An introduction to the stock market Have you always wanted to know how to understand a company's annual report and

financial statements? In this series of lessons, we set out to teach you how to take the financial statements of a company and carefully analyze them to determine what the stock is truly "worth". This allows you make better investin decisions by helpin to avoid the costly mistake of purchasin a company when its share price is too hi h. !ventually, by readin , printin , and studyin these lessons, you will be able to pick up a balance sheet and truly understand what the numbers mean. "t the end of each lesson there is a #uiz to test your understandin of what you learned. In this first installment, we are oin to look at why the stock market e$ists and e$plain how a business oes from bein a small, family%owned company to a corporation with publicly traded stock. Financial Terms Earnings per Share& The amount of profit to which each share is entitled. Going Public& 'lan for when a company is plannin an I(). IPO& 'hort for Initial (ublic )fferin . "n I() is when a company sells stock in itself for the first time. Market Cap& The amount of money you would have to pay if you bou ht ever share of stock in a company. *To calculate market cap, multiply the number of shares by the price per share.+ 'hort for ,arket -apitalization. Share& " share represents an investor's ownership in a "share" of the profits, losses, and assets of a company. It is created when a business carves itself into pieces and sells them to investors in e$chan e for cash. Ticker Symbol& " short roup of letters that represents a particular stock *e. ., "-oca -ola" is referred to as ".)".+ /nderwriter& The financial institution or investment bank that is doin all of the paperwork and orchestratin a company's I(). Introduction The stock market can be a reat source of confusion for many people. The avera e person enerally falls into one of two cate ories. The first believe investin is a form of amblin 0 they are certain that if you invest, you will more than likely end up losin your money. )ften these fears are driven by the personal e$periences of family members and friends who suffered similar fates or lived throu h the 1reat 2epression. These feelin s are not round in facts and are the result of personal e$perience. 'omeone who believes alon this line of thinkin simply does not understand what the stock market is or why it e$ists. The second cate ory consists of those who know they should invest for the lon %run, but don3t know where to be in. ,any feel like investin is some sort of black%ma ic that only a few people hold the key to. ,ore often than not, they leave their financial decisions up to professionals, and cannot tell you why they own a particular stock or mutual fund. Their investment style is blind faith or limited to 4this stock is oin up. 5e should buy it.6 This roup is in far more dan er than the first. They invest like the masses and then wonder why their results are mediocre *or in some cases, devastatin +. In this series of lessons, I set out to prove that the avera e investor can evaluate the balance sheet of a company, and followin a few relatively simple calculations, arrive at what they believe is the 4real6, or intrinsic value of the company. This will allow a person to look at a stock and know that it is worth, for instance, 789 per share. This ives each investor the freedom to know when a security is undervalued, increasin their lon %term returns substantially.

:efore we e$amine how to value a company, it is important to understand the nature of businesses and the stock market. This is the cornerstone of learnin to invest well. :usiness is the cornerstone of every economy. "lmost every lar e corporation started out as a small, mom%and%pop operation and throu h rowth, became financial iants. 5al% ,art, 2ell -omputer, and ,c2onald3s had combined profits of 7;9.<8 billion this year. 5al% ,art was ori inally a sin le%store business in "rkansas. 2ell computer be an with ,ichael 2ell sellin computers out of his colle e dorm room. ,c2onald3s was once a small restaurant no one had heard of. How did these small companies row from tiny, hometown enterprises to three of the lar est businesses in the "merican economy? They raised capital by sellin stock in themselves. 5hen a company is rowin , the bi est hurdle is often raisin enou h money to e$pand. )wners enerally have two options to overcome this. They can either borrow the money from a bank or venture capitalist, or sell part of the business to investors and use the money to fund rowth. Takin out a loan is common, and very useful = to a point. :anks will not always lend money to companies, and over%ea er mana ers may try to borrow too much initially, wreckin the balance sheet. >actors such as these often provoke owners of small businesses to issue stock. In e$chan e for ivin up a tiny fraction of control, they are iven cash to e$pand the business. In addition to money that doesn3t have to be paid back, 4 oin public6 ?as its called when a company sells stock in itself for the first time@, ives the business mana ers and owners a new tool& instead of payin cash for an ac#uisition, they can use their own stock. To better understand how issuin stock works, let3s look at a fictional company 4":>urniture, Inc. "fter ettin married, a youn couple decided to start a business. It would allow them to work for themselves, as well as arran e their hours around their family. :oth husband and wife have always had a stron interest in furniture, so they decide to open a store in their hometown. "fter borrowin money from the bank, they name their company 4":>urniture6 and o into business. The first few years, the company makes little profit because the earnin s are plowed back into the store, buyin additional inventory and addin onto the buildin to accommodate the increasin level of merchandise. Ten years later, the business has rown rapidly. The couple has mana ed to pay off the company3s debt, and profits are over 7A99,999 per year. -onvinced that ":- >urniture could do as well in several lar er, nei hborin cities, the couple decides they want to open two new branches. They research their options and find out it is oin to cost over 78 million dollars to e$pand. Bot wantin to borrow money and be strapped with interest payments a ain, they decide to sell stock in the company. The company approaches an 4underwriter6, such as 1oldman 'achs or C( ,or an, who determines the value of the business. "s mentioned before, ":- >urniture earns 7A99,999 after%ta$ profit each year. It also has a book value of 7< million ?the value of the land, buildin , inventory, etc. subtracted by the company3s debt@ The underwriter researches and discovers the avera e furniture stock is tradin at D9 times earnin s ?a concept we will discuss more in%depth later@. 5hat does this mean? 'imply, you would multiply the earnin s of 7A99,999 by D9. In ":-3s case, the answer is 7;9 million. "dd book value, and you arrive at 7;< million. This means, in the underwriter3s opinion, ":- >urniture, is worth thirteen million dollars. )ur youn couple, now in their <93s, must decide how much of the company they are willin to sell. Ei ht now, they own ;99F of the business. The more they sell, the more cash they3ll raise, but they will also be ivin up a lar er part of their ownership. "s the company rows, that ownership will be worth more, so a wise entrepreneur would not sell more than he or she had to.

