In order to benefit from the magic of compound returns, one should first understand how a share of a stock is created, and how it gets its price.
In the beginning, most companies start out as privately held and unavailable for purchase on a stock exchange. Many remain private forever. Imagine your local pizza shop. It is probably primarily owned by one or two people who work there all the time. They have a nice thing going that pays the bills and makes them happy. They do not have the financial capacity, or desire, to take the business public. That is how most businesses operate.
Meanwhile, perhaps in the next town over there is a pizza place that has really taken off. They have opened locations all over the region. Perhaps they franchise the model. Maybe they started a successful frozen pizza business on the side. They are a really “happening” business and they are a prime candidate to be taken public.
So, they choose some investment banks to help them start the process. They jump through a lot of regulatory hoops, set up an official board, publicize a lot their financial records that were once private, and make a commitment to always act in the best interest of their shareholders. In addition to that, the investment bank determines a value that they all feel appropriately represents how much the business is worth. Based on that value, they break the business up into small pieces called shares. A good amount of those shares go to the founders and early owners and employees of the business. Another large portion of the shares are sold on the market in an initial public offering, aka an IPO.
This is a tedious process. Why do businesses elect to go through it? There are a couple big reasons.
1. Funding: All of the shares sold in an IPO generate free cash for the business that can be directly reinvested into new and existing projects. That gives them cash to expand upfront. Additionally, publicly traded companies have more access to loans and other capital later. All of this gives them a lot of gas to throw on the fire, and the massive funding is why most of the largest corporations in the world are public.
2. An Exit: The founders and early members that built this business from the ground up generally get a very large amount of stock for themselves. A few months after the IPO, they are able to sell their personal shares to investors on the stock market. They typically hold onto a fair amount of stock so they still have an interest in the business, but it is a nice way for them to cash in on their hard work.
This process is good for us as well. Now we can buy a small piece of that company, in a matter of seconds, right on our phone. That’s pretty awesome.
It is important to note that all of the information above is important in order to understand how the market works. However, many investors will never buy a share directly from an IPO. You see, once those shares are divided up among the market, that is just the beginning.
Over the years, thousands of companies have gone public, creating billions of shares that are worth trillions of dollars. The businesses receive their money from selling their shares in an IPO and subsequent stock offerings down the road, but all these shares create a huge secondary market. That secondary market is what most people refer to as the “stock market.” We trade on this secondary market and our money, generally, does not go to the actual business. When you buy a share, your money will go to a person who is selling their share that they bought from someone else.
Imagine limited edition baseball cards. First, the manufacturer puts the cards in a pack and makes money selling them once. After that, the cards within that pack can be traded among collectors for decades. The lion’s share of the capital being exchanged comes with all these subsequent transactions. That is the secondary market.
The secondary market is where pricing stocks gets a little more complicated than simply having a bank estimate a value. Once a stock enters the secondary market, it constantly fluctuates in value and can sometimes experience extreme rises and drops in price. That is because the market constantly decides the value of every security based solely on supply and demand.
Thousands of people, and computers, are monitoring the value of each stock. At any point, if one of them decides that the current price of a stock is too low, and they have money, they will buy some shares. If any one of them feels the current price is too high, and they own the stock, they will sell. Throughout the trading day, millions of shares of any individual company can be bought and sold based on this logic. That creates a free market that is totally reliant on supply and demand. It is a market that is constantly trying to find price equilibrium, but always searching.
When there are more buyers in the market than there are sellers, the stock will be bought at a faster rate than the sellers can supply. This creates upward pressure on the share price. The price of the stock will rise, and that attracts more sellers to accommodate the demand. When an opportunity is really exciting, the share price can quickly and consistently rise because buyers want to get it and sellers want to keep it. Obviously, there is an upper limit and nothing can rise forever. There is always a price most would sell at, we just don’t exactly know what that price is. On the other hand, if there are more sellers than buyers, that leads to a drop in price for the same reason. People want to get rid of their shares and there aren’t enough buyers. The price needs to drop to attract buyers. If the market is overwhelmingly pessimistic about a stock, the price can fall all the way to zero. Whether you are looking at days, weeks, months, or years, you will see constant fluctuations up and down as the market constantly plays this game.
