How does the stock market work?

Guest contributor friedo replies:

Wow, KC, you sure know how to ask Big Questions. The answers to all of them could fill several books, but I’ll try to give a broad answer to your questions. Nitpickers beware.

In order to understand what stocks are and how stock markets work, we need to dive into history–specifically, the history of what has come to be known as the corporation, or sometimes the limited liability company (LLC). Corporations in one form or another have been around ever since one guy convinced a few others to pool their resources for mutual benefit. The first corporate charters were created in Britain as early as the sixteenth century, but these were generally Crown monopolies that resembled what we might think of today as a public corporation owned by the government, like the United States Postal Service. Privately owned corporations came into being gradually during the early 19th century in the United States, United Kingdom and western Europe as the governments of those countries started allowing anyone to create corporations as a routine matter.

The legal status of a corporation derives from three arcane but vital principles: (1) limited liability, (2) transferability of shares, and (3) virtual personhood. Limited liability means that a person who invests in a corporation can never lose more money than he puts in, or to put it another way, investors aren’t on the hook for the corporation’s obligations. The English courts summed up the principle of limited liability nicely: Si quid universitati debetur, singulis non debetur, nec quod debet universitas, singuli debent. (If something is owed to the group, it is not owed to the individuals, and the individuals do not owe what the group owes.) Because the company is a separate, autonomous entity, even if it goes belly up, none of the investor’s unrelated assets are harmed (unlike a partnership, for instance, where the general partners’ other assets might be at risk in case of a lawsuit). Limited liability may sound snarky, but it’s the key to getting people to invest in a possibly risky venture.

Transferability of shares means that an investor’s stake in a corporation may be freely transferred to another person by sale or donation–typically you don’t need anyone’s permission nor does the firm need to be reorganized, as is often the case when the principals in a partnership change. Transferability may be subject to limitation in certain instances. For example, laws in some countries, like France and Belgium, place some restrictions on the sale of shares of privately held corporations, and in the U.S. you may be limited in how soon you can sell stock conveyed to you under a stock option plan. As a general proposition, though, transferability makes the stock market possible.

But what is a virtual person? No, we’re not talking about Commander Data here. Virtual personhood simply means that a corporation, as far as the law is concerned, is treated as though it were a human being. It has a name, can own property, enter into contracts, file lawsuits and be sued, be taxed by the government, open bank accounts and establish credit, and so on. In all these situations, the corporation acts as its own person, entirely distinct from the persons who own it (who, by the way, might be other virtual persons themselves). Corporations even have many of the same rights as persons, such as the right to free speech. Case law in the United States, however, recognizes that the speech of actual persons is generally more important than virtual ones. Curiously, the U.S. Supreme Court established the personhood of corporations through a famous (or infamous) 1886 decision based on the 14th amendment–you know, the one intended to protect the rights of former slaves. The court held that “equal protection of the laws” applies to artificial persons as well as natural ones.

In order for a corporation to do business, it needs to get money from somewhere. Typically, one or more people contribute some capital as an initial investment to get the company off the ground. These entrepreneurs may commit some of their own money, but if they don’t have enough, they will need to persuade other people, such as venture capital investors or banks, to invest in their business. They can do this in two ways: by issuing bonds, which are basically a way of selling debt (or taking out a loan, depending on your perspective), or by issuing stock, that is, shares in the ownership of the company.

Let’s say they go the route of selling stock (the words “share” and “stock” are used interchangeably). A corporation is generally entitled to create as many shares of itself as it pleases. Each share is a small piece of ownership. The more shares you own, the more of the company you own, and the more control you have over the company’s operations. (But not always. Companies sometimes issue different classes of shares, which have different privileges associated with them.)

So a corporation creates some shares, and sells them to an investor for an agreed upon price. Voila, the corporation now has some money! In return, the investor has a degree of ownership in the corporation, and can exercise some control over it. It’s his money on the line, after all. The corporation can continue to issue new shares, as long as it can persuade people to buy them. But the owners must also keep in mind that the more shares they issue, the more they dilute their own ownership of, and power over, the company. If the company makes a profit, it may decide to plow the money back into the business or use some of it to pay dividends on the shares.

