It's Simple, Really
When you buy a share of stock,
you are buying a piece of a
company. Imagine that Harrison
Fudge Company, a fictional
business, has sales of $10,000,000
and net income of $1,000,000. To
raise money for expansion, the
company’s founders approached a
Wall Street underwriting firm (an
investment banker) and had them
sell stock to the public. They might
have said, “Okay, we don’t think
your growth rate is great so we are
going to price this so that future
investors will earn 9% on their
investment plus whatever growth
you generate … that works out to
around $11,000,000+ value for the
whole company ($11 million
divided by $1 million net income =
9% return on initial investment. )”
Now, we’re going to assume that
the founders sold out completely
instead of issuing stock to the public
(for an explanation of the
difference, see Investing Lesson 1:
Introduction to Wall Street.)
The underwriters may say, “You
know, we want the stock to sell for
$25 per share because that seems
affordable so we are going to cut
the company into 440,000 pieces,
or shares of stock (440,000 shares
x $25 = $11,000,000.) That means
that each “piece” or share of stock
is entitled to $2.72 of the profit
($1,000,000 profit ÷ 440,000 shares
outstanding = $2.72 per share.) This
figure is known as Basic EPS (short
for earnings per share.) In other
words, when you buy a share of
Harrison Fudge Company, you are
buying the right to your pro-rata
profits. Were you to acquire 100
shares for $2,500, you would be
buying $272 in annual profit plus
whatever future growth (or losses)
the company generated. If you
thought that a new management
could cause fudge sales to explode
so that your pro-rata profits would
be 5x higher in a few years, then
this would be an extremely
attractive investment.
