What Is a Stock Market?
What Is a Stock Market?
Stock markets are instrumental to economies around the world, but what are they, and how do they work? In a very broad and simple definition, a stock market or stock exchange is a place where companies issue stocks (shares or equities—they are all the same thing) of their company to raise capital for business activities.
A Brief History Lesson
The very first recorded stock exchange was created in Amsterdam in 1611. The Dutch East India Company, or Vereenigde Oost-Indische Compagnie (VOC) in Dutch, was a megacorporation during the 17th and 18th centuries.
In today’s terms, they would be valued at over 7 trillion dollars. With that valuation, VOC was the largest company to ever exist.
VOC had extensive trade routes around Europe, Africa, and Asia trading goods, such as spices, silks, textiles and many other commodities. The vast trading network of trading posts and ships required large amounts of capital to operate.
In order to fund their enterprises, in the early 1600s, they started offering shares in the shipments of goods. Investors would help fund the voyages and then receive a portion of the profits once the ships returned.
The issuing of stocks changed the course of history forever. Now, instead of one investor putting their money on one ship, they could limit the risk and invest in multiple ships. This also made it possible for commoners to begin investing, not just the extremely wealthy.
These changes are what allowed the company to become the largest corporation in history, providing us the blueprint for our current stock markets. If you would like to learn more about the history of VOC, Business Insider has a great news article.
Stocks, Shares & Equites (All the Same Thing)
Stock markets are a great investment opportunity because, just like in the era of VOC, everybody is able to invest and purchase shares. It could be billion-dollar companies or individual investors, such as you and me.
Owning a stock (depending on which type you own) and being a part-owner means you can vote on important company decisions, such as mergers, officer elections, and potential acquisitions, and you can also receive a portion of the profits in the form of a dividend. The Balance.com provides a simple and helpful graphic illustrating how the stock market operates.
Common vs Preferred Stocks
The two most common types of stocks are common and preferred, and they will be further discussed in the section Different Types of Stocks. With both types, you can receive dividends, the price of which is determined by the company issuing the dividends.
However, not all companies offer dividends. Many choose not to. The main difference between the two types of stock is the voting privileges.
Common Stock
With common stock, you DO have voting rights. This means you can vote on important business decisions. BUT it is proportional to how many shares, or how much ownership, you have in the company.
Example
Matt recently returned home from a Royal Caribbean cruise. He was not satisfied with his trip and thinks he can run the company better than the current executives. He knows Royal Caribbean (NYSE: RCL) is a publicly traded company and decides to start buying shares with the goal of owning enough that he can make himself boss. This method of taking control is also known as a hostile takeover, which means taking control of a company against their wishes.
We can use the following information to determine if he will be able to achieve his goal:
How much he has available to invest: $1,000,000
How much a share currently cost: $87.77
How many total shares the company has available to buy (shares outstanding): 254,690,000
In order to make himself boss, Matt needs to own a majority stake, or 51% of the company. The following calculations are used to determine his ownership percentage.
Ownership Percentage = Matt’s Shares / Shares Outstanding
Determining how many shares Matt is able to purchase:
Matt’s Shares = Capital Available to Invest / Price Per Share
Matt’s Shares = $1,000,000 / $87.77
Matt’s Shares = 11,393
Ownership Percentage = 11,393/254,690,000
Ownership Percentage = 0.004%
With 1 million dollars, Matt is only able to purchase 0.004% of Royal Caribbean, which is very far away from his 51% goal.
Important Takeaway
This example illustrates that while it is a benefit to have voting rights with common stocks, you should not expect to have a large impact in the company’s direction, unless you are using large amounts of capital to purchase a significant stake in the company.
Preferred Stock
With preferred stock, you DO NOT have voting rights, but the benefit of these types of stocks is that they are higher in the order of importance. This means that when dividends are paid, the preferred shareholders must all be paid before the common stockholders.
This also means that when a company goes out of business and has to liquidate its assets (sell everything they own), the preferred shareholders must be compensated before the common stockholders. This benefit means shareholders are more likely to recoup some of their investment in the event of a company bankruptcy.
DiversifyFund has a helpful table to show the main differences between common and preferred stocks.
The Importance of Stock Markets
Stock markets are important because they allow companies to raise capital (money) instead of receiving a loan and paying hefty interest charges, some of which can be very substantial if the loans are for millions or tens of millions of dollars. A company is considered a private company until the public is allowed to start purchasing its shares (then it is called a public company).
Initial Public Offerings (IPO)
A company going from private to public is usually done by an initial public offering (IPO); this is when they release a portion of their shares into the market to be bought by outside investors.
Before the IPO happens, the company will determine how many shares it would like to create and how many it would like to sell. They can release a tiny portion of their total shares or all of their shares; it just depends on the company’s needs and goals.
Keep in mind every share it sells is less ownership they have. Many companies will not release all the shares to the public, but they will release portions; this is so the founders and board members still have a majority stake in the business (over 50% ownership) and can still control the direction of the business.