The decision to pay dividends is, in theory, made by the shareholders. (In practice, of course, the shareholders generally ratify a decision made by management.) The owners may feel they deserve compensation for their investment and issue a large dividend, or they may feel it would be better to let the company reinvest its profit so it can grow. If they elect to issue dividends, a chunk of cash will be set aside and divided among the shareholders based on the number of shares they own. The more shares you own, the more dividend cash you get. Big, financially stable “blue chip” companies generally pay a dividend regularly, since the dividend rather than a rapidly rising share price is the chief reason for owning the stock. Fast-growing startup companies, on the other hand, may go for years without issuing dividends, since (a) they need to plow all their profits back into the business, and (b) the company’s rapidly rising stock price is enough to attract investors.

With the new corporate structure in place, people begin buying and selling their shares. People invest for different reasons. Those looking for a steady return on investment may buy shares of a profitable company that issues regular dividends. Risk-takers on the other hand may buy shares of a fast-growing company (or at least one that people assume will be fast-growing someday) in hopes of selling them for a profit later. The more extreme forms of speculation are based on the “greater fool theory.” You can make a foolish investment in the hopes of selling it to an even greater fool later on.

Long ago stock owners realized that it would be convenient if there were a central place they could go to trade stock with one another, and the public stock exchange was born. The history of the modern stock exchange can be traced back to 12th century France, where the profession of courratier de change arose in order to help regulate debt management among agricultural communities. In the town of Bruges in Flanders (now part of Belgium), traders began gathering in front of the house of the Van der Buerse family, eventually leading to the word “bourse” as a synonym for stock exchange. In the 1600s, shares of the Dutch East India Company (the first company to issue shares resembling those of a modern corporation), and later the Dutch West India Company were traded regularly in Amsterdam. The Dutch West India Company founded a small trading post on the southern tip of the island of Manhattan–I understand the stock exchange there eventually got to be a pretty big deal. In 1773, British investors who had been meeting informally in coffee houses moved into their own building, forming what is now the London Stock Exchange.

How each stock market works is dependent on its internal organization and government regulation. The NYSE (New York Stock Exchange) is a non-profit corporation, while the NASDAQ (National Association of Securities Dealers Automated Quotation) and the TSE (Toronto Stock Exchange) are for-profit businesses, earning money by providing trading services.

If a corporation grows large enough, it may decide to “go public” and attempt to sell shares on one of the public markets. The vast majority of corporations are small, privately owned businesses whose shares aren’t traded on public exchanges. So while Starbucks may be found on the NASDAQ under the symbol SBUX, you’re not going to find shares of the local mom-and-pop coffee shop there. Each market has its own rules and regulations about what qualities a company must possess in order to be listed on an exchange. If a corporation violates these rules or loses so much money as to be essentially worthless, it risks being “de-listed,” or kicked off the exchange.

Most companies that go public have been around for at least a little while, having issued privately held shares to investors and venture capitalists. Going public gives the company an opportunity for a potentially huge capital infusion, since millions of investors can now easily purchase shares. It also exposes the corporation to stricter regulatory control: In the United States, the SEC (Securities and Exchange Commission) oversees the financial goings-on of publicly traded companies.

When a corporation decides to go public, after filing the necessary paperwork with the SEC and the exchange it has chosen, it makes an initial public offering (IPO). The company will decide how many shares to issue on the public market and the price it wants to sell them for. This is not an easy decision, as it is sometimes difficult to predict how the market will react to the new kid on the block. When all the shares in the IPO are sold, the company can use the proceeds to invest in the business–or it can squander everything on BMWs and golf club memberships. Prudence, however, would suggest spending the money wisely, since the company may want to sell additional shares later when it needs more money. That only works if people can be persuaded that buying more shares will be a good investment.

How does the price of a publicly traded company on a stock exchange affect the company’s overall health? It doesn’t–at least, not directly. It would be more appropriate to say that the overall health of a company affects its stock price. When people look at the financial statements of a company and become confident in its future, demand for shares of that company will increase, driving up the price. People will want to buy shares of a company that is doing well in order to be paid dividends on their shares, or to sell some of their shares for a profit when the value increases. Simply put, the value of a stock is the value of all its future potential income. While you’re right that dividends are often a pittance compared to the purchase price, the dividends over many years may not be.

Similarly, if a company is clearly going down the toilet and being managed by an inept boob of a CEO, people are going to want to dump their shares. The increase in supply will drive the price down.

Does an economy “need” a stock exchange? Not really–as we’ve seen, stocks can be traded in bars and coffee houses if so desired. But a modern, well-regulated stock exchange is the most convenient and safe forum for trading shares of large companies.

Guest contributor friedo

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