I understand, at a basic level, that a share of stock represents a fraction of ownership in the company. Thus, if a company becomes more valuable (e.g., by announcing higher-than-expected earnings,) its stock price goes up. I also understand that stock prices are influenced by supply and demand–if a lot of people start trying to sell their shares of a certain stock, the prices goes down, and if a lot of people want to buy it, the price goes up.
Trying to think more deeply about this, however, I realize there are things I don’t understand. First of all, any time someone sells a share, someone else buys it, right? So how can there be, at any given time, more people buying than selling, or vice-versa? How can there be such a thing as a huge sell-off that causes the price to plummet–for each of those people selling their shares off, aren’t there people buying them? If not, where do those shares go? And if so, why would the price change at all?
Second, how does it actually benefit a company for its stock price to rise? If there are 100 shares outstanding, each representing 1/100 of the comapny, each worth $10 per share, the company is worth $1000. If the price then rises to $11 per share, then the company is worth $1100. Great, the company is worth $100 more–but the company doesn’t get that money, it’s held by the shareholders, right? So what good does that do the company? I supposed sometimes companies issue additional stock, so it could benefit them by allowing them to raise more capital, but if they issue additional shares, doesn’t that dilute the value of the shares already out there? So they could issue another 100 shares, but then wouldn’t each share represent only 1/200 of the company, and then wouldn’t the price of the previously existing shares, which had been worth $100 each, drop to $50, thus negating any ability to raise capital by selling more stock? What am I missing?
The issue with matching buyers and sellers are dealt with by “specialists” (NYSE) and “market makers” (NASDAQ) These are people who are required to buy and sell shares out of their own accounts to make sure that everyone can buy or sell as necessary. If the stock drops, the market maker is required to buy the stock with their own money. They can then try to sell it, but may have to lower the price so they take a loss. However, in the normal course of events, they are making money on every sale, so they usually make a profit overall.
The company gets no financial benefit once the stock is issued. They get a one-time payment. Issuing additional stock is not a simple process, so companies don’t often do it – only when they want to expand. The benefits are to the stockholders if the stock rises (and most executives own stock in their own company, so profit if the stock goes up).
Here’s BetterExplained on the stock market. I’d say it hits your main questions, and if you have deeper questions after that, they can be handled here.
There can’t be. Well, to be more precise, there are always an equal number of shares sold as there are shares bought. There may be lots of sellers and a few big buyers, or vice versa.
The part you’re missing is that for a transaction to occur, both parties must agree on the price. You want to get rid a share of stock, so you offer to sell it to anyone within earshot for $100. No takers, so you offer $99. Still no takers, what about $98? Someone decides it’s worth it for them to buy at that price, so they agree. A trade is made.
This can lead to a problem, which is what happens if the difference between the lowest price someone wants to sell at and the highest price someone wants to buy at is insurmountable. (The "bid/ask spread.) In olden tymes, to ensure market liquidity, stock exchanges employed “specialists” or “market makers” whose job was to ensure the smooth flow of trades by having shares and cash on hand to buy or sell shares as necessary in order to keep the spread narrow. Stock exchanges still do exactly the same thing, but it’s almost entirely automated. I think NYSE may still employ a few human specialists, somewhere.
Right.
Forgetting about secondary offerings for the moment, the main advantage to a company of increasing share price is that increased shareholder value implies a stronger equity position for the company. Publicly-traded companies often own a large number of their own shares (called treasury stock.) If the value of that goes up, those shares can be used as collateral for lines of credit. If the value decreases, the lender may want to call in the loan. If the value crashes, this can put you in major trouble. (Enron famously pledged a metric ton of treasury shares as collateral for loans, among other things.)
The board of directors and senior executives of many companies are also likely to be large shareholders. They certainly won’t have many complaints if the price increases.
Finally, companies can raise money by offering new stock to the market in a couple ways. The first is to simply sell its existing treasury stock to the public market. This won’t affect the price-per-share – those shares already existed on the company’s books – but it allows the company to raise money easily. A lot of companies will buy back their own shares when the stock is low and sell them again when the price goes up to raise small amounts of money regularly.
The second way is to create new shares, as you said. Creating new shares always has a diluting effect on the existing shares in terms of the percentage each shareholder owns. But it doesn’t decrease the value. The error in your analysis is here:
While the company now has 200 shares outstanding, they also added $10,000 to their balance sheet! That was the cash they took in for selling those 100 new shares. So (assuming the first 100 shares really represent $10,000 worth of value) their market capitalization is now $20,000, and $20,000 / 200 shares = $100.
Really stocks trade the same way anything else does, just faster. If you say, “I have a house I want to sell and I want $500000 for it”, it might be the case that no one wants to buy your house at that price, and you have to say “OK, how about $480000?”, until you find a buyer.
