The stock market. Stocks, shares, buying, selling, price goes up, price goes down. How does it all work? How can it work at a very basic foundational level? Some careful reading of the mere introductions on Wikipedia, some careful thought, and most importantly, some concrete examples are very helpful.
20200224/https://en.wikipedia.org/wiki/Stock_market
20200224/https://en.wikipedia.org/wiki/Stock
So first, the basic definitions, simplified for the purposes of our simple primary example to give first.
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Equity and capital synonyms for money/currency. Therefore, the equity or capital of a company is simply how much money a company has. (More on this later.)
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A share is a fractional ownership of a company out of the total number of shares.
So, let’s give a simple example. Suppose a company has $100 in equity and 10 total shares. Therefore, the price of one share is 1/10 of the total equity, or $100 / 10 = $10. This is how much money a shareholder can get if they sell one share.
So, let’s consider what happens after that action is performed. The shareholder now has $10 more money and one less share in the company. Likewise, the company has $90 in equity and 9 total shares. As it turns out, the price of one share is still $10, since $90 / 9 = $10.
Okay, so that’s easy enough, and that answers the prime question. How do you determine the price to set one share for buyers on the stock market? The answer is easy andstraightforward: divide the total equity by total shares to obtain the share price. Happily enough, this formula will be completely stable even when the number of actual buyers is unknown. The primary variable in the share price is the business operations of the company. In its most basic form, the question of the popularity among shareholders to buy and sell shares does not affect the price of the share.
Of course, this patticular fact is key: The total number of shareholders cannot be zero, else you will get a divide-by-zero error. At the very least, you can define the founder-owner of a company to own one share in the company, and when there are no other shares bought, that is the price of one share.
Now, if an already established company wants to list itself on a stock exchange, one share corresponding to the total equity in a company would make its stock untenable. So, you need to split the one share into multiple shares, effectively decreasing the value of a single share, but correspondingly multiplying the number of shares that existing shareholders have.
Suppose you have a “big box store” company that has $1,000,000,000 in equity but no shares, and it wants to list itself on a stock exchange. Principally, you start by defining the founder-owner of the company to have a single share in the company that corresponds to all of $1,000,000,000 of equity. Now, you want the target share price to be $10, so you split the stocks by a factor of 100,000,000. Therefore, the founder-owner of the company has 100,000,000 shares, and the share price is $10.
Now, what about dividends? Well, simply put, a dividend is a payout per share that effectively decreases the value of a share by that amount. So, if a share is worth $12, and there is a dividend payout of $2 per share, that reduces the value of one share to $10, and each shareholder earns $2 per share.
20200225/https://en.wikipedia.org/wiki/Dividend
In more complex accounting scenarios, a company doesn’t just simply have money, but it also has a combination of assets and liabilities that together form the net worth of a company that can be represented as “equity,” of which only some of is directly represented in cash value. The rest of a company’s assets have a dynamic value that is determined by the market valuation. Say, for instance, a big box store owns the land its store is placed on. That is a tangible asset that is owned that doesn’t have a direct monetary value, but its monetary value is determined dynamically and indirectly by its market valuation on the real estate market. One day, it might be worth $100,000, the next day, it might be worth $10,000. Once the value of such assets are determined, they can be added into the sum of all assets of a company, which can then determine the total “equity” of a company.
Therefore, what I said about “equity” being the same as money was an over-simplification. Indeed, it is the total value of a company, which includes both monetary assets, also called “capital,” and non-monetary assets, such as land, tools, materials, etc.
20200225/https://en.wikipedia.org/wiki/Accounting_equation
Okay, okay, but what about what that one Mr. Money Mustache article said about how stocks work? How can we ever have a market supply-demand relationship here where when more people rush to buy a stock, the price goes up? And, conversely, when a whole bunch of people sell their stock, the price plummets?
20200226/https://www.mrmoneymustache.com/2019/09/12/michael-burry-index-funds/
Well, as it turns out, real world stocks aren’t defined so simply. Rather than being merely a share of equity in a company, they are a measure of a company’s profit. Thus, nonprofit companies cannot be listed on stock exchanges. The profit is principally paid out from dividends. When dividends are not paid out, that is principally a decision to re-invest the profits rather than pay them out to shareholders. Apparently by the examples given by Mr. Money Mustache, with dividend payments, the share price is relatively stable on its own, but as a company’s profits grow, so does the dividend payout grow proportionally. Yeah, that all makes sense.
But how exactly is the share price set? That has something to do with the “net present value” of all future earnings, so I was told.
20200226/https://en.wikipedia.org/wiki/Net_present_value
Okay, let’s continue the fleshing out the full definition using simple terms. Assume that all of the money exchanged when buying and selling shares counts toward a company’s profitability. This means that buying shares increases a company’s profits, which means that more money can be paid out in dividends, and therefore the share prices can be higher. Likewise, selling shares decreases a company’s profits, decreases money that can be paid out in dividends, and therefore decreases the share prices.