Investing 101: What is a stock?
To build a business you need access to money, especially if you want to grow quickly. Let’s pretend that you want to start a local fitness club. Assuming you have a viable business plan along with some of your own money (along with good credit), you can probably convince a bank to lend you funds to help you get started. Once you have a proven business, banks will be more likely to lend you money as you can demonstrate your ability to generate cash (and thus, repay the banks). However, there is a limit as to how much credit you can undertake especially in the formative years of your business. Aside from taking on debt, you can sell part of your business to fund your expansion. This is also known as issuing “equity” or selling stock.
Let’s use a fictional business to illustrate: Bob owns 100% of his business, “Fitness Pros”. The business generates revenues (sales) of $350,000 and Bob keeps about $70,000 in profits after all expenses are paid. Bob wants to open 10 new fitness locations across the state in order to grow his successful business, but he doesn’t want to have any more debt to repay. First, Bob needs to determine the value of his business. Assuming Bob continues to run his operations in a similar fashion, he should generate healthy cash flows for years to come. The value of Bob’s business is found in its ability to earn profits into the future. In other words, Bob’s business is valued at a multipleof current year earnings. To keep it simple, let’s pretend that Bob hires a consultant who determines that Fitness Pros is worth 4 times the net earnings of the business ($280,000). Bob could sell a 50% ownership interest in the business for $140,000 to an investor. That investor will now own stock in Fitness Pros and will be considered an equity investor in the company. Bob could take those proceeds and invest in opening new stores. If he is successful, the overall value of the business will increase. Both Bob and his investor will profit.
While our fictional example of Fitness Pros was a local small business, there are many businesses that expand to a national or global level. Sam Walton purchased a branch of the “Ben Franklin Stores” from another business owner in 19451. By 1950, the store was generating $250,000 in revenue. Sam opened the first Walmart Discount City store in the summer of 1962, almost 17 years later. Within 5 years, Wal-Mart had expanded to 24 stores across Arkansas which generated over $12 million in sales. In order to fund its massive expansion plans, Sam sold part of the company to investors on the New York Stock Exchange (NYSE) in 1970. By 1987, there were almost 1,200 stores with sales of over $15 billion. Currently, Wal-Mart operates over 11,500 stores and generates over $285 billion in global sales. Sam Walton needed the capital markets to fund his expansion plans. He sold part of his holdings in Wal-Mart in order to fund the endeavor. While he no longer owned 100% of the company, without additional capital Wal-Mart could not have expanded as rapidly as it did.
Let’s note some differences in how equity was used between Wal-Mart and Fitness Pros. Bob from Fitness Pros would have sold shares in his business to a private investor. Sam Walton sold shares of Wal-Mart on a national stock exchange. Anyone in the world could buy shares of Wal-Mart stock once it was listed on the NYSE, whereas buying stock in Fitness Pros could only happen (most likely) to someone who knew Bob personally. However, in both cases the business owners sold part of their business in order to grow it into something bigger.
Check out our other Investing 101 topics: