HONORS ECONOMICS Investing 101

From a legal point of view, there are three common types of businesses: sole proprietorship, partnership and corporation. Each has different and important implications for liability, taxation and succession.

Advantages and Disadvantages of a Sole Proprietorship

This is the simplest way to set up a business. A sole proprietor is fully responsible for all debts and obligations related to his or her business. A creditor with a claim against a sole proprietor would normally have a right against all of his or her assets, whether business or personal. This is known as unlimited liability.

In a proprietorship, one person performs all the functions required for the successful operation of the business. The proprietor secures the capital, establishes and operates the business, assumes all risks, accepts all profits and losses, and pays all taxes. The proprietor is said to be self-employed.

Advantages

• Low start-up costs
• Greatest freedom from regulation
• Owner in direct control of decision making
• Minimal working capital required
• Tax advantages to owner
• All profits to owner

Disadvantages

• Unlimited liability
• Lack of continuity in business organization in absence of owner
• Difficulty in raising capital

Advantages and Disadvantages of Partnership

A partnership is an agreement in which two or more persons combine their resources in a business with a view to making a profit. In order to establish the terms of the partnership and to protect partners in the event of a disagreement or dissolution of a partnership, a partnership agreement should be drawn up. Standard form partnership agreements can also be purchased for about $5.00 at stationary stores. Partners share in the profits according to the terms of the agreement.

In a General Partnership, two or more owners share the management of a business, and each is personally liable for all the debts and obligations of the business. This means that each partner is responsible for, and must assume the consequences of, the actions of the other partner(s).

A second type of partnership is a Limited Partnership which involves limited partners who combine only capital. They are not involved in managing the business and cannot be liable for more than the amount of capital they have contributed. This is known as limited liability.

A limited partnership also involves general partners, who are involved in management. They are fully liable for the debts and obligations of the business, but may be entitled to a greater share of the profits.

Advantages:

• Ease of formation
• Low start-up costs
• Additional sources of investment capital
• Possible tax advantages
• Limited regulation
• Broader management base

Disadvantages:

• Unlimited liability
• Divided authority
• Difficulty in raising additional capital
• Hard to find suitable partners
• Possible development of conflict between partners
• Partners can legally bind each other without prior approval
• Lack of continuity

Advantages and Disadvantages of Incorporating

A corporation, also known as a Limited Company, is a legal entity which is separate and distinct from its members (shareholders). Each shareholder has limited liability. A creditor with a claim against the assets of the company would normally have no rights against its shareholders. Business must be incorporated at the state level by filing a charter.

Ownership interests in a corporation are usually easily changed. Shares may be transferred without affecting the corporations existence or continued operation.

The following characteristics distinguish it from a partnership or proprietorship:

Limited liability - normally no member can be held personally liable for the debts, obligations or acts of the corporation beyond the amount of share capital the members has subscribed; and

Perpetual succession - because the corporation is a separate legal entity, its existence does not depend on the continued membership of any of its members.

Advantages

• Limited liability
• Possible tax advantage (if you qualify for a small business tax rate)
• Specialized management
• Ownership is transferable
• Continuous existence
• Separate legal entity
• Easier to raise capital

Disadvantages

• Closely regulated
• Most expensive form to organize
• Charter restrictions
• Extensive record keeping necessary
• Double taxation of dividends
• Shareholders may be held legally responsible in certain circumstances
• Personal guarantees undermine limited liability advantage

Going Public

Corporations are normally financed through reinvestment; using the company's profits to expand or invest in technology to improve production or the product.  Corporations may also borrow money from banks for short-term purposes such as meeting payroll costs.  This is referred to as commercial paper.  Corporations may also borrow money from the public by selling corporate bonds.  A bond is a promise to repay the amount borrowed--called the principle--plus interest at a certain date in the future.  Bondholders are not owners of the company, they are creditors, and have no say in the management of the firm.

Companies discovered a long time ago that that another effective method to raise capital is to issue stock.  When companies start growing they need to find investors willing to invest on the company. They need to raise money to keep buying machines and products and to expand their businesses. So often the company will Go Public, meaning it will issue shares of the company as stock on the open market.  A stock is a share in the company which entitles the owner to a say in the management of the business as well as to a share of the profits of the corporation called a dividend. It is called going public because in order to sell shares, a corporation must open its finances and business plan to every potential buyer, or the entire public. 

The Stock Market is by definition a market in which shares of companies stocks are bought and sold.  Corporations needed to find the investors, while at the same time many investors want to find companies where they can invest their funds so they can receive income from the growth ad profits of those companies. That originated the Stock Market, which have been evolving and improving for a long time. People can trade and invest on this market through Exchanges. For example the New York Stock Exchange, or the American Stocks and Options Exchange. Exchanges are regulated agencies, which facilitate the transactions between buyers and sellers and ensure the fairness of each transaction for everyone. Stockbrokers also facilitate transactions for their clients and earn a commission for doing so.