When a company goes from private to public through an IPO, they hire a securities underwriter (typically a bank or investment broker) to evaluate the company and determine a reasonable price for the shares. The security underwriter looks at factors such as the demand for the company’s shares, the worth of similar companies’ stocks, whether this company is projected to grow, or if it is selling something that will change history (think the invention of the cell phone or iPod).
These underwriters also take on risk from the IPO. They hold the shares on their books until all the shares are sold. This means they are liable for the shares, and if all the shares are not sold, they will owe the issuing company for them.
This provides insurance for the company issuing the stocks. Once all the shares have been sold, the underwriter will close the opening and give the proceeds to the company, minus the underwriting fees. These fees typically range between 2% and 10% of the entire offering.
Direct Public Offering (DPO)
Underwriting fees can be very expensive, costing millions of dollars for the issuing company. It is why some companies elect to perform a direct public offering (DPO). With DPOs, the stocks are issued directly to the public, cutting out the underwriter and saving the offering company money because they do not have to pay the underwriting fees.
The downside of a DPO is the company is not guaranteed to sell all its shares since there is no insurance from the underwriter. And the offering may not have as much marketing exposure because the company itself may not have as good of a marketing network as an underwriter.
Example
Let’s look at an example to better illustrate the difference between an IPO and a DPO.
Bryan’s Accounting Firm determines it needs at least $500,000 to build a new office building. They can either get a loan, pay interest on the loan, get an angel investor (an individual or company that will provide capital for a small ownership stake), or elect to take the company public through an IPO or a DPO.
Since their firm is not large and nationally known, they elect to have an IPO, so they hire an underwriting company.
The underwriter determines that Bryan’s Accounting Firm shares are worth $25 each. Bryan’s Accounting decides to list 30,000 shares.
For simplicity, assume all the shares are sold during the IPO for $25, which means $750,000 was raised.
30,000 x $25 = $750,000
The underwriting company closes the offering and takes out a 5% fee from the earnings. Bryan’s Accounting will then receive $712,500.
$750,000*5% = $37,500
$750,000 – $37,500 = $712,500
Bryan’s Accounting will receive $712,500 from the IPO. This IPO was successful, and Bryan’s Accounting now has enough capital to build a new office building.
Important Takeaway
An IPO and a DPO only raise capital on the initial offering day. Once all the shares are sold to the public, the company does not receive any capital from the outside investors buying and selling the shares between each other.
Secondary Offering
Sometimes, companies have performed an IPO or a DPO in the past but currently need to raise funds. They will perform secondary offerings or follow-on offerings. With a secondary offering, the company can either sell privately held shares, such as a CEOs, or they can create new shares and issue them. The latter method is referred to as dilutive.
Creating new shares and selling them dilutes current investors’ shares because they own the same amount, but now the total available shares has increased, meaning the investors’ total ownership has decreased. Let’s look at an example to illustrate this point.
Example
Dave own’s 100 shares of the ABC Company. The current outstanding shares for ABC Company is 1,000. Dave has a 10% ownership stake in the company. Using the same formula from Matt’s example earlier:
Ownership Percentage = Dave’s Shares / Shares Outstanding
Ownership Percentage = 100/1,000
Ownership Percentage = 10%
The ABC Company would like to acquire another company, so it decides to create new shares and sell them for funding. They create 1,000 new shares, bringing their total shares outstanding to 2,000.
Shares Outstanding after Secondary Offering = 1,000 + 1,000
Shares Outstanding after Secondary Offering = 2,000
Dave still has 100 shares of company, lets calculate his new ownership percentage:
Ownership Percentage = Dave’s Shares / Shares Outstanding
Ownership Percentage = 100/2,000
Ownership Percentage = 5%
Dave is not a happy camper now that his shares are only worth 5% of the company, which is illustrated above by a smaller piece of the pie. It is also very common for the price per share to decrease in this instance.
This is because of simple supply and demand. The number of shares available has increased (supply has gone up) so the price of the share decreases (demand has gone down). This is very common, but there are instances where the price of the shares increases after a secondary offering.
This generally happens when the secondary offering happens alongside a positive press release, such as an acquisition or the release of a new product. The positive press release with the secondary offering signals to investors that the company is growing, whereas other secondary offerings are performed when a company is struggling financially and needs more capital to continue its operations.
Buybacks
The opposite of an offering is a buyback. This is when a company purchases shares back from public investors. This means the company now owns more of its shares and has a higher ownership percentage. Higher ownership means the company has more control and the stakeholders have less control.
Buybacks generally increase the share price because now there are fewer stocks available to be traded, so the supply is less. Once again, it is simple supply and demand.
Conclusion
Important Takeaway
Stock markets have been around for hundreds of years. Through initial, direct and secondary offerings, companies are able to raise capital to fund important business operations, such as acquiring a new company, developing a new product or building a new facility.
Important Takeaway #2
After the completion of offerings, companies do not receive any financial gains or losses from the trading of their shares. These shares are now on the open market for investors to buy and sell amongst themselves.
