In this article, we tell a simple story that demonstrates why stocks and bonds are created.

A Business Is Created
Jack is a farmer, and he is interested in starting up an apple stand for the tourists who pass his place. Since Jack has fairly good credit, he got a business loan to cover the costs of set up, and he now has the ideal land for apple growing. Unfortunately Jack only set aside enough money for getting his land in shape. He forgot all about buying seeds. By a stroke of luck, Jack finds a store that will sell him a magic high-growth, high-yield seed for $100, but Jack only has $50 left.

Initial Public Offering to Raise Capital for Growth
Our clever farmer goes to five of his closest friends (you're included) and asks if they'll each give him $10 to help his business. Jack doesn't know, however, if he can take it in the form of a loan because he may not be able to pay it back if the seed doesn't turn a profit. No worries: Jack promises everyone they'll receive a percentage of the tree's apples that is equal to the percentage they gave. In other words, Jack has given his friends a share in his tree. They agree and the seed is in the ground before you can sing "Johnny Appleseed."

The Distinction Between Being a Partner and Being a Shareholder
This tree, being magic and all, grows rapidly. In the first month, it is five feet tall and there are two apples. Jack keeps one apple because he owns 50% of the business's product, which he paid for with the $50 dollars he put in for the seed. He cuts the other one into five pieces, each of which goes to each of his investors, who can sell or eat it. The investors have a quick meeting and decide they'd rather have Jack sell their portion of the product and give them a percentage of the profit. So Jack makes up little papers saying, "Jack's Apple Company: you have one share guaranteeing you 10% (10/100) of the profits."

Trading Occurs in Jack's Undervalued Stock
So this tree really takes off now - the magic is coursing through the wood and it grows to 10 feet tall! There are 20 apples and Jack sells them all for $10 a piece, keeping $100 for himself and giving his friends $20 each. Jack uses his $100 to buy another seed and plants it. Pretty soon, Jack has two trees producing 40 apples and earning $400 a month.

Some of his neighbors want in on the deal Jack gave his friends, and Tim, Jack's first investor, is interested in selling his 10% of Jack's Apple Company. Judy, Jack's neighbor, wants to buy it and she offers Tim the $10 that he originally paid. Tim is not stupid, however: he realizes that this share is producing $40 a month and Jack is about to buy another seed. So Tim asks for $40 dollars and Judy snaps up the share, which pays for itself immediately.

A Bit of a Bubble Forms
The other original shareholders see how much Tim got and want to sell too, and the other neighbors notice how quickly Judy's investment paid off so they really want to buy in. The offers steadily climb until Jack's shares are being bought for over $100 a piece - more than Jack's trees are producing in a month. Only one original shareholder, Betty, is still in there and holding out on offers such as $120 because she is still getting a regular payment that is pure profit for her. Suddenly, Jack's trees (four in total) are ravaged by aphids. The entire month's production is ruined and several shareholders are wondering if they can pay rent since they used their savings to buy shares.

The Bubble Bursts
The shareholders who need the money sell to Betty at a discount ($40), and then the other shareholders notice, all of a sudden, that their $100 shares are worth $40. This is very disconcerting. The remaining shareholders offer their shares to Betty, but she says she's quite content with three shares. The other shareholders are desperate now, so when the town sheriff offers them $20 a piece for the shares, they take their losses and get out.

Meanwhile, the main drive of Jack's business hasn't changed: people still want apples. Jack needs to get rid of these pesky aphids and he needs the money to buy insecticide.

Jack Issues a Bond
Jack's not too keen on issuing more stock after the fiasco with his neighbors, so he decides to go for a loan instead. Unfortunately, Jack used up his credit with the land preparation so he is once again looking for divine inspiration. He's looking at his equipment to see what he can sell and what he can't, and then it hits him: he'll try to sell his apple crates without actually selling them. The crates are useless without aphid-free product to fill them, but as soon as the aphids are gone he'll need them back.

So Jack calls up Judy (in hopes of making amends) and offers her a deal, "Judy, my good friend, I have an offer for you. I'll sell you my apple crates, which are worth $100 total, for a mere $60 and then buy them back next week for the full $100." Judy thinks about this and sees that in the worst case scenario, she can just sell the crates … sounds good. And a deal is made.

"But Judy," Jack adds, "I don't want to run my crates down there and pick them up again. Can I just write up a piece of paper? It'll save my back."

