Imagine that you run a bakery. Your bakery uses the secret recipies of your late, great grandmother Laura. Business is slow when you start out, but customers love your doughnuts and muffins, and you begin to increase operations. Very soon you are flooded with orders and you just cannot keep up with demand. You decide it is a good idea to open another bakery. It isn’t long and you’ve opened up a third bakery, and so on.
Even with increasing revenue, you’ll most likely discover that you don’t have sufficient money to open up the next bakery. It requires a lot of capital to start a new bakery. A new bakery won’t have an existing customer base, and it’s uncertain as to if a new bakery will be profitable. Some businesses choose to get a loan from a bank. Others decide on raising investment capital. They go to the stock market for money.
You schedule a consultation with an investment banker from a well-known Wall Street firm.
During your meeting, the investment banker looks over your operations and determines that you’ve a great business going with a real competitive advantage (your great granny’s recipes). The investment banker believes that you can make even more money if you start expanding. He says he’s going to make a couple of phone calls, set up meetings with some clients, and then get back with you.
It takes a couple of weeks, but he finally gets back with you. He thinks you are a perfect candidate for going public. He’s drafted a mess of legal papers and if you are interested in moving forward, you need to come down to his office to review them. If you sign on the dotted line, your bakery will start trading on the stock market. Your company’s market cap (company value) will be $ 80 million.
You own some of the shares. Partners the investment banker has lined up own a portion of the shares. The remainder will be offered to the public during an initial public offering. After the IPO, the value of your bakery chain will be decided by the stock market. The millions raised by the IPO go toward future expansion of the bakery chain.
A year goes by and the bakery business has been really good. The stock price has more than doubled, but how come?
The stock market is like a two-way auction marketplace. Buyers and sellers come together on a price they each consider fair. The price depends on several factors: the track record of management, projected future growth of earnings, company earnings, the company’s book value (what the assets of the company are currently worth), the economic outlook of the industry the company operates in, and more. Stocks increase in value when these factors are positive. Stocks tend to fall in value when these factors are negative.
Warren Buffet once said, “If a business does well, the stock eventually follows.” This is a unique truth of the stock market. When everything else is equal, companies who do well will see their stock price rise. Businesses who do poorly see their stock’s price plummet. That is the basic underlying foundation of the stock market.