Wall Street for dummies

Factual Questions
1

This thread is an appeal to the stock market expertise that is in ample display in Doper Land. My objective is to present a forum that could be used to evacuate frequent misconceptions and doubts regarding the subject.

I will start it off with a few inquiries. Everyone is welcomed to post their own questions. And, of course, those in the know are invited to step in and help dispel some ignorance.

Now, to my questions:

Why is the Dow Jones index called an industrial average. That doesn’t sound proper since it includes in its sample service-oriented companies such as McDonalds and Walt Disney. Is this erroneous naming a result of tradition?

What prompts companies to do stock splits?

2

Dunno about your first question, but as for your second, suppose you start a company. After the IPO your shares stableize at $10. Then you invent the Widget. Your stock surges to $500 a share! Everyone who invested in you is happy. But the high price makes it difficult for people to buy individual shares. So you create twice as many shares for half the price. If Dude X had 1000 shares worth $500, he now has 2000 shares worth $250. This has other advantages. Since the major stockholders have more shares, they have more freedom in their transaction. Also, the more accessable price will mean more people buying, thus the value will get an added boost.

Or at least that’s what I remember from when someone 'splained it to me.

I have a stock broker who I pay to know these things.

3

As for the first part of your question,

the Industrial Index is really named to differentiate from some other indices like the Dow Jones Utility and Dow Jones Transportation. When first derived, I don’t think there was much distinction between service based companies and heavier industries like automobiles and steel. So it is really a broader interpretaion as service industries have becoming a larger share of the production.

4

Splits are usually touted as only an accounting measure which keeps share prices in a convenient range. Warren Buffet never believed in them, and BRKA has a share price in the 60000’s right now.

There are pyschological reasons, though. Naive investors may not wish to invest in a $80 stock, but will look at a company they’ve heard of at $40/share, and say “gee, that’s a good price” in spite of the fact that it is selling at exactly the same multiple over earnings that it had pre-spli at 80.

It also increases liquidity. I have a perfect example of where it may be sorely needed. I have a position in Macromedia (MACR) from an old employee option. Take a look at them. They bounce up and down like a yo-yo. If you look closer, you realize that (in addition to being a very volatile high tech issue to begin with) they have 52 million shares outstanding, and less then 20 million float (shares not held by insiders or large investors). They have an average daily volume of 1 million - they are trading over 5% of their float on a daily basis. If a split happened, the theory goes, it would allow smaller investors to get in as you could trade the issue in smaller increments. The daily volume would go up, but probably not double, and they might only trade 3 or 4 % of their float daily.

5

Hope someone can explain this to me:
Stocks represent a portion of ownership, right?
I know that a company sells stocks to raise capital for whatever reason. However, what effect does the value of the stock after it’s been sold have on the business? If I buy 100 shares of Consolidated Great Company for $10 a share, and a year later they’re worth $100 and I sell, does Consolidated Great Company reap any benefit from that? There can only be so many stocks on any given company, right? So they can’t just create more stocks to sell, can they?

In case you haven’t guessed, I don’t have any stocks and I have yet to figure out what it’s all about.

I’m not even going to try to understand “futures”…

6

In a straight 2-for-1 split, the amount of shares doubles but the prices splits by half. This makes the investor have more shares but each individual one is worth less. It is only a paper transaction; the investor’s overall stock account balance doesn’t decrease at all.

If a guy has 1 share at $50 and it splits, he now has 2 shares worth $25 each. He still has $50 worth of stock.

In your example, the price of each share has decreased by half, but the overall value is still $500.00

Before split: 1,000 shares at $0.50 per share = $500.00
After split: 2,000 shares at $0.25 per share = $500.00

There are also 3-for-1 splits and reverse splits, but they are nowhere near as common as 2-for-1 splits.

7

No, at least not directly. The company gets money from the original sale of stock, but nothing after that. However, the stock price is a measure of how good the company is doing, so the company makes decisions in order to please the stockholders. Stockholders are the owners of the company. Although they have no day-to-day say, if they don’t like what the company is doing, they can change the board. More likely nowadays, they can sell their stock to another company that is trying to take over the original. So if the stock is too low, the company is bought up and the officers canned.

Each company is chartered to sell a certain amount of stock. In theory, they can continue to sell stock up to that limit, but they hardly ever get near the limit. If a company needs money, it can try to sell more stock, but there are complications. For instance, any additional stock affects the price of the existing stock.

You make your money from stocks in two ways: dividends (companies pay a certain amount per share to all stockholders) or appreciation (i.e., the stock goes up). Most people nowadays are looking for the latter method, since it gives greater returns.

8

If you were saying that the guy has 1,000 shares worth $500 each* and after the split he has 2,000 shares worth $250 each, then your description of how splits work is correct.

I thought you were saying the total value of all his stock went from $500 to $250 - which, if you were, then my “friedo, you were wrong” post stands.

Of course, I noticed that I may have misinterpreted after hitting “submit.” Isn’t that always the way it happens …

9

I’ll try this.

There is a thing called the company’s “Market Cap”, short for “Market Capitalization”. It is arrived at by multiplying the number of shares by the share price, and generally viewed as what the company is “worth”. Companies are generally sized on the basis of this value as “large-cap”, “mid-cap”, “small-cap”, etc, terms which you will have heard. Large cap companies are generally viewed as more stable, and better risks. The market cap also translates into ability for the company to negotiate larger loans and so on to fund their projects, or acquire other companies. Think of it the way you would think of the collateral in your house.

Also, many of the company’s principals have probably retained large positions, and the company may have been giving employees stock options or allowing them to participate in an ownership plan. These people are obviously very happy if the stock goes up and may stay there as a result.

