Mommy, Where Do Stocks Come From?
Child: Mommy, where do stocks come from?
Mom: That’s a great question. I guess you could say that a stock starts with an idea or a gleam in a business owner's eye. The idea is anything that makes money for the owner and becomes a business. It could be a
- ladies’ clothing store (Chico’s - Stock Symbol CHS)
- search engine (Google - Stock Symbol GOOG)
- apparel manufacturer (Levi Strauss and Co. – private company)
- agricultural company (Cargill - private company)
Child: Does a stock come from a business?
Mom: Yes, a stock comes from a business but not all businesses have stock. Some businesses are privately owned by a family or a few investors; others have publicly traded shares or stock.
Child: Why does a business get stock?
Mom: A business sells stock to raise money that it needs to operate and grow.
Child: Why does it need more money? Doesn’t the business make money?
Mom: Well, it’s true that the business makes money or should make money. But the business may need a lot more money than it makes in a year.
For example, a manufacturer may have a plant that produces and sells 1,000 widgets per month. But then a customer tells the company that it needs 10,000 widgets per month. So the company decides to build a bigger plant. But building a plant costs money.
Or, a store sells $400,000 worth of things every year but spends $150,000 to buy things and $50,000 in operating costs plus spends $150,000 to manage the business (corporate functions, such as purchasing and accounting). Every year, the company makes $50,000. But if a second store could sell the same amount, then both stores could make a total of $250,000 per year; there is more work in having 2 stores but now the business is making 5 times as much profit. The business might need $100,000 to start one new store or $1 million to start 10 new stores; then it could make lots of money.
Child: How can the business get money?
Mom: It could borrow from a friend who has lots of money and is willing to lend that money rather than buy real estate or help someone else’s company. Or the business might borrow from a bank. Either way, the business will need to pay back the money plus extra (interest).
But if the business needs lots of money, then it might not be able to get a giant loan. The other problem with the loan is that if that customer who needed 10,000 widgets per month stopped ordering for a while or people stopped buying things at the store for a few months, the businesses wouldn’t be making money but would have to keep paying the loan.
So, instead of borrowing money, the company issues stock, getting money from investors in exchange for giving up ownership of the business. The company doesn't have to pay back the money but it does try to make money for the investors.
Child: Is that where stock comes from?
Mom: Well, I guess you could say that the stock is conceived when the company gets the idea that it should issue stock to raise money.
Child: How does the stock get born?
Mom: Usually, the company goes to an investment banker to help it raise the money it needs. The banker does all the financial calculations, figures out what the company is worth, sets a price for the stock, and then makes arrangements to sell the stock. The company also has to get approval from the SEC (Securities and Exchange Commission) to make a stock and has to prepare a report called a prospectus that tells potential investors all about the company.
When Google made a stock, though, it didn’t use an investment banker but used an auction process instead to sell the stock. The company did file a big piece of paper (Registration Statement) with the SEC. So, there is more than one way for a stock to enter the world.
Child: When is the stock born?
Mom: I suppose you can say that the stock is born on its IPO day (IPO=initial public offering). The stock is made available for investors to purchase the company and that is where stocks come from.
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