"I don't know - can we call it a promissory note?" Judy asks enthusiastically.

"Sure can, but I was thinking more of calling it a bond or a certificate," says Jack.

And lo and behold, Jack eliminates the aphids, pays Judy back, and turns a healthy profit that month and every month thereafter.

The Bottom Line
This story will not explain everything about investing in stocks, but it does highlight one very important point: the price of Jack's stock followed investors' opinion of the stock's value rather than just the performance of Jack's company. Because the stock market is an auction, there is no set price for a certain stock, there is a concept that derails most people's trains of thought: the price paid for a stock is what it's "worth" until a lower or higher price is offered.

This fluctuation of worth is good and bad for investors because it allows for profit (when you buy an undervalued stock) but also makes losses possible (when you pay too much for a stock).

SEE: Bond Basics

Related Articles
  1. Investing

    The Advantages Of Bonds

    Bonds contribute an element of stability to almost any portfolio and offer a safe and conservative investment.
  2. Personal Finance

    Promissory Notes: Not Your Average IOU

    These may be a handy way to borrow money, but this convenience does not come without risk.
  3. Entrepreneurship

    The Small Business Jobs Act: Make It Work For You

    Understanding how to manage business credit is the key to obtaining small business loans.
  4. Trading Strategies

    Can You "Learn" The Stock Market?

    All of the knowledge in the world won't ensure the perfect trade every time - but is it possible to improve your odds in the market?
  5. Investing

    Use Breakup Value To Find Undervalued Companies

    Find out a company's worth if it were sold in pieces - it may be more than you think.
  6. Investing Basics

    5 Tips For Investing In IPOs

    It’s not easy to profit from IPO​s, but the money is there.
  7. Investing Basics

    5 Tips For Investing In IPOs

    Thinking of investing in IPOs? Here are five things to remember before jumping into these murky waters.
  8. Charts & Patterns

    Understand How Square Works before the IPO

    Square is reported to have filed for an IPO. For interested investors wondering how the company makes money, Investopedia takes a look at its business.
  9. Active Trading Fundamentals

    The Companies of Peter Theil's Founders Fund

    Learn about the major public companies that Peter Thiel has invested in and companies that are on the verge of going public at multibillion-dollar valuations.
  10. Investing Basics

    If You Had Invested Right After Amazon's IPO

    Find out how much you would have made if you had invested $1,000 during Amazon's IPO, including how the power of the stock split affects investment growth.
RELATED TERMS
  1. Dog And Pony Show

    A colloquial term that generally refers to a presentation or ...
  2. Red Herring

    A preliminary prospectus filed by a company with the Securities ...
  3. Muppet Bait

    Naive investors who are lured into buying hot stocks or securities ...
  4. At A Discount

    This specifically refers to stock that is sold for less than ...
  5. Aftermarket Report

    A summary of how shares of an initial public offering (IPO) performed ...
  6. Small Corporate Offering Registration ...

    A form of corporate securities registration designed to reduce ...
RELATED FAQS
  1. What kind of assets can be traded on a secondary market?

    Virtually all types of financial assets and investing instruments are traded on secondary markets, including stocks, bonds, ... Read Full Answer >>
  2. Why would a company decide to utilize H-shares over A-shares in its IPO?

    A company would decide to utilize H shares over A shares in its initial public offering (IPO) if that company believes it ... Read Full Answer >>
  3. How do I place a buy limit order if I want to buy a stock during an initial public ...

    During an initial public offering, or IPO, a trader may place a buy limit order by choosing "Buy" and "Limit" in the order ... Read Full Answer >>
  4. How do corporate actions affect floating stock?

    Corporate actions, defined as a company's actions that affect the amount of outstanding company stock shares, can either ... Read Full Answer >>
  5. What are the advantages and disadvantages of listing on the Nasdaq versus other stock ...

    The primary advantages for a company of listing on the Nasdaq exchange are lower listing fees and lower minimum requirements ... Read Full Answer >>
  6. What securities does the primary market deal with?

    The primary market deals with all newly issued securities. When businesses, governments or other groups want to raise capital ... Read Full Answer >>

You May Also Like

Trading Center
×

You are using adblocking software

Want access to all of Investopedia? Add us to your “whitelist”
so you'll never miss a feature!