http://www.straightdope.com/mailbag/mstockmarket.html
I thought I would take a stab at KC’s questions, since friedo’s answer seems to be more of a discussion of how companies work.
“What is the connection between the price of a stock on the stock market and the actual “health” of a business?”
At the most basic level, a stock price can be thought of as a prediction of how much money a shareholder can expect to receive from the stock. That prediction takes into account the time value of money (a dollar today is worth more than a dollar next year) and the riskiness of the stock. A healthy business is expected to produce larger dividends (even if, like many young companies, it is not currently paying any dividends) and to be salable for a larger amount than a troubled company.
The stock price should take account of all relevant information, so there can be many factors other than the health of the business that affect stock price. For example, if interest rates go up, then bonds will become a more attractive investment and people will sell stocks, so stock prices will go down. Or, if someone decides to buy the company by making a tender offer, the stock price will rise, even though the health of the business is unchanged.
“I understand that an IPO raises money for a company, and that shareholders then have some sort of say-so in managing the business, but after the stock is owned by someone else, why should its price on the stock market, high or low, have any bearing on whether or not the company is profitable and pays its bills? Does WidgetCo have to declare bankruptcy just because their stock tanks–couldn’t the business be doing just fine?”
Normally the stock price has little bearing on the business, beyond limiting its ability to raise additional funds by selling stock. If the stock price gets low enough, the stock may be delisted from its stock exchange, but it will not ordinarily cause the company to file for bankruptcy. Of course, if the stock price is that low, the business is probably not doing just fine.
In a few cases, companies have entered into complex arrangements that are dependent on their maintaining a high or even a rising stock price. In such a case, a dropping stock price may indeed force the company into bankruptcy. However, that is quite unusual.
“And finally, how do you become rich simply owning stock rather than speculating? Aren’t the yearly dividends a pittance compared with the purchase price?”
When you own a stock, you own both the right to receive dividends and the right to share in the future growth of the company. A company with strong growth prospects will have a relatively low dividends or no dividend at all. Many large fortunes have been amassed by buying and holding companies whose good prospects were not immediately recognized. For example, 100 shares of Home Depot would have cost you as little as $1850 (plus trading commission) on December 31, 1981. Today, as a result of stock splits, you would hold 34,172 shares, with a closing price on Friday of $32.16 per share, in addition to the dividends you would have received along the way. Of course, almost nobody thought to buy Home Depot at only $18.50 per share - only 800 shares were traded on December 31, 1981.
“If these questions don’t make sense, maybe this short, pithy question would be better. What constitutes an “economy,” and does it need a stock market?”
An economy is a system for the production, distribution, and consumption of goods and services. An economy does not have to have a stock market, and historically most economies have not. However, large, modern economies do need stock markets. Stock markets provide companies with a cheap source of financing, and they provide investors with investments that are fairly valued (at least, as compared to the alternatives) and are readily salable. These advantages are so compelling that the existence of a functioning stock market is an important measure of the functionality of an economy.
I think that answers KC’s questions, though of course he or she may have more. A few comments on friedo’s answer, which is more about companies than about the stock market:
–Friedo talks about corporations, or at one point the limited liability company. Most publicly traded companies in the United States are indeed corporations or business trusts (often used for passive investment vehicles such as mutual funds). The limited liability company, a relatively recent creation, is not suitable for public companies, though it has become extremely popular for closely held companies.
–It isn’t just France and Belgium - U.S. law also places restrictions on the sale of shares of privately held corporations. For a company to be publicly held and its shares freely tradable, it must register with the Securities and Exchange Commission, a difficult and expensive undertaking but one that virtually all large companies find well-worthwhile.
–A company is not a “person.” A person is an individual. A company is simply a group of individuals who have organized themselves to carry on business. However, a company may be treated as a person for some limited purposes (including, as friedo says, owning property, entering into contracts, bringing lawsuits, and so forth).
–The decision to pay dividends is made by the board of directors, not the shareholders. The shareholders elect the board of directors to oversee the company on their behalf. In practice, corporate management (who typically will include some directors) will propose dividend payments to the board.
What’s my claim to know about this stuff? I’m a practising securities and corporate lawyer (Harvard Law School 1984), specializing in investment management. You can take a look at my FundLaw blog/email list, which gives updates on securities law developments, at http://groups.yahoo.com/group/fundlaw/.
John Baker