10

As for why companies choose to split stock, I tend to think Yabob has the right of it in that it’s mostly psychological. People will look only at the price of a stock without stopping to other relevant factors (price-to-earnings, growth, etc…).

I’m not sure I buy the liquidity argument. Again, I think this is more of a psychological thing than anything else. In this case, however, it’s the psychological impulse to buy stock in nice round numbers of lots (100, 200, etc…). There is absolutely nothing stopping you from buying 1 share of a stock, but there is a stigma attached to this practice (i.e., odd-lotters don’t know what they’re doing).

There are exceptions to this, of course. One such exception is Berkshire Hathaway BRKA stock. The share price is so high that many people cannot reasonably afford to buy even a single share of the stock. This prompted the company to issue BRKB stock, which is essentially a splitted version of the original issue (20-1 or something like that, I think).

An interesting effect of stock splits, however, is that because of these psychological factors, the share prices tend to rise after a split, benefitting current shareholders. I believe this is what Warren Buffet, being a value investor, objects to. After all, the reasoning goes, the company hasn’t gained value simply by the paper transanction of splitting stock, so why should it’s market capitalization (# of shares outstanding x share price) increase? He argues that stock splits merely increase volitility.

FairyChatMom, I don’t believe companies get anything out of the value of the stock once it’s sold to the general public. I imagine though that there’s a “confidence factor” involved here, in that poor performance in the stock market would be deemed to reflect poor performance of the company at large. Along those lines, a company certainly could issue new stock if they so chose, in order to raise more cash, and in fact, companies have done this in the past. This practice generally has a negative impact on the share price, however. If the total value of all issued stock is suppose to correlate in some fashion to the worth of a company (however you choose to define worth), then if you suddenly issue new shares, the value of each share should decrease.

11

Buffet only created the BRKB stock in response to the proposed formation of a mutual fund that would invest only in BRKA stock, then selling shares of that fund based on the value of the holdings. This fund would have effectively split the BRKA stock without Buffet having anything to do with it.

I don’t have any cites handy, but if I recall my finance classes correctly, a stock which has split does not perform any better over a reasonable period of time than one which has not. That is to say, when adjusted for portfolio risk and market fluctuation, the company is worth just as much as would be expected had the stock not split.

That doesn’t mean there aren’t short term distortions, just that as the folks snap up the shares that now are in a price range that lets their psyche buy them, bidding up the price, the big players see the stock as overpriced and unload shares brining the price back into equilibrium.

12

[hijack]
sdimbert has started a game over in MPSIMS for those of us that don’t know enough about the market to risk real money, and this seemed like a cool place to advertise for more players. We use a site called Virtual Stock Exchange to trade on, and we’re gonna see who can raise the most green by the end of the year.

He’s given the game a clever name, calling us the Teeming Millionaires.

The MIPSIMS thread is at: http://boards.straightdope.com/sdmb/showthread.php?threadid=41234 You can pretty much ignore the first two pages of the thread, since the game started on a different stock site. It had bugs, so we had to switch to VSE.

13

That’s what I was saying. I will turn myself in to the Ambiguity Police immediately.

14

Indysloth,

Thanks, didn’t know that about Berkshire Hathaway. But IIRC, you are actually permitted to trade in your shares of BRKB for BRKA at whatever the “split ratio” is (it’s something like 20 to 1). The kicker is that you can’t trade the other way, so the problem with volatility is somewhat avoided (i.e., you can’t turn a quick profit by buying and selling BRKA and BRKB back and forth in an attempt to capitalize on slight value differences between the two issues).

Yes, a stock doesn’t perform different before or after a split in the long term, if the value investors are to be believed. But it’s the short term ramp up of the stock value (motivated by the psychology of the “low” post-split share price) that causes the volatility in the stock.

15

friedo, the Ambiguity Police, in their guise as the Read Thoroughly Before You Post Police, are too busy with me to worry about you.   ;)

16

Another twist to the “market cap thing” is that companies often issue bonds rather than take out loans like you would. The lower a ratio of debt they have, and the less risky they are viewed as being, the higher quality their bond issues are. They can sell their bonds at lower interest rate.

17

Yabob said

Could you please elaborate on the concept of float shares. Is there a quantitatively defined limit, starting at which a stock ceases to be called outstanding and begins to be referred to as floating? Or in other words, what conditions must an investor need satisfying in order to be considered an insider or large investor?

Fairy Chat Mom

As far as my understanding goes, futures are issues that you commit yourself to buying at a fixed price, on a previously established time in the future–hence their name. This is a risk management alternative that allows you to protect yourself from the possible fluctuations that may affect the issues you are dealing with…

Of course this a very elementary explanation. Hopefully a more knowledgeable doper will come on board and provide a more precise definition.

Reality Chuck said

Who determines up to what point can a certain company emit stock? Does the SEC do it? How do they come with that limit and what does it represent, that is, is it fixed by the market value of the organization or, if it is not, by what consideration is it established?

18

The corporation’s charter tells how much stock the corporation is authorized to sell. It may say something like “XYZ Corporation is authorized to sell 500 million shares of stock.” It will most likely sell a number way under the limit – say 100 million.

The corporation picks a number that should encompass any stock offerings that may ever be made. I think, though, you can amend your charter to increase the number.

The SEC goes over a company’s prospectus, but primarily to check for fraud.

19

They don’t. The float is a portion of the outstanding shares. The yahoo profile page which I was quoting the numbers from said this in their help page:

How rigorously defined the concept has to be I don’t know, but the basic idea is that it is a measure of shares in the hands of the public as opposed to shares held by insiders and large (probably institutional) investors. Never mind “rule 144”. Macromedia’s float only being 40% of the outstanding shares is extraordinarily low. Numbers like that are more typical of recent IPO’s. For example, Apple has 336 million outstanding shares and a 322 million share float.