Conversely if you go out an announce, “I want to buy a house for $200000”, you might not not get anyone willing to sell to you, and you’ll have to come back and update your offer to $250000 (or look in a cheaper neighbourhood, but for the sake of argument, let’s say all houses are the same).
The difference is house buying is very rare, so houses can sit on the market for some time without being sold, and buyers can be on the market for a long time trying to find a house before accepting that they’ll have to pay more to get what they want.
Not so for stocks of big liquid companies. There are so many buyers and sellers at any time that you can (almost) always find a buyer quickly by lowering your asking price just a little bit, and can almost always find a seller quickly by increasing your bid price just a little bit.
Stocks don’t sit on the market for months waiting until the asking price is lowered by 30% like houses might, but the same dynamics come into play. Just replace “months” by “milliseconds” and “30%” by “0.1%”.
Note that the quoted price is just the price the last transaction cleared at (i.e. the last time shares changed hands it was at that price). It is not a guarantee that the next transaction will happen at anything like that price. The next bidder may have to raise the price, or the next asker may have to lower the price to draw a counterparty into the transaction they want.
Company employees have stock plans and benefit, plus it impacts the company’s ability to sell more stock at reasonable prices.
Yes, dilution occurs unless the company invests the money and earns returns that pay off the new shareholders and have additional earnings left over for old shareholders. Otherwise you would never issue new stock.
E.g. The new shareholders expect a return of 12%, and you invest in a 15% project, the extra 3% gets divided up among all shareholders, new and old, so everyone wins.
To clarify the actions of money makers, they typically specify two prices: A “buy” price at which they will accept any offers of stock, and a slightly higher “sell” price at which they fulfill any requests for a purchase of stock. Their hope is that there will be an equal number of buyers and sellers so the market maker doesn’t accumulate any stock at all, and just makes the difference between its buy and sell price all day.
Of course, if the market maker finds there are actually more buyers than sellers, or more sellers than buyers, it immediately adjusts its buy and sell prices up or down as appropriate until the number of buyers and sellers are equal.
Why do executives try and raise the price of the stock if they have sold the stock to shareholders? Because it’s their job. That’s what they are paid to do. The president of Boeing Aircraft is not paid to make airplanes. He is paid to make money. He has a fiduciary obligation to the shareholders to make as much money as possible. He just happens to do it by making 737s. If the stock price falls, then someone will buy a lot of the stock and replace the board of directors and the officers.
(This is baffling to me. I know nothing of the stock market, so it isn’t much of a stretch to be baffled.)
Does this mean that a Specialist’s job is to “buy high, sell low”, pretty much a recipe for losing money? If so, then is it the case that they are working with such small degrees of “high” and “low” that their cut (commission? what?) is always more than the self-inflicted loss?
Prices go down when lots of people want to sell. In order to make sure YOUR share is the one that sells (since there aren’t enough buyers at the current price) you have to price it lower than everyone else trying to sell.
Now imagine everyone who wants to sell doing the same thing. Of course the price plummets. Eventually there are buyers for all the shares, but only when the price is low enough that people are willing to buy in equal numbers to the people who want to sell.
Now, imagine the same, but in reverse. If you want to buy more shares than people want to sell, you need to offer a higher price than the other buyers offer. Every other buyer is doing the same thing. Eventually the price is high enough that people who want to buy are equal in number to the shares people are willing to sell. Easy peasy!
I definitely agree, but there’s a more fundamental reason the board of directors and executives like the CEO are motivated to keep prices up: their jobs are on the line.
I’ll elaborate for the OP: The board of directors in most companies is elected by shareholders, usually at an annual shareholder meeting. In the simplest scenario, one share equals one vote but most companies have multiple classes of stock with different voting rights (even non-voting shares). Anyway, if a shareholder sees the value of their stock going down, they’re likely to respond like any voter: get rid of the current guy and vote in someone else. If he’s a large enough shareholder and he thinks he can do a good job, maybe he votes himself in.
The board of directors, in turn, appoints executives like the CEO. If things are going badly, the board has an incentive to be proactive about replacing the company’s management before the shareholders replace the board.
So in a very real sense, even a CEO and the chairman of the board are answering to their bosses, the shareholders.
The shareholders can vote for other things too. For example, they could vote to shut the company down, sell its assets and distribute all the money to the shareholders. If a company’s future prospects are not worth more than their current value, there might not be a company any more.
This illustrates why share prices aren’t just about monetary value when you’re talking about the biggest investors. Bill Gates wants (well, wanted) billions of shares of Microsoft not just as an investment, but as a way to keep control of “his” company.
I think the key is that a lot of buyers are issuing market orders - which is essentially saying “I trust you to buy/sell for me at the best price you can get” rather than specifying your price in advance.
