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How Stocks work

By Edited Jun 10, 2015 0 0

Stocks as a way to raise money and spread ownership

Let us take an example her to see how stocks help company raise the money easily. Assume the company is ABC and it wants to have money to expand or set up a new manufacturing plant or get more resources on its rolls to expand. One way to do so is to go for money from the bank which can be in the from of a working capital loan or a bigger longer term loan and in the company mortgages the assets of the firm. This selling of assets is by the way of a “bond”.

The second way to part with the equity of the company. So in the above example ABC has a equity capital worth say 100 dollars with the 100 shares worth 1 dollar each on the books. The second way is definitely beneficial in a way that you do not have to mortgage the assets. You can rope in a new equity partner and sell some shares out of those 100 shares.

Private Equity

At the beginning the ABC company is small to it looks for Private equity via bringing is  special investors or venture capital funds to take in some equity. The venture capital funds buy in some equity as they believe the company will do well in future and they are willing to take the risk by putting in money in the company ABC. Let us assume that venture capital funds take in about 30% equity which means they pay the company for the 30 shares. Now we cannot assume that they will buy the shares at 1 dollar each. In fact, assume that they pay 9 dollars premium on the shares. This will mean that the net flow be 300 dollars into the company.

Public Listing via IPO

Now let us fast forward two years and the company ABC is doing good. They now want more money to expand so what they do is go for a public listing.  That public listing will be either on NYSE or NASDAQ.

Note: The listing norms of each of NYSE and NASDAQ will be different.

Each of these stock markets have a way of working and how the stock markets work is a subject for another article. 

Assuming the company ABC launches an IPO or as they call the initial public offering for listing on NYSE. The market determines that they are willing to pay 29 dollars premium for the shares which have a book value of 1 dollar. The company will then list the shares at 30 dollars.

The net inflow of money in the company will depend on the equity that the company is willing to part with. Assume ABC is willing to part with another 30 percent which will mean that net inflow in the company is 30 shares multiplied by 30 i.e 900 dollars.

Venture Capital funds which picked up the equity at 9 dollars premium can now exit the company at 30 dollars or more based on high the prices go in the stock market. Assume that they exit at an average price of 30 dollars so on an investment of 10 dollars a share the venture capital has made another 20 dollars. That is huge in a period of two years. However this is an example and in the real world there are examples of companies which have had not so good listings and venture capital funds have lost money.

Some famous examples of IPO’s

Zynga Inc. – This Company is the make of games like FarmVille, CityVille etc. They issued about 100 million shares of the company at $10 each share. This will mean that they raised $1 billion by the listing. They have said that they will use the money more games and even more marketing.

Google – Now Google raised money in 2004 via an IPO and they raised about $1.9 billion.

Facebook IPO – This is most anticipated since Google. It is being said that Facebook will have a market capitalization of $100 billion once listed and it will make Mark Zuckerberg a billionaire several times over. 

Short term vs long term investing in stocks

Given the above example you can see that the venture capitalist definitely made money on the stocks. Now as the owning public, you can also make money of the stocks and how.

As and investing person you think that company ABC is promising and your research shows that in the near future the company will do well , so you go ahead and buy some stocks on the NYSE via your online broker. Assume that you buy stock of the company ABC at 30 dollars. Within six months the stock market price goes to 35 dollars. At this point you think that ABC has reached the price where you have made enough money and you sell at 35 dollars. You gain 5 dollars on 30 dollars that is a gain for you. This means that you have made money in the short term.

Now if you are a long term investor and think that in the long term the stock ABC will do well then you can buy at 30 and keep the stock for long terms. By long term the general assumption is that you will keep the stock for longer than 5 years may be even 10 – 20 years. 

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