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All posts by Dan Whalen,
Providence, RI (resume)

Friday, July 13, 2012

Stock Markets and IPOs

What is a “stock market”?

Let’s say you went on down to the stock market and bought stock in Facebook.  Who are you buying from?

A lot of people assume that when you “buy stock” in Facebook, you buy it from Facebook itself.  You don’tWhen you buy stock, you buy it from some other person - another trader or broker or individual who already owned the share.

Ok, so where did that person get it from?  Same as you.  They bought it off of somebody else.  That somebody else got it from another somebody else.  And so on.

Of course, at some point there has to be a first purchaser.  Stocks just don’t materialize into existence.  So how did patient zero pick it up?

Alright, you got me.  The first person who purchased the stock, they bought it off of the company.  But they are the only one, and that purchase likely happened years ago. 

Stocks are sold into circulation by companies at a single event called an “Initial Public Offering” (IPO).  Sometimes you’ll hear this referred to as “going public.”  After that, they’re circulated through transactions between individuals: a set of “second hand trades,” if you will.

Ok, so you go down to the stock market to buy a share in Facebook from some guy…and find that it costs $30 a share.  It was Facebook who set the price, right?  Sorry…no again.

Companies do set the price for their stock during the IPO.  But for the rest of that stock’s life, it’s traded naturally, at market value – its price simply is whatever people are willing to pay for it.  Facebook has no control over what people pay for its shares after it has put them into circulation.


The big picture

1)      At the outset, Facebook is “privately owned.”  There’s no such thing as “Facebook stock.”

2)      Facebook makes the decision to go public.  It sets a price per share and schedules a single event where they will be selling shares to the world – the IPO.  (A lot of sweat goes into determining what price shares will be sold at during the IPO.  If the shares are too cheap, they lose revenue on IPO day.  They make them too expensive, no one will want or be able to buy.  The maximum revenue lies in the “not so cheap, not too expensive” range.)

3)      Once the price is set, Facebook holds their IPO.  They sell as many shares as they can at that pre-determined price.  Most IPOs last only a few hours.  (Now, in your typical IPO, a company may sell off millions of shares.  They don’t want to deal with millions of little individual transactions.  So they tend to sell stocks off in big chunks – like, thousands at a time!  The only buyers at IPOs are banks, stock brokers, big investment firms…not individual people.  This is because very few individuals would be able to buy any stock in lots of thousands.)

4)      The banks, stock brokers and big investment firms who bought the shares at the fixed price (directly from Facebook, at the IPO) then turn around and try to auction off their shares to the rest of the world.  (Or maybe they hold on to them.  Or maybe they sell half and hold on to the rest.  It’s up to them what happens next.  Facebook is no longer owns their shares, whatever happens to them is literally "none of Facebook’s business.")

5)      After the initial buyers auction their shares off to the rest of us, we sell our shares to other folks, who can sell them to others, so on and so on.  As long as Facebook still exists, the share can continue to be traded around.


A corollary

Sound alien?  Well, there’s already a market that you're probably very familiar with that operates quite similarly: the market for cars.

When car companies roll out new models, they sell them in lots directly to dealerships at fixed prices.  Think of the car companies as Facebook, the cars as shares, and the dealerships as the banks and brokers buying at the IPO.

The dealerships then “distributes” the cars to the world – the individual buyers like you and me.  We can negotiate the price of the car with the dealerships, just like we “negotiate” the price of a stock while shopping at the stock market – through the open market mechanisms, or buy telling the dealership/stock broker “I’m just not sure about the price...could you come down a bit?”

After the public has bought the cars from the dealerships, whatever happens to them is in the the public's control.  Will they drive them forever?  Sell them to a relative?  Sell it to a used car lot in a year? 

Similarly, when the stock brokers and bankers who bought Facebook shares at the IPO turn around and sell those shares all off to the public...whatever happens from there on out is up to the stock's owner, not Facebook.

When you want or need to get rid of your car, you can sell it off to another person.  When you do, the car's manufacturer is not involved in the transaction.  If I sell my 2002 Sable on Craigslist, I don’t have to notify Mercury, give them a cut or ask them what price I need to sell it for. 

Just like my Facebook stocks!  After they’re in my hand, I can trade and sell them without Facebook being involved at all. 


Ups and downs – for whom?

Take a stab at this question:  Facebook sold its shares at $38 a pop at its recent IPO.  By the next day, it was being traded at $34.  How much money did Facebook lose when the price of their stock fell?

You ready for it?  The correct answer is: $0Facebook doesn’t own those shares after the IPO.  The public does.  So why would the value of the shares affect Facebook financially?  If a used 2005 Jetta sells on Craigslist for around $3000 today, and $2000 tomorrow, VW doesn’t lose $1000 right?  The owners of 2005 Jettas do.

After the IPO, the buying and selling of stocks is actually just the process of banks, investors, members of the public, institutions - really anybody - shuffling around the shares that already exist. 

So why do companies obsess over their stock price?  If the price of the stock doesn’t help or hurt the company’s financial position, why would they care if it fluctuates at all?

Stock prices are used as a barometer of how the market views the health, value and longevity of a business.  It’s a quantifiable way to measure the world’s confidence in that company.  The more people are willing to pay for a share, the assumption goes, the better off they must believe that company is doing.

So while Facebook never lost any money when their stock prices fell, they certainly lost a lot of face.  That’ll cost the company money in the long run – but indirectly.

A sudden drop in stock prices (especially so quickly after an IPO) can scare off other investors, make it a little bit trickier for Facebook to borrow money, negatively affect what they can charge advertisers...and it’s a more than a little embarrassing!


So why buy stock?

Here’s another vital question I’m sure you’re now asking:  What’s the incentive to purchasing stocks in the first place!?  When a company schedules and IPO, what’s the incentive for people to show up?  What is the benefit of owning a share in a company?

Owning stock in a company does come with some perks – dividends and voting rights.

Companies promise to pay every stock holders either a fixed sum, or a tiny percentage of profits every year.  This cash payment is called a “dividend.”  If you're the legal owner of a company's stock on their dividend day, you get a cut of the take.  If you can buy the stock for less money then the dividend pays, its an easy profit for you. 

Stock ownership also typically comes with the perk of voting rights in major company actions (like whether or not to create new products lines or services, for example).

These perks can be kind of a liability for the company in the long run.  They’re used as bait to incite buyers on IPO day.  But the company is on the hook for them for forever, long after the financial gains of the IPO have been spent.

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