"fter discussin it, the couple decides to keep G9F of the company and sell the other 89F to the public as stock. ?This means that they will keep 7H.I million worth of the business. :ecause they own a maJority of the stock, they will still be in control of the store.@ The other 89F they sold to the public is worth 7A.D million. The underwriters find investors who are willin to buy the stock, and ive a check for 7A.D million to the couple. "lthou h they own less of the company, their stake will hopefully row faster now that they have the means to e$pand rapidly. /sin the money from their public offerin , ":>urniture successfully opens the two new stores and have 7;.D million in cash left over ?remember it was oin to cost 78 million for the new stores@. :usiness is even better in the new branches, which are in more populated cities. The two new stores both make around 7I99,999 a year in profit each, with the old store still makin the same 7A99,999. :etween the three stores, ":- now makes an annual profit of 7D.; million dollars. This is reat news because, althou h they don3t have the freedom to simply close shop anymore, the business is now valued at 7A; million dollars ?multiply the new earnin s of 7D.; million per year by D9 and add the book value of 7K million0 there are three stores now, instead of one@. The couple3s G9F stake is worth 7<9.G million dollars. 5ith this e$ample, it3s easy to see how small businesses seem to e$plode in value when they o public. The ori inal owners of the company are, in a sense, wealthier overni ht. :efore, the amount they could take out of the business was limited to the profit. Bow, they are free to sell their shares in the company at any time, raisin cash #uickly. This process is the basis of 5all 'treet. The stock market is, at its core, a lar e auction where ownership in companies Just like ":- >urniture is sold to the hi hest bidder each day. :ecause of human nature = the emotions of fear and reed = a company can sell for far more or less than its intrinsic value. The ood investor3s Job is to identify those companies that are sellin below their true worth and buy as much as they can.
hen a company !ants to issue stock in itsel"# it has an IPO$ hat is an IPO% a+ Investment (rofit )peration b+ " 2ividend c+ " ,eetin with the 1overnment d+ Initial (ublic )fferin I" a company !anted to borro! money# but did not !ant to go to a bank# !hat could it do% a+ :uy 'tock b+ Issue :onds c+ 2eclare a stock split d+ :uy :onds &ook 'alue is$$$ a+ The size of the company's bank account b+ The value of the company's assets minus debt c+ The current stock price d+ "nother word for stock options A company that speciali(es in taking other companies public is called$$$ a+ :ank b+ :rokera e c+ /nderwriter d+ Lenture -apitalist &esides raising money# stock is use"ul "or$$$ a+ (ayin for "c#uisitions b+ 5ritin down income ta$es c+ Increasin :ook Lalue d+ Eeducin 2ebt The "ounders o" A&C Furniture o!ned )*+ o" the e,uity$ hat is e,uity% a+ Lotin (ower b+ 2ebt c+ (rice d+ )wnership At the end o" our e-ample# A&C Furniture !as !orth ./0 million$ a+ :ook Lalue c+ ,arket -ap b+ :alance 'heet d+ -ost (er 'hare hat is another term "or this%

I" A&C Furniture earned ./ million dollars o" pro"it in a year# and the company had a market capitali(ation o" .1/ million# !hat is the P2E 3atio%

a+ ;8 c+ K

b+ ;H d+ DD

Assume A&C Furniture has a market cap o" .45 million dollars# and 6$/5 million shares o" stock issued$ 7o! much is each share selling "or% a+ 7<;.DA c+ 7D<.8H b+ 7<A.99 d+ 7DI.IA

8sing the ans!er "rom the pre9ious ,uestion# i" A&C paid a di9idend o" .6$0* per share# !hat !ould the yield be% a+ I.A<F c+ G.<AF b+ H.DIF d+ I.G;F

I" a company paid a di9idend o" ./$0* per share and the yield !as 1$0:+# ho! much is the stock currently trading at% a+ 7G;.AK c+ 78H.<A b+ 7I<.H9 d+ 7GD.GA

hat is another name "or an 8nder!riter% a+ Investment :anker b+ Investment :roker

c+ (rivate !#uity >irm d+ -ommodities 2ealer I" an under!riter took a company public at 56 times earnings ;annual pro"it !as .05$)/ million<# the original "ounders retained 5/+ o" the common stock# and the under!riters took 4+ as their "ee# ho! much cash !as raised "or the company% a+ 7<DI,KD;,999 b+ 7DA<,<88,999 c+ 7<9;,8IK,999 d+ 7;HD,GH8,999