Before you start in any investment, it is imperative that you understand all aspects related to it, if you shall avoid large losses in the future. What are stocks?
Let's say a certain Mang Inasal wants to start a chicken restaurant business, but he does not have money to buy all the tables, chairs, ovens, the restaurant to start the business.
He has two choices to obtain money for this:
A. Go the the bank or his friends to ask him to lend him money.
B. Gather his friends, pool all their money and agree that they will all have a share the profits and ownership of the business.
This my friends, is the simplest example of the 2 main kinds of activities to raise capital in the capital markets. Choice A represents the debt market, and Choice B represents the stock or equities market.
Businesses can be one of one of these legal entities: sole proprietorship, partnership or corporation.
Now a corporation is considered to have its own cashflows, thus legally, it is considered as a separate economic entity as distinct from its owners.
The very advantage of a corporation lies in a concept known as limited liability.
This means that the owners can only lose the amount they have invested in the business or corporation.
If the business corporation incurs large debts, the owners are not responsible to pay this debt, and their losses will be limited only to the amount they invested in the business.
A stock is comparable to the cell of a human body. A cell makes up a living organism. In the same way, a share of stock makes up a corporation. A corporation could be a profit or non-profit economic entity, as distinct from natural persons which are also considered economic entities.
Now going back to the english language; stocks are shares of a corporation. Owners of big business corporations represent their ownership of the stock by holding large amounts of the company or corporate stock.
When a stock is listed in the stock exchange, it means it is made available to be sold to the public.
Why on earth will corporations sell themselves to the public, you may ask.
Well the answer is found in our example above. Selling their shares to the public is exactly what Mang Inasal is doing in Choice B above. They do this to generate additional cash to expand their business. They sell the ownership represented by the stock to the public in order to raise additional capital to buy properties, plants and equipment. Along with rights to ownership, owners of stock or stockholders are also entitled to a share of profits which are distributed as dividends.
A corporation will almost never sell ALL of the shares or stock to the public, or else they lose control or ownership of the business corporation. They only make available a certain percentage of the total number of shares to the public. This is called public float.
Stock markets are called capital or financial markets for this reason. In essence, business corporations sell their shares in this market to generate capital. There is another kind of capital market, which is the debt market. (Choice A in above example) Because another way to raise cash, as you probably know, is by borrowing money. Corporations can do this by issuing debt papers which represent their indebtedness to the money lender.
Investors interested in this may also buy these debt papers, and you as holder of this paper represents the lender to the issuing corporation. You are thus entitled to receive your original principal and interest payments as profit.
These debt papers and stock are otherwise known as "securities".
It is called a "Market" because the capital markets are where these stocks or debt papers are bought and sold. Yes, debt and ownership are actually bought and sold!
On my next post I will show you how to participate in such markets.
