Village builders

Block 6: The How

Like we said, buying a stock represents ownership of a business. But what about all the details; how does this stock market thing actually work? Good question once again!...

 

Let’s say Uncle Ned meets a magic genie and one of his wishes is that his landscape company will grow big enough to IPO (I really hope someone reading this actually has an Uncle Ned with a landscaping business). Ned decides to sell 50% of his company, “Wonderscape” to the public and the ticker (the letters that signify a company’s stock, for instance Apple’s stock ticker is AAPL), is WNDR.  Let’s say he sells 10 million shares at a price of $10 per share. He will raise $100 million so he can invest in new landscaping equipment, hire more people, or make a plethora of business decisions. He keeps the other 50% so he, alone, owns 10 million shares.

 

So WNDR IPO’s and investors buy heavily into the company on the first day. The stock jumps from $10/share to $13/share (this type of first-day return called a “pop” happens often but it is rare that a retail investor, not a fancy banker, can get in “on the floor” at that $10 price). Let’s say you buy in at $12 though and the stock price ends up at $13. That is an 8.3% return. Pretty good! But what caused the price to go up in the first place?

 

Well the price is determined, like in all markets, by supply and demand. If people are willing to pay a higher price for a stock (i.e. demand is higher), the stock price will increase. Companies are valued pretty much how other goods and services are valued. Things are valued at what people will pay for them. For example, if Nike sets the price of their new shoes at $200 and no one buys them, they will lower the price of the shoes. If people start buying them at $150, $150 becomes the price. The world works with more complexity but this concept of supply and demand is the essence behind price movements. Now that we have covered some of the nitty-gritty, let’s dive into another important idea…