Stock Basics

In this post, I’ll cover some of the basics of stocks, illustrating some of the concepts by using real examples for a specific company: Google. I chose Google because it’s well known and is a relatively new company. I’ll discuss shares, stock, IPOs, market capitalization, growth/value, etc.

One way a company can raise money is by selling shares of stock to the public. This is known as a public offering. In a public offering, the company is selling part of the company to the investors who buy the stock. Each share of stock represents a unit of ownership in the company. Stocks are also referred to as equities (equity implies ownership).

A company that has not sold shares to the public is said to be privately held. The company may be a corporation with shares of stock, but all shares are held privately by the founders, employees, and possibly private investors (e.g., venture capitalists). Shares of a private company are not publicly traded on any stock exchange. Google was incorporated in 1998, and was privately held until 2004.

When a company first sells stock to the public, it’s referred to as an Initial Public Offering (IPO). Google had its IPO in August 2004, selling about 14M (million) shares at $85 per share, raising about $1.2B (Billion)¹. The phrase going public also is used to describe a company’s first offering of shares of stock for sale to the public. After the IPO, a company may raise more money through additional public offerings.

The company uses the money it raises (from selling stock) to grow its business. In the document filed for Google’s IPO, they stated that they intended to use the money for “general corporate purposes”, and “for acquisitions of complementary businesses, technologies or other assets”; i.e., to buy stuff that would help them grow their business. Other uses of money raised by selling stock are to invest in R&D, hire more employees, pay for marketing and advertising, and buy buildings and equipment to increase production capacity.

After a company’s IPO, the publicly held shares trade on a stock exchange, such as the New York Stock Exchange (NYSE) or the NASDAQ; Google trades on the NASDAQ. Shares traded on an exchange do not provide money to companies, but to the investors selling the shares. Nevertheless, the secondary markets provided by public stock exchanges benefit public corporations; without them it would be difficult for companies to sell shares to the public, since it would be difficult for investors to later sell their shares if so desired.

The market capitalization (market cap) of a company is the total value of all of its stock. It is calculated by multiplying the price of one share of stock by the total number of shares owned by all stockholders. You can look up the market cap, number of shares, and share price using www.google.com/finance; type in GOOG, then click Get quotes. As of June 14, 2010, Google had 318.49M shares priced at $483.19 per share, for a total market cap of $153.89B (318.49M shares X 483.19 dollars/share = $153.89B). So, on June 14, the value of all the Google stock owned by all stockholders was about $154B.

Google is considered a large-cap company, since its market cap (total value of its stock) is large compared to other companies. One way to get a sense of how big large-cap is is to look at the median market cap of a large-cap index fund, and compare it to the median market caps of mid-cap and small-cap index funds. Here are the median values for Vanguard’s large-, mid- and small-cap index funds:

• Large-Cap: $34.5B (Billion)
• Mid-Cap: $5.2B
• Small-Cap: $1.4B

Another thing we can do is look at the market cap of the largest holding in each fund:

• Large-Cap – Exxon Mobil Corp.: $293B
• Mid-Cap --  Liberty Media Corp. – Interactive: $8B
• Small-Cap -- Valeant Pharmaceuticals International: $3.6B

So, Google, at $154B,  is about half the size of the largest large-cap US company, and about 19X larger than the largest mid-cap company. If you look at the holdings of the Vanguard Large-Cap Index fund as of 3/31/2010, Google was the fifteenth largest holding. The Vanguard Large-Cap Index fund owns stocks of the largest 750 US companies.

As of 5/31/2010, these were the 10 largest holdings of the Vanguard Large-Cap Index fund:

1 Exxon Mobil Corp.
2 Apple Inc.
3 Microsoft Corp.
4 Procter & Gamble Co.
5 General Electric Co.
6 International Business Machines Corp.
7 Johnson & Johnson
8 Bank of America Corp.
9 JPMorgan Chase & Co.
10 Chevron Corp.

These same companies are the top 10 in the Vanguard Total Stock Market Index fund, and the top 9 are the same in the Vanguard 500 Index fund. This is because these funds are all cap weighted, large-cap US stock index funds, and will hold most if not all large-cap US stocks (including Google) in proportion to their market value, with the largest cap companies comprising the largest holdings.

Google also is classified as a growth stock, and as such is the fifth largest holding of the Vanguard Growth Index fund (as of May 31, 2010), with Apple, Microsoft, IBM and Cisco above it, and Wal-Mart, HP, Coca-Cola, PepsiCo and Exxon Mobil² below it. Growth and Value are terms used to characterize a stock based on how quickly the company is growing and how expensive the stock is relative to other ways of valuing the company (e.g., book value and earnings). Companies with stocks classified as growth (as opposed to value) tend to be growing more quickly, and have higher stock prices relative to book value and earnings.

The top 10 holdings of the Vanguard Value Index fund (large-cap value) as of 5/31/10 were Exxon Mobil², Proctor & Gamble, GE, Johnson & Johnson, Bank of America, JPMorgan Chase, Chevron, AT&T, Wells Fargo and Pfizer.

The Vanguard Large-Cap Index fund is a large-cap blend fund. The term blend means that the fund owns a blend of growth and value stocks. Since Google is a large-cap growth stock, it is likely to be among the top holdings of any large-cap growth or large-cap blend index fund.

So, if you own shares of any large-cap blend or growth index fund, you probably own some Google, and you own many other large-cap stocks. The fund holds shares of Google and the other stocks directly, and each of your mutual fund shares represents a fraction of each of the stock holdings of the mutual fund.

Notes

1. As part of Google’s IPO, existing stockholders (who already owned shares when the company was privately held) also sold about 5.5M shares to the public, receiving about $464M. This money was not used by the company, but was received by the existing stockholders who sold their shares. Many more shares than were sold to the public were retained by the founders and employees (making them very rich).

2. Based on the methodology of the indices Vanguard uses, a company can be included in both the growth and value indices. Essentially, part of the company is included in one index, and the rest is included in the other index. For example, Exxon Mobil is in both the Vanguard Growth Index and Vanguard Value Index funds, but it is the largest holding in the value index, and the tenth largest holding in the growth index. This tells us that Exxon is more of a value company, but with with enough growth characteristics to be a top holding in the growth index fund. Since the Large-Cap (blend) Index fund includes both growth and value stocks, and Exxon Mobil is the largest cap company overall,  Exxon Mobil is the largest holding of this fund. For all the gory details of the index methodologies used for the funds discussed in this post, see the MSCI Methodology Book: MSCI US Equity Indices