Stock tables can be used to select promising investment opportunities and to monitor a stocks’ performance. The stock tables in major business publications, such as The Wall Street Journal and Investor’s Business Daily, are loaded with information that can help both investors and speculators.

The table below shows a sample stock table. Each item gives you some clues about the current state of affairs for a particular company.

Here’s what each column means:

• 52-week high: This column gives you the highest price that particular stock has reached in the most recent 52-week period.

• 52-week low: This column gives you the lowest price that particular stock has reached in the most recent 52-week period.

• Name and symbol: This column tells you the company name (usually abbreviated) and the stock symbol assigned to it. Financial tables list stocks in alphabetical order by symbol, and you need to use them in all stock communications.

• Dividend: A value in this column indicates that payments have been made to stockholders. The amount you see is the annual dividend quoted as if you owned one share of that stock.

• Volume: This column tells you how many shares of that particular stock were traded that day. If only 100 shares are traded in a day, the trading volume is 100.

• Yield: This column refers to what percentage that particular dividend is to the stock price. Yield, which is most important to income investors, is calculated by dividing the annual dividend by the current stock price.

• P/E: This column indicates the ratio between the price of the stock and the company’s earnings. This ratio (also called the earnings multiple or just multiple) is frequently used to determine whether a stock is a good value.

• Day last: This column tells you how trading ended for a particular stock on the day represented by the table. Some newspapers report the high and low for that day in addition to the stock’s ending price.

• Net change: This column answers the question “How did the stock price end today compared with its trading price at the end of the prior trading day?

  So many factors affect a company's health that it is nearly impossible to construct a formula that will predict success. It is one thing to assemble data to work with, but quite another to determine which numbers are relevant. A lot of information is intangible and cannot be measured. The quantifiable aspects of a company, such as profits, are easy enough to find. But how are qualitative factors measured, such as the company's staff, its competitive advantages, its reputation and so on? This combination of tangible and intangible aspects makes picking stocks a highly subjective, even intuitive process. Because of the human (often irrational) element inherent in the forces that move the stock market, stocks do not always do what they are anticipated to do. Emotions can change quickly and unpredictably. And unfortunately, when confidence turns into fear, the stock market can be a dangerous place.

Investors are corporations or individuals that want to invest an amount of money, usually a large amount, and keep on the market to profit in the long term. Investors are much more concerned about the company the stocks represent than the value of the stocks themselves; and value long-term growth and dividends. They are not gamblers. They usually have large amounts of available funds so they can afford to leave their money on the market for months and some times even many years.

Speculators usually want fast profits. Speculators usually take considerably higher risks than investors do by betting on capital gains in stock value over short periods of time.  Most speculators are less interested in the actual company the stock represents than the short term trends of the stock's price on the market.

Speculators are strictly concerned with the here and now; they look for stocks that, at this moment, are trading for less than their apparent worth (undervalued stocks), or those that are trading for more than their apparent worth (overvalued stocks). Speculators buy undervalued stocks in the hopes that the price will increase and capital gains can be made from reselling the stock; this is called 'Going Long'.  Speculators will also bet on overvalued stocks going down; this is known as a 'Short Sale', and speculators will then 'Cover' in order to realize capital gains. Speculators focus on Technical Analysis; they are not concerned with a company's production, leadership, assets, revenue, or profit, but instead look at past market activity to determine future price movements based on graphs and formulas.  The PE ratio is one of the most important parts of technical analysis.

Investors, on the other hand, focus on the future potential of a company, with much less emphasis on its present price. Unlike speculators, Investors buy companies based on long term trends:  dividend yield and capital gains--generally with the belief that the companies' intrinsic worth will grow and therefore exceed their current valuations.  Investors use Fundamental analysis to find the worth of a company, or its intrinsic value based on both quantitative and qualitative analysis.  In quantitative analysis, a company is evaluated on it's financial statements and balance sheet. In other words, a company should be worth all of its assets and future profits added together.  Some qualitative factors affecting the value of a company are its management, business model, industry and brand name.

At this point, you may be asking yourself why stock-picking is so important. Why worry so much about it? Why spend hours doing it? The answer is simple: wealth. If you become a good stock-picker, you can increase your personal wealth exponentially. Take Microsoft, for example. Had you invested in Bill Gates' brainchild at its IPO back in 1986 and simply held that investment, your return would have been somewhere in the neighborhood of 35,000% by spring of 2004. In other words, over an 18-year period, a $10,000 investment would have turned itself into a cool $3.5 million! (In fact, had you had this foresight in the bull market of the late '90s, your return could have been even greater.) With returns like this, it's no wonder that investors continue to hunt for "the next Microsoft".