How The Stock Market Works – A Brief Tutorial
There are many books on how the stock market works but we don’t have that kind of time nor want to do that kind of research. Instead, this is a brief tutorial on how the stock market works in general so that you can get an understanding of how it all comes together and what some of the information means.
A company sells stock in itself to raise money, what they call “working capital”. They do this so they don’t have to use their own money if they have it, or to raise money if they don’t. What happens is that, along with their financiers, there is a determination of how much the business is worth and how much money is needed to get things done. The final piece is how much is estimated the company can make back in profits, because investors won’t pay for anything where they don’t have a chance to make money back.
Once they make the first determination the second is how many shares they need to sell, based on how much they believe people will pay per share. If a company needed to raise $500,000 and thought that they could get 500 people to pay $1,000 a share for it, they’d list it like that on whichever exchange they qualified for. By the way I’m just using that as a number because the minimum amount on the NYSE is $750,000. Anyway, that would be incredible and a bit unrealistic because the idea is to set the price at a rate where not only does it become attractive enough for someone to buy, but they also hope that no one entity buys so much of that stock that they have an overwhelming say in what does on in the company; that’s for another time.
Staying with our example above, depending on what kind of company it is and how well known it is, an opening stock price might be better coming in between $10 and $25; I’m sure Facebook will come in at a lot higher starting price when they finally hit the market. At $10 per share the company would need to sell 50,000 shares; at $25 they’d need to sell 20,000. Using the NYSE again, a company has to come in at least at $4 per share before being allowed to join, so both of those figures are easily high enough.
Now, those are only starting prices. If the stocks start selling well new buyers will want to get in on the game and they’ll be willing to pay more for it. That’s how stock prices start to go up, especially as the number of shares outstanding start to dwindle and it gets harder to find them. Of course the higher the stock price goes means both the company and the early investors make more money and everyone’s happy. As long as the share price continues going up, buying more shares at certain levels means you’ll continue making money; everyone’s happy.
That is, until the share price starts going down. I’m using low numbers here as a way to explain things but there are way more shares outstanding than the figures I mentioned. That’s why you rarely see a stock fall rise or fall more than a couple of dollars a day, if that. Anyway, as the stock price goes down, the more you own the more money you’ll lose. Now, every company has blips here and there, so for the most part if you’re brave enough to ride it out you’ll do fine. But when the price goes down a few days in a row it’s time to do some research to see if something bad is going on to determine your next move. If you’ve had your shares for a long while and have to sell, you may still be in a position to come out ahead. If not, you could lose money.
The beauty of the stock market is that there are so many companies out there that you can do many different things. You can own shares in multiple companies. You can move your money from one to another. You can buy mutual funds which means your money is spread between multiple companies and thus protects your investment better, although it also limits how fast your money can generate new money. And there are lots of other options as well; it’s probably best to talk to a professional investment company, although you can always use one of the online services if you want to do it all on your own.
One final thing. If you buy a certain amount of shares and never buy any more, your investment only grows or falls based on that amount. So if you buy 100 shares, your dollar amount can only increase so much and never grow, and can only fall so much and never bankrupt you, so to speak, unless the company’s stock price falls below a dollar, in which case the company gets delisted and your money is gone. Of course, you’d know it was coming and hopefully would have sold your interest before then.
As I said, down and dirty, but hopefully it gives you a start on your investing knowledge.