Personal Finance for Professionals Part II – Investing in Stocks & Bonds
Welcome to Personal Finance for Professionals, Part II, which will explore investing in stocks and bonds. In this series, you will learn about these two asset classes: what they are, why you should invest in them, and mechanically how to do it. You will receive an MBA-level education on stocks and bonds that will prepare you to manage your own investments or make informed decisions when allowing someone else to do it for you.
In Personal Finance for Professionals Part I, which contained six lessons and covered the basics of personal finance, we learned that the most important component of building wealth is to spend less than you earn and invest the difference. You may have found yourself asking, “ok, that makes sense, but invest in what?” In Part II of this series, you will learn the answer to that question and many more.
What is Investing?
Investing is defined as purchasing an asset that you expect to increase in value so that you can sell it for a profit in the future. Passive investing is when you buy an asset for which you have no direct control – you are simply along for the ride. Active investing is where you have some control over the outcome – you work in an attempt, but not a guarantee, to make the asset increase in price.
Asset Classes
In the context of personal finance, an asset is something of value that you own that can be used to produce positive economic value. Assets represent a value of ownership that can be sold or leveraged for cash. There are many forms of assets, but for our purposes, the most common are listed below.
Tradable financial assets that hold monetary value and represent ownership are called securities. Both stocks and bonds are considered securities, whereas physical assets such as real estate, gold, and currencies are not.
We’ll discuss securities here in Part II, while Real Estate is covered in Part IV. These are the most common asset types owned by individual investors, and medical professionals should thoroughly understand each of them.
Understanding Stocks
The Basics
Investing in the stock market is fundamental to building your net worth and becoming financially independent. And discussion of stocks and the stock market is ubiquitous, from Jim Cramer on traditional media to financial influencers on social, from Hollywood blockbusters like The Wolf of Wall Street to the talkative Cardiologist in the doctor’s lounge.
But how many of us really understand stocks and how the stock market functions? In the following lessons, you will learn everything you need to know to feel comfortable investing in this asset class. Let’s start by answering a few basic questions.
What is a Stock?
Stock simply represents ownership of a business. A company can be divided into shares of stock, or discrete ownership units. If you own stock in Apple, you own a tiny fraction of the company, which generally allows you to participate in the financial outcome of the business.
Why Would a Company Issue Stock?
If stock represents ownership, why would a company want to sell part of itself? Businesses need money for many things, including routine operations, inventory, growth, capital expenditures/equipment, and acquisitions. There are only so many ways for a company to raise money.
A small business can raise money through a capital call, in which each owner is required to contribute an amount commensurate with their ownership percentage. This method is limited by the owners’ financial resources and the size of the ownership group, making it feasible for smaller, private companies with few owners. Another way is through an asset sale. A business can sell equipment or real estate it owns to raise cash, which is obviously limited by how many tangible assets it owns and is of limited utility for growth.
Another way for a company to raise money is through retained earnings, when a business uses its profits to grow rather than distributing them to owners. However, this method is limited by the company’s profit. During a period of rapid growth, retained earnings are often insufficient.
A company may also take on debt by borrowing from a bank or other lending institution or by issuing bonds, which are like IOUs. However, there is a limit to how much debt a company can raise. Much like an individual, the amount and interest rate of the debt are closely related to the borrower’s creditworthiness. The company must generate sufficient profits to repay the loans, and these payments limit future optionality.
The final way for a business to raise money is by selling equity, or ownership, in the form of stock. A company only receives money from the sale of stock when it sells it directly. Once a share of the company has been sold, any resale of that share benefits the current stockholder (or shareholder), not the company. It’s like selling cars – Toyota only makes money when you buy the car from them, not when you sell it to someone else. Every time a company issues stock, it dilutes the current owners’ stake in the business, so this method must be used in moderation.
What is a Public vs a Private Company
While stock can represent ownership in any business, we will focus only on publicly traded companies, as there are significant differences between investing in public and private businesses.
Public companies are allowed by the government to sell their stock directly to the public as long as they follow specific regulations regarding the format of their accounting and the transparency of their finances and operations. Shares of public companies are listed on a stock exchange, such as the NY Stock Exchange (NYSE) or the NASDAQ, where institutions and private investors may purchase them. Because of tight governmental regulations and a large market, shares of publicly traded companies are liquid, meaning they can be freely bought and sold.
