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Why do companies sell stock?

Imagine a small, local company that produces clothing.  They sell their clothing through local shops and have an excellent reputation for producing fashionable, high-quality merchandise at an affordable price.  Local stores sell out as fast as they can produce.  The stores are ordering more and more product every week, but the small small company can't keep up!  If only they could expand their business, they'd be able to make more clothing, hire more people and make more money!

There are two solutions to this.  The company could borrow the money.  Of course it isn't always easy to get a business loan.  Plus that money would have to be repaid, with interest!  Finally, banks are cautious.  They won't lend money to new companies without a proven track record.

Another alternative is to issue "shares" of the company.  This would allow people to buy a small portion of the company. Why would people want to invest?  Simple - to make money!

There are drawbacks to this, of course.  It would mean the current owners would have to share control of their company with their co-owners, the stockholders.  If they don't keep the stockholders happy, they could find themselves pushed out of the company they started!  There are many, many instances of this.

On the other hand, it also means they wouldn't have loans to repay.  The money they raised by selling shares of stock would allow the company to expand.  The money could be used to buy a larger factory, more materials, better equipment and hire more employees.

Two examples

Imagine it is 1986, and instead of clothing the company is making computer software.  You have $200 you'd like to invest, so you invest in a new company.  By 2010, that $200 would have grown to $72,000 if that software company you chose was called Microsoft!

Of course there are risks as well.  Investors in one company saw it's stock triple in price on the first day it was sold!  Just five months later, it was selling for $174 a share!  If you'd purchased 10,000 shares at the initial price, you'd have turn a profit of $1,500,000 in less than half a year! 

However investor enthusiasm for anything and everything to do with the internet soon faded, and within 3 years, anyone who had held that stock expecting skyrocketing growth would have lost over $1,600,000!  Netcape, the company that had built an internet browser that put everyone else to shame, simply couldn't sustain the expectations of an over-inflated stock price.

What Determines a stock price?

Stock is worth whatever people are willing to pay for it.  Which would you rather own, a profitable company with strong sales, or a company that is losing money and has declining sales?  You wouldn't be alone choosing the first company, and with so many people wanting a share of it, the price will go up.

A market also reacts to news.  Could good movie reviews make you money?  It could if you own stock in Disney when it releases a hit movie.  Investors are always looking for positive news so they can catch a stock before it rises.

Not all news is good however.  What happens if a manufacturer's new product doesn't sell?  What if they produce a defective product?  What if business is going fine until somebody else starts selling the same type of product for half the price?  Investors are also watching for bad news, so they can sell a stock before it starts to lose ground.

The ultimate successful strategy

The best stock strategy is summed up in four words.  BUY LOW, SELL HIGH.  You want to buy a stock at a lower price and sell it at a higher price.  What is the low price and what is the high price is the hard part - and that's your challenge!