Stock market for beginners 2020
When you look at the stock market, it’s difficult to understand why each stock is priced in such away. I mean, look we all have heard the news that Apple I the first trillion-dollar company, its world’s biggest and most successful company.
Maybe the stock price should be higher as well, right? Not really! The reality is quite different. Apple’s stock price right now is 258 dollars, while a company that is hundreds of times smaller like NVR Incorporated has a stock price of 3000 dollars.
Does that mean that NVR incorporated is bigger than Apple, the short answer is No. However, it’s a little bit more complicated than it might seem. If fact, the entire stock market seems quite complicated at first look. But there is a logical explanation behind most of the things.
To make a sense out of the stock market, we have to understand what a stock is in the first place. Let’s say, for the last 6 months, you have been thinking of starting a business. The only problem you have is, you don’t know what business to start. One day, on your way to college, an idea strikes your mind.
You pull out your phone and write it down, you rush to your house and start planning. Everything looks perfect; you know how to turn your idea into a multi-billion dollar company. Congrats.
But its too early to celebrate because you don’t have the capital to start. You gather your family members, and you explain to them the idea hoping that they will invest in the company. Everyone thinks you are crazy, except your uncle, who decides to bet on you.
10 thousand dollars in exchange for 20 percent of the company. It might not seem much, but it’s actually a lot. Because your uncle just valued your idea that’s not proven yet at 50 thousand dollars. So you register your company, issue 100k shares, and your uncle gets 20k of them.
You start building your website and designing your product. In a few months, you run out of cash, and you need to raise more money. Unlike last time, where you simply had an idea. Now you have a concept to present.
So, instead of going to your uncle again, now you can do something different, like talking to some of the big guys. Such as investors, investors are usually the rich dudes who are looking for innovative ideas or young entrepreneurs to invest in.
Something like sharks in the shark tank. It’s not easy to convince these guys to throw money into your business, because statistically, 9 out of 10 businesses fail. And you have to prove to them why you are an exception.
After talking to multiple investors. Luckily, you could get one of them on board. But first, you have to agree on the valuation. There is pre-money valuation and post-money valuation. It’s not as difficult as it sounds.
Pre-money valuation is how you value the company before receiving the investment.
And post-money valuation is pre-money valuation plus the investment.
The higher the pre-money valuation, the less portion of the company the investor is going to take. You enter into a negotiation, and you convince the investor to throw 1 million dollars into your business, with 2 million dollars post-money valuation.
So the investor is going to take 50 percent of the company(1/2). And your shares will get diluted together with your uncle ones. That doesn’t mean, you are going to have fewer shares, the company will simply issue another 100 thousand shares for the investor.
So, now there are a total of 200k shares instead of 100k shares, and your stake is 40%(since you own 80k share and your uncle’s take is 10%). With a million-dollar, you rent an office, hire some designers, engineers, and specialists to complete your product.
Finally, everything is ready; you are about to launch your product, app, service, whatever. But guess what, you are out of cash. And you still need a marketing budget and salespeople, so you decide to raise some more money.
You go for a series B. This time, you meet some VCs or Venture Capitalists. They are not your typical investors. These are dudes with MBA’s and work in venture capitalists firms, who take other people’s money and invest in companies such as yours.
Anyways, after multiple negotiations, they decide to bet on you. Since you already have a team and a product to launch, your company hopefully now worth more. Let's say the VC offers you a 10 million dollar investment with a 20 million dollar post-money valuation. You find that offer fair, and you accept it.
The company issues another 200k share, and everyone’s stake gets diluted again. Since the VC just purchased 50% of the company. (your 20%, uncle’s 5%, investors 25%) in case you are wondering.
No one has lost money so far. In fact, everyone just got wealthier. The investor, for example, had 50% of 2 million dollars when he invested in the company. Now he has 25% of a company that worth 20 million dollars (which is 5 million dollars).
