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How Stocks Work

Wall Street, NY in 1867

For many years nobody could explain to me the rational basis of the stock market. They told me that prices were controlled by the law of supply and demand. Investors expected the the price of shares in successful companies to rise and so they bought them. This demand then drove the price up. Those who got in early enough would make money when they later sold their appreciated shares. This is all true, but it did not answer my question: why do shares have value in the first place.

I spent a long time struggling with this problem. I thought surely the answer was that the company undertook to reward the stockholder at some future date, perhaps by paying dividends or buying the stock back at a higher price. But in each case I was told that, while these things might happen, they are not required for stocks to have value and not the primary reason even when they are expected.

I think that my difficulty was that nobody ever properly explained what shares of stock are and how they work from start to finish. Once I figured that out, everything was clear. Recently I saw a question online from someone who was struggling to understand how stocks worked. He wrote:

I am interested in the mechanisms which a company can use the money that investors give them when they buy a public stock since they are being bought and sold constantly. How can a company spend other people’s assets when the shareholders still own their stocks and they still retain a liquid value? To me it seems like stocks are a case of “having your cake and eating it too”.
(How can a company use money from stock investors when they are constantly being bought and sold?)

So I wrote the following answer:

I myself was confused about this for a long time, and so I think I know where you are coming from.

Most of the time when investors buy and sell stock the company is not a party to the transaction. To understand how this can be, lets reduce it to a simple example with two investors:

Imagine you need $10,000,000 to start a business, but have only $5,000,000. So you find someone else with $5,000,000 who wants to own half of the business. Now say that the business is successful and ten years later the two of you sell it to a larger company for $25,000,000. You get $12,500,000 and he gets $12,500,000. You have each make $7,500,000 profit.

But what if five years ago someone offered your partner $7,000,000 for his half. He decided to take the $2,000,000 profit and get out. Now when the business is sold the person who bought your partner’s half gets the $12,500,000 and so earns his own $5,500,000 profit.

When your partner sold his half, no money was added to or removed from the business. The buyer gave your partner money and your partner gave him a document showing that he is the new owner of half the business.

Stocks are simply a way of breaking ownership of a business into tiny pieces called “shares”. To raise money the founders sell off a bunch of these little pieces of the business. The owners of these little pieces can sell then them to other people if they decide they want to use their money for something else, but this does not take any money away from the business. The business still has the money it got from selling the shares in the first place.

So once a company has sold stock, the investors generally cannot get their money back from the company. Investors who want out have to find someone who will take their place as investors. This is what stock markets are for. On the stock market buyers pay according to what they think that little piece of the company is worth now.

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