In my previous post, I mentioned that my main motivation for starting this blog is to understand concepts through writing. Being that I’ve been interested in the world of finance for some time now, I’m always eager to explore increasingly more challenging and complex topics. Despite that, I think that revisiting from time to time the fundamentals is extremely important, as a good understanding of them is absolutely necessary to be able to grasp later, and more complex, topics.
I’ve decided to create a series of articles focusing exactly on those fundamentals. But, where to start?
I will first introduce equity investments, by giving mine definition of what a stock is.
A stock is a security that represent the ownership of a fraction of a company. When you hold a company’s stock, you become one of his owners, entitled to a specific share of that company’s profits and net assets. When we say that a stock is publicly traded, it means that the pieces (shares) of that company are able to be bought and sold by anyone in the public marketplace, something that we refer to simply as the stock market.
But why do we have stocks in our world? What purpose they fulfil? It goes all back to capital. Companies needs capital to expand their operations and invest in new projects, like buying a new machine, invest in a R&D project or opening a new store location. There are lots of ways to raise capital, but that is a story for another time. One of the options that the business has is to sell part of their company to interested investors and use that money to fund their projects.
Let’s make an example.
Imagine you run a classic Italian “pizzeria” in London, the business is going very well and you decide to open a second store location a couple of blocks away. You decide to contact an investment bank, let’s say Goldman Sachs for example, and tell them that you wish to issue shares of your company in an initial public offering (IPO). Goldman Sachs will analyse your company and giving it a specific value determined your pizzeria current situation and future outlook; based on that, the share price of the stock will be determinate and then all shares issued will be sold to interest investors. This is called primary market. Once the initial sale is completed, all shares issued are now available for trade in the secondary market, best known simply as “the stock market”.
These shares can now be traded freely among investors through brokerage and banks accounts, you too can buy a piece of your favourite company right now if you desire. The price of that stock will be set following the usuals rules of supply and demand: if lots of people want the same stock, its price will go up. Why prices are what they are, how they move and respond to various events are topics beyond the scope of this article, just know that exist an entire field specialized in that (asset pricing).
This article is one of the shortest I will ever make, but it will be probably one of the most important, as this definition is the base of a big chunk (and the most interesting to me) of the investment and personal finance space.
If you read this explanation and have questions, please ask me, I love answering questions about this stuff.