In fact, your stake worth now 4 million dollars. Anyways you can go for series C, D and so on… few years have passed. Congrats, you have made it. Your idea turns out to be a success. Your business is finally making money.
Remember, everyone who has invested in your company has been waiting for you to grow big enough so that they can cash out. Especially your uncle, who’s 10k investment now worth millions.
You have two options, you either get sold to one of the giants of the industry like Instagram did. Or you go public like Facebook. And that’s known as IPO(Initial Public Offering).
It’s just another way to raise funds and issue shares, but this time, anyone can buy your shares. They are open to the public. Your uncle or that investor can sell their shares and make a fortune. In fact, people can buy and sell their shares among themselves in the stock market.
So before going public, the stock price is determined by what you and the investor would agree on. But after going public, the number of factors would influence the price slightly change. The laws of demand and supply would determine the price.
Facebook went public in May 2012, at 38 dollars per share, valuing the company at 104 billion dollars. But the public didn’t agree with Facebook, so the demand for Facebook shares wasn’t as high as the supply, therefore, on the day of IPO, the stock price dropped to 18 dollars per share.
But Facebook still managed to sell enough shares to raise 16 billion dollars, making it one of the largest IPOs in the country. The price of the stock doesn’t accurately present the true value of the company because the number of factors that can influence the demand and supply of a certain stock is just too many.
Let’s just say hypothetical, some kind of disease would spread around the world, that would push the media to talk and exaggerate about how the disease could crush the economy. That would scare off immature investors and would push them to sell their stocks before the market would go down as the media said.
So the supply of a certain stock let’s say Facebook would be much higher than the demand for it in the market, which would push the price to plummet. And that could scare off the rest of the investors and push them to sell their shares as well before it drops even further.
Even though this particular disease in any way isn’t effecting Facebook, it still forced its stock price to drop significantly. Here is another example. The company might realize its earnings for the last quarter, and they might not meet the expectations slightly.
That could get some negative press, and negative press could easily push some investors, especially immature ones, to sell their shares, and that would increase the supply of the shares and would drive the price down and even scare off more professional investors. It is a never-ending cycle.
That’s why a panic over a crisis can destroy the economy. The company might not be making a profit for years or decades. But because it seems like some time in the future, it is going to make a lot of money. Investors would keep buying its shares, hoping that one day it is going to pay back, and that hope would keep the price rising like in the case of Amazon.
It didn’t make a profit for 20 years, and yet it made Bezos the richest man in the world. If a company would keep doing great, the stock price could rise to an unbelievable amount.
Berkshire Hathaway’s stock price peaked at 340 thousand dollars a share in February. Yes, you heard it right, a single stock costs 340 thousand dollars, that’s what it takes to invest in Warren Buffet’s company.
So some companies play around with their stocks to increase the demand for the stock by splitting their stocks, for example, to keep them attractive even to small investors. Take an example of Apple; the stock price currently is 247 dollars, but did you know that in June of 2014, it was 649.88 dollars.
That doesn’t make sense! Right?! because the company doubled its market capitalization and iPhone sales skyrocketed since then. Then what does that suppose to mean? Let me explain.
In June 2014, Apple split its stock 7 for 1. In simple words, apple divided each stock to 7 stocks, so the stock price dropped to 92.7 dollars. So if you had I Apple stock back then that cost 650 dollars, now you have 7 stocks, and each of them costs 92.7 dollars (7X92.7).
Nothing really changed, but the stock seems more affordable now, which increased the demand for them, hence the price would rise as well.
The number of factors that could influence the stock price is way more than we can possibly cover in this blog, but here is the catch. The trick is to find out if the price of the stock does really represents the true value of the company. If its overvalued, it does not worth investing because sooner or later, the price of the stock will drop to its real value, on the other hand.
If the stock price is lower than what the company really worth, then it is a great investment since the stock price sooner or later will rise to its real value.
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