How Does the Stock Market Work?

The stock market plays a part in everyone’s daily lives, yet Wall Street is still one of the most mystifying places on planet earth.

The stock market serves three vital purposes:

  1. Helps companies raise capital – Companies raise money by selling shares in an IPO or secondary offering in which the company sells shares of stock in exchange for cash needed by the business to expand, pay down debt, or simply cover on-going expenses.
  2. Provides liquidity – The stock market serves as a place where people can buy or sell ownership of companies quickly and inexpensively. Whereas you might spend years trying to find a buyer for a 50% stake in a McDonald’s franchise, billions of dollars of McDonald’s stock is sold each day on the stock market. You can find a buyer for a partial share of a company listed on a stock exchange much faster than you can for a private company.
  3. Gives reference point to investors – The stock market is a great reference tool for investors to examine what private companies might be worth. It also provides a historical guide for what’s “normal” in valuing businesses.

Stock Market

 

The Business of Wall Street

Every company starts out small. Walmart was once a single store with only a handful of employees. Now it is one of the largest companies in the world.

As businesses grow, they need capital. Typically, small businesses get bank loans or investments from friends and family. Friends and family and small bank loans are a great source of financing from day one, but a growing business will need more and more money for expansion.

Today, most businesses start selling stock privately before doing it publicly. Young businesses start selling shares to venture capitalists, who fund risky new businesses. Venture capitalists are in the specialty of investing in small startup businesses. The venture capitalist’s’ goal is to invest in fast-growing young companies for eventual sale to another investor.

Selling out of a billion-dollar company is difficult if you cannot raise funds from hundreds of thousands, if not millions or billions, of people. So once a company starts to mature and no longer matches the desired traits of early investors, it goes public. It sells shares to the public, not private investors, to raise capital or to pay off early investors on the stock market. When companies go public, they do so on Wall Street.

There are three reasons a company goes public:

  1. Bring in more investors and potentially more capital.
  2. Allow early investors to sell their stock.
  3. Use the stock market as a mechanism to manage a growing base of shareholders.

When companies list on the stock market, they often do so by selling shares of the company to raise new money. Also, early investors who want out of the company sell their shares as part of an initial public offering.

Companies may later issue more stock on the stock market as part of a secondary offering in which they issue new shares to raise much needed cash. (This usually happens when companies cannot borrow money for whatever reason – bad financial history, weakness, or simply for the fact they already have all the debt that the company could possibly manage.)

How Stocks Work

When you buy a share of stock, you own partial ownership in a company. Having ownership in a company gives you a right to vote on shareholder proposals, and a right to the profits that the company earns.

You are part owner in any company that you invest in. This does not give you the right to make decisions like a dictator; you’ll need to own 51% for that. Rather, owning part of a company gives you part of the influence in how a company is ran and managed. Most importantly, owning a share of stock gives you part of the company’s future profits.

There are two ways that stocks can make money for their owners:

  1. Dividends – Companies can pay out all or part of their earnings to shareholders in the form of cash, known as a dividend.
  2. Capital appreciation – Companies often rise in value as they grow and accumulate assets. Thus, stocks rise proportionately with the rise in the value of the whole company.

In general, fast growing companies do not pay dividends as such businesses would prefer to reinvest that money in growing their business. Investors will profit from the appreciation in the company’s value, however, as it grows.

Older and more mature businesses usually pay dividends because they cannot invest all of their earnings into continued expansion. Investors in mature businesses will profit from dividends and increases in the stock’s value as the company slowly grows or accumulates assets.

Participating in the Stock Market

The stock market is as American as apple pie. It gives everyone the opportunity to participate in the beauty of capitalism by investing in businesses that provide goods and services to the public for the potential profit of the investor.

By investing in the stock market, you are buying part of a company’s future earnings and growth. It gives everyone the chance to be a partner in a business. You might not have the time or money to start an oil company, but the stock market allows you to be a part owner in Chevron. You might not have the prowess to be a retailing king, but through the stock market you can be a part owner in well-known brands like Target, Walmart or Amazon.

Participating in the stock market by investing in individual stocks, or funds of multiple stocks like mutual funds or index funds gives you the chance to profit on the world’s future superstars of business. It’s the only place where individuals, rich or poor, can be a partial owner of a business.

5 Responses to How Does the Stock Market Work?

  1. Sadly not enough people are aware of the opportunities for them in the stock market. I believe in a mixture that provides for both dividends and capital appreciation. Make sure you know what you doing as I have seen a lot of people just put money into the stock market with a clue of what they are doing. Those early investors do seem to get a sweet deal but a lot of them invest in a lot of start ups or business that never work out.

    • JT says:

      Yes, definitely. Those who get in early do get the advantage of selection, but venture capital isn’t without its risks. Even if I could be a VC, I think I’d favor publicly-traded companies just for the track record and liquidity.

  2. I love dabbling in the stock market. There is no way I would have paid off as much of our debt without being an active stock and currency trader.

    The current market conditions might be putting off a lot of new comers though, as it is very volatile and difficult for long term investors to make money (perfect for trading though)

    Good post :)

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