Mommy, Where Do Stocks Come From?

by Julie Rains on 14 February 2008 7 comments
Photo: mrhayata

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

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.

For more information on where a stock comes from, see IPOs by Inc.How NASDAQ IPOSs Work from Howstuffworks, and The ABCs of IPOs from The Motley Fool.

Tagged: Investment, IPO, stocks
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Guest's picture

However:

---- 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

I beleive that every limited liability company has stock. For example, I have an LLC (or Ltd outside of the US, Gmbh in Germany etc), which i use for contracting. There are 100 shares - stock - of which I own 99 and my wife owns 1. They are worth £1 each.

This is not a public company, so the directors (me and my wife) control who can buy shares, and we publish our financial info to those who have stock. The difference with a public company is anyone can buy stocks (they are "listed"), but in the same way, the financial info must also be published to the public.

The only businesses I can think of that do NOT have stock are partnerships (which are technicly not a company, tho they often look like one) and single people who are self employed, and they are quite thin on the ground.

Julie Rains's picture

Thanks for the additional insight into "stock" -- you are right that other companies have stock but are not publicly traded or publicly held. I decided to make things simple for this post (one version had a detailed explanation but I didn't want to confuse the "child" with the difference between closely held and privately held stock vs. publicly-traded shares, and so removed the extra, potentially confusing information). I hope this helps explain some things for people who are getting started with investing.

Guest's picture
Amanda

The title of this post reminds me of the explanation given by Sherman's wife to their daughter about how he makes money as a bond trader.

Something to the effect that Sherman is like some one who passes slices of cake around and collects the crumbs. If you pass a lot of cake, you end up with a lot of crumbs.

Amanda

Guest's picture
K

You just made me realize something very discouraging.

Offering stock is like taking out a loan that you don't necessarily ever need to pay back.

As a potential lender in such a situation, that sounds really, really unwise.

Julie Rains's picture

K, I see your point. For me, thinking about how companies raise money made me realize that being compliant with SEC regulations doesn't necessarily mean a company is a good investment. I believe in investing but feel reasonably more skeptical of just any ole publicly held company.

I should mention that banks or private lenders can structure loans in a way that matches a business's cash flow (seasonal fluctuations in earnings, temporary slowdowns, etc.) but loans still need to be paid back or a company gives up assets, declares bankruptcy, etc.

Guest's picture
maj

This made me remember a conversation with my father when I must have been around 5. I came away from it thinking he bought and sold "chairs" of companies and that there was a big warehouse somewhere full of chairs all piled up to the ceiling. And when you bought a "chair" they would put your name on it, like a park bench.

It wasn't until a few years later I realized he'd been talking about "shares."

Now I wonder if "chairs" aren't a better investment.

Guest's picture
Guest

so stocks are like baseball cards, you can't get anything out of it expect you are able to vote at investor's meetings and you can sell it, right?