Although the price of any given stock is entirely determined by supply and demand, this is far from a random process. At its core, investors primarily consider four different factors when choosing a stock. These factors are as follows:
Income: How much cash does this business bring in? Can it consistently cover its expenses and use profits to return value to the shareholder? Stable, consistent, and predictable income can lead to stable, consistent, and predictable price movements. Surprising and unpredictable income can lead to volatility.
Assets: What assets does this business own? How much is the real estate, inventory, equipment, and cash in the bank worth? Does the company have a strong brand or unique patents that ward off would-be competitors? What barriers of entry prevent competition from coming in? What about the reputation of the management and the skill of the employees? When you invest in something, you own a tiny piece of all of the company’s assets.
Growth: Investors pay a premium if they believe a company has potential to grow in the future. If it is widely believed that a business will earn higher profits in the coming years, you are generally going to have to pay more for it today. This is where things can get interesting. While current income and assets are fairly concrete, calculating growth can be a little more subjective. When a company comes about with big promises to be the potential leader in an up-and-coming industry, and investors are optimistic about the story, you can see rapid share price appreciation. This is how unprofitable companies with not many assets can be worth billions.
Debt: Most companies use debt to some extent to finance operations. Used correctly, debt can help a business grow and achieve a competitive edge. However, too much debt can be toxic for any business. When a corporation can’t pay its obligations, they risk defaulting on loans and filing for bankruptcy. That often leads to a stock price of zero. When a company faces challenges that impede it from paying its short-term or long-term debts, that is when you can see massive drops in share price.
In addition to all of that, most stocks give you voting rights that allow you to make decisions that affect the company. This power has value, but it is usually not super relevant unless you own a ton of shares.
As you can imagine, over time, share prices tend to go up. After all, the main purpose of any publicly traded company is to return value to the shareholder. Corporations are constantly trying to innovate, grow earnings, add relevant assets, pay out income, and ultimately be perceived as more valuable. With all of that in mind, while share prices do go up and down, they tend to rise in the long-term.
It is important to note that the market is widely believed to create extremely efficient prices. You have tons of people, and computers, analyzing all sorts of data about these companies. All that data is considered, and people trade accordingly. Thus, a huge amount of facts, data, estimates, opinions, and predictions are represented in every stock’s price. For every buyer, there must be a seller. There are no “locks” or “sure things.”
Herein lies the problem with how many individuals trade. Some people load up on one stock they feel is a sure thing and risk a large portion of their savings. Others only buy when there is euphoria and sell when things take a turn. Perhaps you lose sleep at night because of your portfolio. Maybe you avoid investing all together because you equate it to gambling. All of these things are derived from those pesky price swings.
Have no fear. We really have no control of those price swings, so why worry about them. Fortunately, there is a variety of things that we can control when investing. There are many steps that you can take to not only help you profit from the stock market, but to actually build something that works for you. Something that can not just make you money, but can make your life better. Something that is completely passive and allows you to the ability to no longer trade your time for money. Something that is customized for your situation and diversified to hedge against the unknown. Something that you can build yourself, at your own pace. So, if only just for a second, let’s put the price movements aside and look at the the things you get full control over.
Key Takeaway: It is widely believed that everything trading on the market is efficiently priced, to a degree, based on all information available to traders. For this reason, purely speculating on the rise and fall of share prices may be a fruitless endeavor for many investors in the long-run. On the other hand, the stock market allows anyone the opportunity to own a share of a wide array of businesses and debts. That makes it the most passive wealth generator in the world. It may be in an investors best interest to focus on the simple act of investing, rather than timing and price movements.