Wednesday, April 15, 2009

Stocks versus Businesses

Even though there is so much information available about intelligent investing, the general public has limited understanding of investment basics. When people think of the stock market they see ticker symbols moving across computer screens. The media and investment professionals often make the subject of investing overly complicated. Perhaps they want to create something out of investing that it is not. Or maybe it is easier for money managers to get clients when they confuse them and make them believe that investing is only for rocket scientists.

Investors should be aware of the difference between stocks and businesses. Stocks are certificates of ownership in particular businesses. Stocks cannot exist without the underlying businesses. Businesses, on the other hand, are enterprises whose purposes are to manufacture products or provide services for compensation.

How Do Businesses Come Into Existence?

To keep things simple, let's take a look at an easy-to-understand business. Tom, an entrepreneur, want to use his grandmother's lemonade recipe to open a lemonade stand close to a university stadium. He estimates that many people who come to watch sporting events will spend money to buy his lemonade. If he sells enough lemonade, he will earn a good return on his investment.

To has $1,000. To launch his business he will need the following:

1) $100 for ingredients - inventory
2) $300 for tools - equipment
3) Place of production is at home. So ignore cost related to this item for simplicity.
4) $400 for a cart - equipment
5) $100 for cups - inventory

After spending $900 for equipment and inventory, he is left with $100 in cash. Tom's business will have the following balance sheet.

*Note that Assets must equal Liabilities + Owner's Equity. Because Tom used his own money, he does not have any liabilities.

If Tom had left his money in the bank, he would have earned 2% per year on his money ($1,000 x 2% = $20). Today banks don't even pay 2%, but let's just assume they do. If Tom cannot generate $20 per year of net income after expenses from his business, he would be better off having left his money in the bank.

Tom believes he can make $100 per year operating his business. Since his equity shown in the above balance sheet is $1,000, he will earn 10% on his investment. This is equivalent to a Return on Equity (ROE) of 10%.

Return on Equity = Net Income/Equity

This is much better than 2% at the bank. In order to see if Tom can achieve that, we need to find out what his revenues and expenses are while he operates his business.

During the full year of operations, he sold $800 worth of lemonade and it cost him $700 to operate his business. Tom's estimation was correct because he earned a net income of $100. His income statement is shown below.

*Note that wages are included. If Tom hires somebody to make and sell lemonade, he will have to pay wages. If Tom decides to make and sell lemonade himself, he will pay himself wages. Because he is also the owner of the company, he will collect the net income in addition to wages.

Tom's Lemonade Enterprises only has one owner. The business produced a net income of $100 for the first year in operation. Tom's business has value and Tom could technically sell his entire business or part of it to one individual, many individuals, or the general public through an Initial Public Offering (IPO).

If Tom does sell his business to the public, investors can buy shares of stocks in his business and have a small percentage of ownership in his enterprise. If the IPO is offered to a total of 100 investors, the $100 of net income would belong to those investors. Each share would be assigned $1 ($100 net income/100 investors). Over the long-term the value of the shares is directly correlated with earnings assigned to each share, just like a private business that is worth more when it generates more money. In the short-term price and value might not correlate, but in the end the company's earnings must be high enough to support the price.

The most important concept to learn is that stocks are a way to be part of businesses. If an investor is part of a great business that does well over time, the stock price will appreciate on its own to reflect the value of the underlying business.