If you ever do your own trading for individual shares, you’ll see this in action. It’s not unusual place to place a buy order when the market says $54.40 and then see that you actually paid 54.50 per share. Or you sell when it says 54.40 and only get 54.30.
After all, it’s these market order types who want the order fulfilled right now, where the Specialist can help with liquidity. If they wanted to pay $54.00 and only $54.00, they’d issue a different kind of order that would be fulfilled only when/if the price was actually 54.00.
No, their job is to buy low, sell high, just like everyone else is. The only difference is that they are publishing and committing to what “high” and “low” mean for them, expecting that there is as many people willing to buy from them at their “high” price as there are people willing to sell to them at their “low” price so they don’t make any net transactions.
This is similar to the behaviour of money changers at airports. 1 Euro is about 1.13 USD, so an American money changer might say, “I will buy Euros at $1.10, and I will sell Euros for $1.16 to anyone who will deal on those terms”. He has no intention to have more or less Euros at the end of the day than he started with. He intends to quickly resell every Euro he buys and pocket $0.06 for every Euro that passes through.
Of course, do do that, he has to set his prices sensibly. If he says “I will buy euros at $2.50 and sell Euros at $2.60”, he’s going to see a lot more people wanting to sell to him than people wanting to buy, so he will accumulate Euros. Similarly, if he says “I will by Euros at $0.50 and sell them at $0.60”, he’s going to get a lot more interested buyers than sellers.
In order to get equal selling and buying, he has to bracket the “going rate”. And in fact that is how the “going rate” is determined (although not by the airport guy, who probably just googles it).
Perhaps it helps to note explicitly that all modern exchanges trade using something like a limit order book. Loosely, you can place two kinds of orders: limit orders, and market orders. A limit order is an instruction to the exchange that you want to “buy at a price no greater than x”, or “sell at a price no less than x”. A limit order works kind of like a classified ad to buy or sell a used car: after you place it, the order just sits there, waiting for someone to take the other side of the trade. A market order is an instruction to buy or sell immediately, at whatever posted limit order offers the best (lowest to buy, highest to sell) price; it’s like looking through those classified ads to find the best price, and calling the buyer/seller to make a deal. *
At any time, the best buyer’s bid is lower than the best seller’s asking price. If it weren’t, then the buyer and seller would be willing to trade with each other, and those orders would get filled against each other and disappear. So if you buy a share of stock with a market order, and then immediately sell it with a market order, and the price doesn’t move in the meantime, you lose money and the market maker gains. Essentially, you are paying the market maker for the privilege of executing your orders immediately, instead of waiting for a “real” seller/buyer who wants to take the other side of your trade. A used car lot makes money in roughly the same way as our market maker, by buying low and selling high, but nonetheless getting customers because it’s more convenient than placing the classified ad and waiting for a response.
So market making has the potential to be extraordinarily profitable. In some exchanges, particular firms promise to always maintain orders to both buy and sell on the exchange, with a spread within some limits, like the “Specialists” discussed above. In other exchanges, no one is obligated to do this, but they do it nonetheless, because they think they’ll make money.
They can lose money too, though. If the market maker sees a sudden burst of selling in a stock, then consider two possibilities: (1) the owner of that stock wants to buy a house, and needs the proceeds for his down payment; and (2) the owner of that stock just saw on the news that the company’s CEO has been indicted for fraud. In case (1), the market maker should buy and warehouse the stock, and maintain its price; nothing about the stock’s fair price has changed, and buyers and sellers should roughly even out over time. In case (2), the market maker should drop the price immediately.
If you can trick a market maker into dropping the price when something like (1) happens, or maintaining the price when something like (2) happens, then you will make money and the market maker will lose. The tighter the bid-ask spread, the less the market maker “automatically” gains on each round trip, and the easier it is to trick them profitably. Multiple market makers can compete, to try to offer the tightest spread (since if you don’t, your orders will never get matched) without losing money due to informed traders’ marketable orders.
Actually, a limit order can be marketable (i.e., able to be matched against an existing limit order) or non-marketable, and marketable limit orders execute immediately, like market orders. If you’re e.g. a long-term investor buying stock in a retail brokerage account, it’s often a good idea to use marketable limit orders instead of market orders, to avoid big surprises on the execution price.
The company still has owners before they publicly issue stock. By offering stock, they are diluting their ownership stake. Probably in exchange for fat stacks, which may go in their wallets or get injected into the company. The company and its owners are considered separate entities for many purposes, but there’s always one or more humans at the end of the ownership chain.
That’s oversimplified to the point of being wrong. The primary offering goes into the company’s coffers (owned by the owners), but the initial owners keep some stake that they can also sell off in the new public market.