FEBRUARY 2007 :: CONSUMER ED

The Center of the Universe
What Is Wall Street, and What Exactly Happens There?

The media throw around the term "Wall Street" so casually-"Stocks surged on Wall Street today ..."-that the place almost seems mythical, like Main Street, U.S.A.

›Adapted from "The Wall Street Journal Complete Personal Finance Guidebook," by Jeff D. Opdyke. Copyright 2006 by Dow Jones & Co. Published by Three Rivers Press, an imprint of the Crown Publishing Group, a division of Random House.

But Wall Street is a real place. It's a short, narrow lane in Lower Manhattan. And at the corner of Wall and Broad streets stands the New York Stock Exchange, the center of the financial world. Every business day, between 9:30 a.m. and 4:30 p.m., more than one billion shares of stock trade hands here in a series of orally negotiated transactions on the busy, noisy trading floor.

Despite its concrete geography, however, Wall Street really is a catchall phrase for the entire investment universe-stocks, bonds, mutual funds, investors, the stock markets, banks, brokerage firms and the all people who work in the investment industry.

This investment universe gets bigger and more complex all the time, but what made Wall Street famous is one of the most simple investments: stock.

What Is Stock?

Stock is partial ownership of a business. That is as complicated as it gets.

When you buy shares of stock, you own a part of the business, and get to share in its ups and downs. If the company's net income, or profit, rises over time, then the stock's price tends to rise, too. If net income falls or slips into losses, the stock price falls on the assumption that the business is not as valuable as before.

Stockholders may also be entitled to a share of the profits in the form of dividends that the company pays out. So if you own, say, a single share in the Starbucks chain of coffeehouses, then every time someone orders a high-priced latte, a small sliver of the profit from that sale has your name on it.

Many factors can affect a stock from hour to hour, but ultimately, it's earnings (or expected earnings) that drive a stock's price, because earnings represent the reason a company exists-to generate profit.

Stockholders have the greatest potential for reward but also accept the most risk for loss. If a company excels in its business, then the value of just a relatively few shares of a company can turn a small sum of cash into substantial wealth. On March 13, 1986, you could have purchased 100 shares of Microsoft stock at between $25.50 and $29.25 each, the range in which the software giant's shares were bought and sold on its first trading day.

Twenty years later, that original investment of less than $3,000 would be worth roughly $800,000. That's the reward side. You bought into Microsoft's stream of earnings, which grew exceedingly fast. That, in turn, boosted the value of your small ownership stake in the company.

Then there's the risk. On Feb. 11, 2000, you could have spent $1,100 on 100 shares of Internet retailer Pets.com. Within months, as Pets.com flamed out amid the Internet bust, your shares would have been worthless.

The Key Numbers

Informed investors keep track of a company's stock price, its earnings and a few other useful statistics that show the relationship between the two:

Earnings per share: The net income of a company divided by the total number of shares the company has in the hands of investors. Investors scrutinize this number every possible way every three months and then again annually to see if a company's profits are rising, falling, or stagnant.

Price/earnings ratio: Known as the P/E, this is the current price of a stock divided by the earnings per share for its four most recent quarters. P/E ratios differ for various sorts of companies. Fast-growing technology stocks can trade at a P/E of 50 or more. A slow-growing utility might fetch a P/E in the single digits. The trick is to examine the P/E in relation to the company's historic range, its competitors and against the broader market.

Dividend yield: A company's annual dividend payment divided by the stock's current price. Slow-growth industries like utilities typically have fewer investment options for the cash they generate, so they pay bigger dividends, providing a bigger yield. Fast-growing companies, meanwhile, often pay no dividends-and thus, have no yield-because they hang on to their profits to try to expand the business.

The Indexes

Earnings per share, P/E and dividend yields offer a view of a particular company's performance. But to get a picture of how the overall stock market, or a particular segment of the market, is performing, investors study indexes. Indexes consolidate dozens, hundreds or even thousands of stock prices into a single statistic that offers investors an easy way to measure how the market is doing at a particular time.

These days nearly every corner of the stock market has an index to measure something. The Russell 2000 tracks small-company stocks. The Wilshire 5000 measures the performance of virtually the entire U.S. market, 5,000 stocks in all. The SOX tracks just companies in the semiconductor industry

But for the most part, mainstream investors and the media pay attention to three major indexes: the Standard & Poor's 500, the Dow Jones Industrial Average, and the Nasdaq Composite Index. When news reporters say "stocks were up today," they mean that these main indexes all rose that day. When one index moves in one direction, and the other two go the other way, stocks are said to be "mixed."

The S&P 500 measures the performance of what Standard & Poor's defines as the 500 largest publicly traded stocks in the U.S. and is considered the benchmark for the broader U.S. market. These stocks are widely held by investors and are spread across the industrial, transportation, utility and financial sectors.

The Dow Jones Industrial Average consists of 30 very large stocks selected by the editors of The Wall Street Journal, who occasionally alter the mix of stocks in the index to reflect the changing composition of American industry. Critics complain that the Dow's lack of breadth makes it less relevant than the S&P 500. Yet the index has proved remarkably reflective of America's economic growth and largely moves in sync with other major market indexes.

The Nasdaq Composite tracks the performance of a large proportion of stocks that trade on the Nasdaq Stock Market, which is dominated by technology companies. Because it's so laden with technology stocks, the Nasdaq Composite is considered a poor reflection of the broader market and is viewed more as a barometer of the digital economy.