APRIL 2003

Lesson 201

Growth Stock & Stock Exchanges

Phases of Development

How the Markets Work

Growth Stock & Stock Exchanges

A stock represents a proportional ownership interest in a company. When you own stock, either directly or through a stock mutual fund -- you own a portion of a company. Studies have shown that ownership of common stocks, either directly or through mutual funds, has the highest long-term potential return of any investment.

Owning part of a company means that value of your ownership stake -- also known as shares -- can go up when the company's fortunes are rising, and can also fall when the company's fortunes decline.

You can increase your chances of profiting from the stock market by investing in growth companies. Growth companies are those that regularly increase their sales and earnings. As a company increases its sales and earnings, its stock price is likely to increase in line with that growth.

Company growth comes from many sources, including management, market expansion, acquisitions, patents and new technology. Growth companies with consistent, innovative management are the most likely to succeed.

Phases of Development

Companies go through distinct phases of development as they mature. These include:

1. The start-up phase when earnings are unpredictable and business may be erratic.
2. The explosive growth phase when a company's products take off in the marketplace, often sparking spectacular sales and earnings growth.
3. The mature growth phase when a company's revenue and earnings become so large that it is difficult, if not impossible, to maintain growth at the same explosive rate.
4. The stabilization phase when sales and earnings settle into a slower, more predictable pattern.

Be wary of companies that aren't working to develop innovative products to expand their markets, as they are likely to experience stagnating or declining growth.

If you buy the stock of a company in the explosive stage of development, you should hold onto it during the mature phase unless it experiences significant problems. By selling too early, you may miss out on years of growth and accompanying stock price appreciation.

How the Markets Work

While companies have to meet certain requirements to be listed on a stock exchange, the fact that a company is listed doesn't mean it is a growth company suitable for investment. Many, many thousands of companies are listed on the exchanges, from mature companies to the newest initial public offering (IPO). An IPO is the process a company goes through to bring shares to the stock market.

Privately held companies work through brokerage firms and the stock exchanges so that they may offer shares to the investing public. While many IPOs have exciting business plans and innovative products, most don't have a history of producing growth in sales and earnings.

Many are in the start-up phase and some will not survive to reach the explosive growth, let alone the mature phase of growth. During an IPO, a company's stock price is set at what the company and sponsoring brokerages feel the market will bear. Once the IPO process is complete, and a company is trading on a stock exchange, it is said to be publicly held.

The stock market is made up of a number of different stock exchanges where shares are bought and sold. The most well known domestic stock exchange is the New York Stock Exchange (NYSE).

When you buy a stock listed on the New York Stock Exchange, your order is placed with a broker, either over the phone or online. Your order is then routed to a market maker on the trading floor where it is executed. Notice of the trade is sent back to your broker and is also posted to the exchange's consolidated tape that lists all trades.

The Nasdaq National Market (the Nasdaq) is an electronic exchange. On the Nasdaq, market makers and electronic communications networks work through sophisticated computer systems buying and selling shares for investors.

U.S. markets hold day trading sessions, which runs from 9:30 a.m. to 4 p.m. Monday through Friday with exception of most major holidays. Several different markets and electronic communication networks run early morning and evening sessions, which are collectively known as after-hours trading.

Stock and mutual fund quotes can be found in newspapers, magazines and Web sites. Traditionally, stock prices had been quoted in fractions, but in 2001, exchanges gradually shifted to quoting stock prices in decimals.

This process, known as "decimalization," means that stock quotes are more accurate. Decimalization has narrowed the gap between what stock shares are bought and sold for, resulting in lower trading commissions for investors.

Stock Splits

Many publicly held companies will at some point announce a stock split. A stock split means that a company will either substantially increase or reduce the number of shares available to the investing public.

A traditional stock split means that a company will issue more shares, and once the shares are issued, the price of the company's stock will drop in a direct reflection of the amount of issued shares.

For example, if a company trading at a price of 40 with 100 million shares outstanding announces a 2 for 1 split, it will issue 100 million more shares and after the split will trade at a price of 20. In this situation, an individual investor who owns 100 shares in the company at $40 per share will now own 200 shares at $20 per share.

More rare is a reverse split. Companies that employ reverse splits usually have stock trading at a very low price, and seek to raise the price of that stock by removing shares from the market. A reverse split can mean that a company is in financial trouble, and is seeking to raise its price by reducing the number of shares outstanding, rather than improving company fundamentals such as sales and earnings.

For example, in a 1 to 4 reverse split, a company with a stock price of $1 with 200 million shares outstanding could reduce its outstanding shares by 150 million and raise the share price to $4 a share. In this case, if you owned 400 shares of such a company at $1 a share, after the reverse split you would own 100 shares of the company at $4 a share.

Investors who own companies that either go through a traditional split or a reverse split don't actually gain or lose any stock or profit in the split process.