Video Learning
The YouTube channel Concerning Reality has a great video explaining some of the previously mentioned concepts. Click on the video below to watch it. We do not take any credit for their work or claim the video to be ours. Please like, follow, and share their video to support their channel!
Extra Resources
Don’t forget to check out the Materials Tab for helpful extra resources and definitions of Key Terms!
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Extra Resources:
- How Does the Stock Market Work? (investopedia.com)
- Stock Market - What is the Stock Market and How it Works (corporatefinanceinstitute.com)
- How an Initial Public Offering (IPO) Is Priced (investopedia.com)
- Direct Listing vs. IPO - What’s the Difference? | Personal Capital
- Direct Public Offerings - advantage, type, disadvantages, cost, Advantages, and disadvantages (referenceforbusiness.com)
- What Is an Underwriter, and What Do They Do? - SmartAsset
- Underwriting Fees Definition (investopedia.com)
- Understanding Preferred vs. Common Stock (investopedia.com)
Key Terms (Courtesy of Investopedia):
- Common Stock – “Common stock is a security that represents ownership in a corporation. Holders of common stock elect the board of directors and vote on corporate policies. This form of equity ownership typically yields higher rates of return long term. However, in the event of liquidation, common shareholders have rights to a company’s assets only after bondholders, preferred shareholders, and other debtholders are paid in full. Common stock is reported in the stockholder’s equity section of a company’s balance sheet.”
- Dividend – “A dividend is the distribution of some of a company’s earnings to a class of its shareholders, as determined by the company’s board of directors. Common shareholders of dividend-paying companies are typically eligible as long as they own the stock before the ex-dividend date. Dividends may be paid out as cash or in the form of additional stock.”
- DPO – “A direct public offering (DPO) is a type of offering in which a company offers its securities directly to the public to raise capital. An issuing company using a DPO eliminates the intermediaries—investment banks, broker-dealers, and underwriters—that are typical in initial public offerings (IPO), and self-underwrites its securities.”
- Hostile Takeover – “The term hostile takeover refers to the acquisition of one company by another corporation against the wishes of the former. The company being acquired in a hostile takeover is called the target company while the one executing the takeover is called the acquirer. In a hostile takeover, the acquirer goes directly to the company's shareholders or fights to replace management to get the acquisition approved. Approval of a hostile takeover is generally completed through either a tender offer or a proxy fight.”
- IPO – An initial public offering (IPO) refers to the process of offering shares of a private corporation to the public in a new stock issuance. Public share issuance allows a company to raise capital from public investors.
- Preferred Stock – “The term “stock” refers to ownership or equity in a firm. There are two types of equity—common stock and preferred stock. Preferred stockholders have a higher claim to dividends or asset distribution than common stockholders. The details of each preferred stock depend on the issuer.”
- Private Company – “A private company is a firm held under private ownership. Private companies may issue stock and have shareholders, but their shares do not trade on public exchanges and are not issued through an initial public offering (IPO). As a result, private firms do not need to meet the Securities and Exchange Commission’s (SEC) strict filing requirements for public companies. In general, the shares of these businesses are less liquid, and their valuations are more difficult to determine.”
- Public Company – “A public company—also called a publicly-traded company—is a corporation whose shareholders have a claim to part of the company’s assets and profits. Through the free trade of shares of stocks on stock exchanges or over-the-counter (OTC) markets, ownership of a public company is distributed among general public shareholders.”
- Secondary Offering – “A secondary offering is the sale of new or closely held shares by a company that has already made an initial public offering (IPO). There are two types of secondary offerings. A non-dilutive secondary offering is a sale of securities in which one or more major stockholders in a company sell all or a large portion of their holdings. The proceeds from this sale are paid to the stockholders that sell their shares. Meanwhile, a dilutive secondary offering involves creating new shares and offering them for public sale.”
- Stock – A stock (also known as equity) is a security that represents the ownership of a fraction of a corporation. This entitles the owner of the stock to a proportion of the corporation’s assets and profits equal to how much stock they own. Units of stock are called “shares.”
- Stock Buy Back – “A stock buyback, also known as a share repurchase, occurs when a company buys back its shares from the marketplace with its accumulated cash. A stock buyback is a way for a company to re-invest in itself. The repurchased shares are absorbed by the company, and the number of outstanding shares on the market is reduced. Because there are fewer shares on the market, the relative ownership stake of each investor increases.”
- Stock market – “The stock market refers to the collection of markets and exchanges where regular activities of buying, selling, and issuance of shares of publicly-held companies take place.”
- Underwriter – “An underwriter is any party that evaluates and assumes another party’s risk for a fee. The fee paid to an underwriter often takes the form of a commission, premium, spread, or interest. Underwriters play a critical role in many industries in the financial world, including the mortgage industry, insurance industry, equity markets, and some common types of debt security trading. An individual in the position of a lead underwriter is sometimes called a book runner.”