To many people, stocks are merely ticker symbols that go up seemingly at random. But for those of us that know how the stock market actually works, stocks do not move at random, but instead follow the trajectory of a real life business. To understand this, one needs to understand what a share is.
A share of stock is just an ownership stake in a business.
It is really that simple.
Shares are claims to partial ownership of an underlying business. Buying shares entails you becoming part owner of a business. They are claims to the profits of actual real world businesses. Having this paradigm shift will allow one to see the stock market in another way, not merely a conduit for gambling, but that which can build wealth over time.
I think a big part of the reason people are scared away from investing is they don’t understand that a share of stock is a piece of ownership.
Let’s look at the Colgate-Palmolive Company as an example.
When you look at Colgate Palmolive , you see a business that sells great products ranging from Colgate toothpaste to Protex soap to Axion dishwashing liquid to Hills pet food.
Last year, it brought in $15,544,000,000 in sales. After paying all of the expenses, salaries, and taxes, the owners were left with $2,400,000,000 in profit.
Since the company that is Colgate is divided into roughly 873,000,000 ”pieces”, or shares, each piece of the business was entitled to $2.75 of the profits. So if you own one share of Colgate, $2.75 would be attributable to you.
It’s a really simple thing. If you owned 1,000 shares, it means your cut of the sales came to $17,800. It means your cut of the profits were £2,750.
Likewise, if you owned 10,000 shares, it means your cut of the sales came to $178,000. It means your cut of the profits were £27,500.
Whilst the profit is attributable to you, the Board of Directors make a decision of how much they are going to pay out in dividends and of how much they want to retaining order to upgrade equipment, research new products, expand factories, acquire new companies or whatever else they think will help the business in the long-run.
For the last financial year, they decided that they were going to mail $1.66 per share in dividends. They would keep the rest of the profits of, $1.15 per share in order to reinvest it within the business.
The maths again is simple. If you own 1,000 shares, you would have $1,666 paid to you in four equal instalments a year.
If you own 10,000 shares, you would collect $16,666 a year in cold hard cash.
What’s marvellous about it is this is a totally democratic process. Your share of Colgate Palmolive doesn’t care if you are male or female, old or young, black or white, Christian or atheist, gay or straight, conservative or liberal … it is still entitled to 1/873,000,000ths of Colgate’s results for the year.
If toothpaste profits are up, you make more money. If dishwashing liquid profits are up, you make money. If pet food profits are up, you make money.
It is really that simple.
In fact, investors have been reaping the rewards from Colgate Palmolive for many years. As a result of constant growth and profitability in its range of brands, Colgate has paid increasing dividends for the past 50 years.
Instead of focusing on those numbers – how much stuff is sold and how big the profits are – investors get caught up in “the stock market”, which is nothing more than a giant auction where people who want to buy or sell ownership pieces get together and try to work out a deal. In other words, they focus not on the economic engine of Colgate Palmolive – selling fast moving consumer products- but on what other people are paying for an ownership stake at the time.
Take a look back over the past 50+ years. There have been periods when Colgate’s shares would skyrocket or crash. There have been multiple wars, recessions, oil crises, financial crises, multiple government administrations, inflation, deflation, the rise of the Internet … yet, if you owned a stake in Colgate, you collected a heck of a lot of cash.
A period like 2008-2009 is a wonderful example. The stock fell close to 30% as people tried to liquidate whatever they could during the recession, yet dividends at Colgate were increasing!
Far from being upset, even if your account statement had fallen by half, this is a cause for celebration. It means you could buy even more ownership for a cheaper price if you wanted to increase your stake in the firm so you got to keep more of the money brought in from Ajax, Palmolive soap, Sanex, Speed Stick and Sta Soft.
I’m looking at a table of the Colgate dividend payments dating back to 1965 as I type this and it’s just a beautiful thing. No matter what happened in the stock market, that list shows you that Colgate kept sending you more and more money. You take the number of shares you owned multiplied by the dollar and cents amount and that’s how much cash appeared in your account. And because the products are so steady, this is a business that has a reputation for delivering uninterrupted year on year dividend growth.
That’s money you can use to buy more shares of Colgate, if you want, or go out to dinner, buy theatre tickets, get a new car, help pay for a university education, get a new pair of trainers, or whatever else you desire. That money showed up during stock market crashes and booms.
If you want to understand Colgate, start by reading the most recent annual report to owners . It may seem confusing at first, but highlight the parts you understand. No one is born with the ability to know what all of that means. It’s a learned skill, just like riding a bicycle or learning how to talk. That’s how I started – I picked up annual reports a long time ago and began to notate them as I tried to figure out what all the charts and numbers meant. It exists to tell you how the business is doing; where the money is coming from, where it is going, and how much is left for you, the owner.
I think the taboo of the stock market would fizzle out if people focused on buying ownership in companies they understand, that produce real profits, and then sitting back and collecting their dividends. They would no more see it as casinoesque with random movements in stock prices. By focussing on the underlying business,, one would be able to see why stock prices go up or down over the long term.
So that’s it. That is what a stock is. It is really simple.
But as stated in lesson 1, any investor who wants to invest in individual stocks has to put in the work in order to understand the business. Not doing so would be akin to a bull in a china store.
(P.S I sell a stock list which provides the names of companies I have researched and I deem to be the best in the world)
If the research process which we will discuss in a lesson further down the line seems daunting to you, but you still want to put your money to work in the stock market and benefit from its long term compounding effect, worry not. They are other ways to benefit from he stock market without you having to personally pick individual companies. And that is what the next two lessons are about – investing in index funds and mutual funds. So stay tuned for the next lessons.