soistock market basics

7/31/2019 SOIStock Market Basics

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Stock Market BasicsHow a Company Goes Public -- Mr. Yates


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Some Financial Terms

Earnings per Share : The amount of profit to which each share is entitled.

Going Public : Slang for when acompany is planning an IPO. IPO : Short for Initial Public Offering.

An IPO is when a company sells stockin itself for the first time.


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Terms continued

Market Cap : The amount of money you would haveto pay if you bought ever share of stock in acompany. (To calculate market cap, multiply thenumber of shares by the price per share.) Short forMarket Capitalization.

Share : A share represents an investor's ownershipin a "share" of the profits, losses, and assets of acompany. It is created when a business carves itself into pieces and sells them to investors in exchangefor cash.

Ticker Symbol : A short group of letters thatrepresents a particular stock (e.g., "Coca Cola" isreferred to as "KO".)

Underwriter : The financial institution orinvestment bank that is doing all of the paperworkand orchestrating a company's IPO.


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Purpose of the Stock Market

Almost every large corporation startedout as a small, mom-and-popoperation and through growth, becamefinancial giants.

Wal-Mart, Dell Computer, andMcDonalds had combined profits of $10.34 billion this year.

Wal-Mart was originally a single-storebusiness in Arkansas.


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Stock Market

Dell computer began withMichael Dell sellingcomputers out of hiscollege dorm room.

McDonalds was once asmall restaurant no onehad heard of.


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How did they grow?

How did these small companies growfrom tiny, hometown enterprises tothree of the largest businesses in theAmerican economy?

They raised capital by selling stock in themselves.


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Example of a Company: New to Public

After getting married, a young couple decided tostart a business. It would allow them to work forthemselves, as well as arrange their hours aroundtheir family. Both husband and wife have alwayshad a strong interest in furniture, so they decide to

open a store in their hometown. After borrowing money from the bank, they name

their company NW Furniture and go into business. The first few years, the company makes little profit

because the earnings are plowed back into thestore, buying additional inventory and adding ontothe building to accommodate the increasing level of merchandise.


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NW Furniture

Ten years later, the business has grownrapidly. The couple has managed to pay off the companys debt, and profits are over$500,000 per year.

Convinced that NW Furniture could do aswell in several larger, neighboring cities, thecouple decides they want to open two newbranches.

They research their options and find out it isgoing to cost over $4 million dollars toexpand. Not wanting to borrow money andbe strapped with interest payments again,they decide to sell stock in the company.


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NW Furnitures Value

The company approaches an underwriter,such as Goldman Sachs or JP Morgan, whodetermines the value of the business. Asmentioned before, NW Furniture earns$500,000 after-tax profit each year.

It also has a book value of $3 million [thevalue of the land, building, inventory, etc.subtracted by the companys debt] Theunderwriter researches and discovers theaverage furniture stock is trading at 20

times earnings.


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NW Furnitures Book Value

What does this mean? Simply, youwould multiply the earnings of $500,000 by 20. In NW Furniturescase, the answer is $10 million.

Add book value, and you arrive at $13million.

This means, in the underwritersopinion, NW Furniture, is worth $13Million.


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So how much are they willing to give up?

Our young couple, now in their 30s,must decide how much of the companythey are willing to sell.

Right now, they own 100% of thebusiness.


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Giving it up

The more they sell, the more cashtheyll raise, but they will also begiving up a larger part of theirownership.

As the company grows, that ownershipwill be worth more, so a wiseentrepreneur would not sell more thanhe or she had to.


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NW Furniture Goes Public!

After discussing it, the couple decides tokeep 60% of the company and sell the other40% to the public as stock.

[This means that they will keep $7.8 millionworth of the business. Because they own amajority of the stock, they will still be incontrol of the store.]

The other 40% they sold to the public isworth $5.2 million. The underwriters find investors who are

willing to buy the stock, and give a check for

$5.2 million to the couple.


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So now they have cash to expand.

Although they own less of thecompany, their stake will hopefullygrow faster now that they have the

means to expand rapidly. Using the money from their public

offering, NW Furniture successfully

opens the two new stores and have$1.2 million in cash left over.

[remember it was going to cost $4

million for the new stores].


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Expanding

Business is even better in the newbranches, which are in more populatedcities.

The two new stores both make around$800,000 a year in profit each, withthe old store still making the same

$500,000. Between the three stores, NWFurniture now makes an annual profitof $2.1 million dollars.


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So what are they worth now?

This is great news because, althoughthey dont have the freedom to simplyclose shop anymore, the business isnow valued at $51 million dollars

[multiply the new earnings of $2.1million per year by 20 and add the

book value of $9 million; there arethree stores now, instead of one]. The couples 60% stake is worth $30.6

million dollars.


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Ahh, thats how it works!

With this example, its easy to see how smallbusinesses seem to explode in value whenthey go public.

The original owners of the company are, in asense, wealthier overnight. Before, the amount they could take out of

the business was limited to the profit. Now, they are free to sell their shares in the

company at any time, raising cash quickly.

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