index will be composed of each firm.  (For example, what % of the index will be composed of Hammock Outlet?)

Selected Solutions


About 10%.  Not all of this return comes from increased stock prices, but most of it does.  Stocks provide value to the shareholder in two primary ways--increased stock prices and dividends.


Probably not.  Stocks are volatile.  If you need to have $50,000 in 7 weeks, it’s too risky to invest in stocks.  This would be a good time to hold money in a savings or checking account or something similar.

Probably!  Over seven years, you can be pretty confident that stocks will increase in value.

Price weighted index base a stock's weight in the index on the share price.  Share prices are arbitrary; since firms can decide how many shares to issue, share prices are not at all indicative of a firm's size.  In a price-weighted index, one company with an arbitrarily high share price can take a large share of the overall index.

There’s no telling.  We cannot determine market cap without the number of shares outstanding.


Large-cap.  There isn't a huge difference in performance among different firm sizes, but historically large-caps have performed worse.  Why?  This is likely because large firms are less risky so investors looking for less risk are willing to accept lower expected return in these stocks.

Although large caps have performed slightly worse, they tend to be less volatile.  Also, as we will learn, it’s smart to be as diversified as possible—this includes holding lots of stock.  Also, large caps make up the bulk of the total US stock market’s market cap.  It’s unreasonable to not invest in such a huge portion of the overall US stock market.

No, unless Coca-Cola is issuing new stock.  When you buy shares of stocks, you are buying them from another investor, not directly from Coca-Cola.


Math-based practice problems

They are equal in value.  Both have a market cap of $10,000,000.

Market Cap = Shares Outstanding*Share Price

Shares Outstanding = $494,100,000,000/$1,220.00 = 405,000,000

The following table displays share prices and the market cap for four different firms.  Use this information to answer the remaining questions.

11. How many shares of Plex Fitness stock have been issued?

Market Cap = (Shares Outstanding)*(Share Price)

Shares Outstanding = Market Cap/Share Price

Shares Outstanding = $125,100,000/$20.85

Shares Outstanding = 6,000,000 


12.   Suppose there is a price-weighted index of these four firms.  Determine what share of the index will be composed of each firm.  (For example, what % of the index will be composed of Hammock Outlet?)

Total index value = $65.80

Bill’s Warehouse share of index = 10.55/65.80 = 16.03%

Plex share: 31.69%

Hammock share: 12.95%

JJ share: 39.33%

13. Suppose there is a value-weighted index of these four firms.  Determine what share of the index will be composed of each firm.  (For example, what % of the index will be composed of Hammock Outlet?)

Total market cap = $127,752,090

Bill’s Warehouse share of index = 316,500/6127,752,090 = 0.25%

Plex share: 97.92%

Hammock share: 0.01%

JJ share: 1.82%