In contrast, private companies are usually smaller with more opaque finances and operations because the government does not specifically regulate them. While they must provide financial information to their owners, they are not required to make that information public. Private companies may issue stock, but the shares are not listed on an exchange and must be bought and sold by private buyers, making their stock illiquid.
What are Public Offerings?
An initial public offering, or IPO, occurs when a private company sells stock to the general public for the first time. This generally dilutes existing private shareholders by creating additional shares; however, it allows an avenue for the original investors to cash in on their ownership stake by making their equity more liquid.
IPOs are usually underwritten by an investment bank, which the company hires to sell or offer the shares to the public. As in our Toyota example above, it is important to remember that once a company sells stock, any further trading of those shares no longer benefits the company.
A publicly traded company that wishes to raise additional capital by selling equity can also conduct a secondary offering of stock, which is similar to an IPO. This event is also dilutive to current shareholders, and companies must use this option sparingly.
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Putting it All Together
In order to understand stocks, you have to understand business, so let’s discuss a company named Slater Industries. The company was founded and operated by John. He owns 100% of the business and, over several years, grows it into a profitable enterprise. John eventually decides that he needs more capital (money) to expand the business. John has two options. He could sell part of the company (equity) to raise capital, or he could borrow it (debt).
Slater Industries is worth $1,000,000. John decides to sell equity to raise the money, so he divides the business into 100 equal shares, each valued at $10,000.
100 shares x $10,000/share = $1,000,000
Samantha purchases 10 shares from John for $100,000 and now owns 10% of the business. She now has equity in Slater Industries, which entitles her to a share of the company’s profits.
John uses the $100,000 to buy inventory and expand the business. Over the next five years, Slater Industries grows to be worth $10,000,000. Each share is now worth $100,000. Believing the business still has room to grow if he just had more capital, John sells 10 more shares to David for a total of $1,000,000, which is used for further expansion. The ownership of the company is now:
| Owner | # of Shares | % Ownership | $ paid | Current Value |
| John | 80 | 80% | $0 | $8,000,000 |
| Samantha | 10 | 10% | $100,000 | $1,000,000 |
| David | 10 | 10% | $1,000,000 | $1,000,000 |
| Total | 100 | 100% | $1,110,000 | $10,000,000 |
Ten years later, Slater Industries has grown to $100,000,000 in value. The owners are all rich, but their money is tied up in the company because it has used all its profits to grow. The company’s private stock has increased in value, with each share now worth $1 million!
| Owner | # of Shares | % Ownership | $ paid | Current Value |
| John | 80 | 80% | $0 | $80,000,000 |
| Samantha | 10 | 10% | $100,000 | $10,000,000 |
| David | 10 | 10% | $1,000,000 | $10,000,000 |
| Total | 100 | 100% | $1,110,000 | $100,000,000 |
The owners would like to cash out some stock to diversify their portfolios and enjoy their wealth. They also believe that if the business had more cash, it could expand and grow faster. The owners decide to “go public” through an initial public offering (IPO). An IPO is the mechanism by which a company sells shares to the general public for the first time. The private company usually retains an investment bank to sell a set number of shares during the IPO.
Slater-Industries contracts with Goliath Bank for the IPO, which values the company at $ 100 million. The stock is split into five million shares, each valued at $20. Goliath Bank agrees to sell one million shares, or 20% of the company. If successful, this will raise $20,000,000 that Slater-Industries can use for expansion.
The original owners still own 80%, and after a predetermined “lock-up” period, they can choose to sell their shares on the open market to cash out their equity. If the stock price rises to $30 per share, the company’s market value will be $150,000,000. The market value of a company is the number of shares outstanding multiplied by the current share price. For Slater Industries, this is 5 million shares x $30 per share = $150,000,000 market value.
| Owner | # of Shares | % Ownership | Current Stock Price | Current Value |
| John | 3,200,000 | 64% | $30 | $96,000,000 |
| Samantha | 400,000 | 8% | $30 | $12,000,000 |
| David | 400,000 | 8% | $30 | $12,000,000 |
| Public Shares | 1,000,000 | 20% | $30 | $30,000,000 |
| Total | 5,000,000 | 100% | $30 | $150,000,000 |
John now has an unrealized capital gain of $96 million, Samantha $11.9 million, and David $11 million.
Conclusion
Now you know the basics of stocks and how they relate to business. Lesson two in this series, Understanding Stock Investing, explores how to value individual stocks and introduces the stock market. If you haven’t already read Personal Finance for Professionals Part I, you should do that now.
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