For the record, I have no stock picks for you. Zero. Zilch. Nada. Surprised? I mean, isn’t that what financial educators … educate about?
Well, no.
Here’s the thing about individual stock recommendations—from anyone. By the time a stock tip reaches you—and I don’t care who you are—it is most likely already too late. Too late? Too late for what? Too late for you to get more out than what you put in.
But I’m getting ahead of myself. Let’s start at the beginning. The very beginning. Here’s where the edumacating thing happens.
Since I live in Wisconsin, let’s say I own a cow:
A bovine beauty! Let’s say, too, that I want to start a cheese-making business with the creamy, delicious milk—that I, umm, don’t drink—from my cow. To do so, I need money for equipment and … other stuff. Maybe a course on How to Make Cheese and a hairnet. Like any owner of a new enterprise, I have a few options for how to fund my start-up costs, call them $10,000. We’re looking at artisan, small-batch cheese made by former New Yorkers here.
The first, and most common source of funding for small entrepreneurs, is to tap my own savings, or Net Worth, the second is to take out a bank loan (debt), and the third is to find equity investors (issue stock).
All these funding sources have pros and cons for me, cheese-mogul-in-the-making. If I use my own savings and the business goes nowhere faster than you can say salmonella, my Net Worth could take a hit. On the flip side, if the cash is just sitting around (i.e. not invested anywhere else), there’s no additional cost to using these funds. If I invest in my cheese business, I also can’t fritter that money away on impulse purchases … hahaha! Just kidding! I DON’T MAKE IMPULSE PURCHASES.
Alternatively, I could borrow the $10,000 from a bank. On paper, though, I probably look like a poor risk. I have no cheese-making experience, and for the life of me, I can’t distinguish between Parmesan cheese and Romano. I come from a people known to be lactose intolerant. Still, a bank might loan me the money if I offer up enough collateral, or valuable stuff they can take if I don’t pay back the loan. Like my cow. Or my car. For the privilege of using its money, I will pay the bank an annual interest rate that reflects how risky the loan officers think my business is. Then again, if my cheese goes bacterial … I mean viral (cheese-making joke!), the bank gets only the original $10,000 loan paid back. They don’t get any extra cheese.
*snicker*
Finally, I could find equity investors, a.k.a. people with money to spare who are charmed by the notion of owning part of a small cheese-making operation run by the same person who preps their kid for the ACT. In a nutshell—or a cheese rind heh—here’s how this would work. I issue 25 shares of stock, each one worth 1% of my nascent company. I offer them for sale for $400 a piece. If I sell all 25 shares, I’ve raised $10,000 in exchange for 25% of the company, valuing my total enterprise at $40,000 … all before I’ve sold a single hunk o’ cheddar.
Who in the world would purchase such a share? Well, why did you buy that stock from your brother-in-law’s hot tip? We’ll ponder these things next time.
Hi Grace – Nice example of the “IPO” scenario. I agree, IPO’s are almost never an intelligent place to put one’s hard-earned capital. IPO’s may be an OK place for the “speculator”, but not for the investor who deploys his/her capital with the mindset of a long-term, fractional owner of a publicly traded entity. So the answer to your question is that only a “speculator” would purchase such a share. A prudent investor would wait for your cheese making enterprise to become profitable before determining a “reasonable” market price to pay for that stream of “cheesy” earnings….. I look forward to more of your pondering about the subject. (sorry if I jumped ahead of your lesson plan). Keep up the good work.
Jim—yes, stay tuned! You’re right in that I’d definitely want to “wait and see” how a company grows … but I do wonder how much any investor can really see.
Yes, in the case of your small scale mom & pop “cheese enterprise”, once it is off and running and producing profits, any financial statements that you would provide to other prospective equity investors to conduct a fundamental analysis could be open to accounting shenanigans on your end, thus possibly introducing great investing risk to future “would-be-partners”. However, in the case of larger, publicly traded firms, there is some higher-level of assurance that financial statements are “above board” due to SEC regulations and independent, third party auditing firms signing off on them. (No blue-chip auditing firm wants to become the next Arthur Anderson). ….not that every generation or so won’t experience their own version of “Enron” or “WorldCom”, it is far more likely that corporate 10K’s are legitimate enough to help make a partnering investor decision (and not that CEO’s/CFO’s cannot still “manipulate” certain things under GAAP reporting to make the business situation appear slightly better than the economic reality). …But for the most part, if you stick with analyzing the world’s best blue-chip, businesses with long histories of excellent investor/business stewardship, you can probably sleep very well at night knowing that your capital has been well-allocated by partnering with these firms. ….now, back to the small-scale cheese maker….???