ADVANCED LESSON 14 The Stock Market

In this lesson you will learn:

• The definition of the stock market.
• The difference between corporate debt and equity.
• The social function of stock speculation.

The Stock Market

In everyday conversation, people often refer to “the market” and ask whether it is “up or down.” What they mean is not the overall market economy but rather the stock market. The stock market is a particular market in which buyers and sellers trade shares of corporate stock, which are legally transferable fractions of ownership of corporations. For example, if someone owns 50 shares of stock in the Acme Corporation, and there is a total of 1,000 shares outstanding, then this person owns 5% of the Acme Corporation itself. He and the other shareholders have proportional claims on the assets and income earned by the Acme Corporation.

Purchases and sales of stock shares occur on stock exchanges, such as the New York Stock Exchange (located at 11 Wall Street, New York, N.Y.) or the London Stock Exchange. You have probably seen frantic traders yelling out bids as stock prices scroll across a large display screen. With the development of the internet, it has become much easier for average people to buy and sell stocks (through Stock brokerages) without physically visiting a stock exchange.

When people refer to a particular stock’s price, they usually mean the price at which the last trade was conducted. In many settings unrelated to the stock market, a seller will fix a price and wait a long time to see how many he sells, before adjusting the price. For example, a couple trying to sell a home will list their price and probably wait at least one month before considering a reduction. A grocery store might update the price it charges for milk or eggs much more frequently, but even here a shopper doesn’t usually see prices for these items change from hour to hour. Things are different on the stock market, where billions of individual stock shares may change hands every day, and where prices may be extremely volatile, changing from moment to moment as new information hits “the market.”

Why Issue Stock? (Debt versus Equity)

In Lesson 12 we learned that entrepreneurs sometimes borrow money from others in order to accelerate the growth of their businesses. If a business is a sole proprietorship, the individual owner who wants outside funds might ask friends and family for loans, relying on informal contracts and their trust in his character.

However, an alternate method is to raise capital by selling ownership claims to the business. In this case the existing owner or owners can go public by incorporating the business and selling shares to others in an initial public offering (IPO). Or, an existing corporation can raise more capital by selling additional shares of stock (thus diluting the ownership claims of the original shareholders).

There are various regulatory, legal, and tax reasons that favor incorporation over other business forms for certain companies. In this lesson, our goal is merely to understand the basic distinction between a corporation raising new funds by issuing debt versus stock. The latter move is also called issuing equity, because it confers ownership in the corporation.

For concreteness, let’s imagine the Acme Corporation is doing quite well and wants to raise $100 million to expand its operations. One way to do that is to sell new bonds to lenders, which (say) promise to pay them 5% interest annually, and a return of the principal in ten years. Under this route, Acme gets its desired $100 million right away, and then must make ten annual payments of $5 million before paying out the $100 million and retiring the bonds. (If Acme doesn’t want to come up with $100 million at that future point, it may of course try to roll over the debt by issuing new bonds—this is like refinancing for a homeowner.)

There are pros and cons for Acme raising the funds by issuing new debt. If things go as planned, the $100 million injection of new funds (to be spent on a new plant, advertising, recruitment of skilled managers, etc.) will allow Acme to boost its revenues by more than $5 million each year, meaning the debt issuance will “pay for itself.” That is to say, the increase in Acme’s revenues will allow it to more than cover the interest payments, so that in the long run the owners of Acme (i.e., the shareholders) will be richer, because of their decision to issue debt. Whether the decision turns out to be just a good one or a fantastic one, Acme still has to pay the same fixed 5% interest payments on the borrowed money.

The downside of taking on additional debt is that Acme has to pay its creditors (i.e., the bondholders) whether or not the expansion is profitable. If the $100 million in new funds doesn’t allow Acme to generate at least an additional $5 million per year (on average), then Acme’s owners will be poorer because of their bad decision. Had they properly forecast the fate of their company, they would not have agreed to borrow money at a 5% interest rate, yet once the bonds are sold they can’t avoid their contractual obligations. They are locked into making the annual $5 million interest payments, regardless of Acme’s health.¹

Rather than issue new debt, the Acme Corporation instead can sell new shares of stock. For example, suppose that originally Acme has 2 million outstanding shares, owned by various people in the community. If Acme then issues 2 million new shares at $50 each, it will raise the desired $100 million in new funds for its expansion. But now that the total number of Acme shares has risen to 4 million, the proportional ownership of the original shareholders has been diluted. For example, if Bill Johnson owns a block of 200,000 shares, he originally owned 10% of Acme. But after the new issuance of stock, Bill’s original 200,000 shares only represent (200,000 / 4 million) = 5% of Acme.²

By expanding the pool of ownership in Acme itself, the issuance of new shares does not commit the corporation to a fixed stream of payments (the way the bonds would have). As part owners, the new shareholders share in the “upside” if the expansion goes well and the corporation enjoys substantial earnings, but on the other hand they suffer proportional losses if Acme does poorly in the upcoming years. Because shareholders are residual claimants, their stocks entitle them to a fractional share of ownership in Acme’s assets only after the other creditors have been satisfied. For example, out of their revenues in a given year, Acme officials will first have to pay contractual interest payments to their bondholders, before sending a dividend to the shareholders.

Economists and other financial analysts have different theories and rules of thumb to explain the ideal balance between debt and equity for a given corporation. For our purposes here, it is enough that you understand a new issuance of debt (versus equity) increases the possible returns to the existing shareholders, but it carries greater risk. In contrast, if the existing shareholders issue more stock and spread their ownership over a bigger pool of people, then their scope for high returns is diminished but at the same time they can share the pain of losses with more people as well.

A firm’s leverage refers to the relative size of its debt compared to the equity held by the owners. The higher a firm’s leverage, the greater the potential returns for its owners, but the greater potential it has to go bankrupt. In the financial world, firms differ in the amount of leverage they take on. Certain investors buy stock in (or lend money to) conservative companies with little leverage, whereas other, more aggressive investors are interested in companies carrying high debt loads but with a sound business plan.

The Social Function of Stock Speculation

From the individual investor’s viewpoint, corporate stocks are a particular avenue for his saved funds. Rather than keep money under his mattress or lend it to a bank, the investor can choose to purchase shares of stock in one or more corporations. His hope is that the market value of his investment will grow over time, either because of periodic dividend payments—in which the corporation distributes some of its excess earnings to shareholders—and / or because the market price of his stock rises. Many people invest at least a portion of their savings in corporate stock, because it typically offers a higher rate of return than bonds.³

Although there is in fact no clear dividing line, people often distinguish between stock investors versus stock speculators. A speculator buys a particular stock not because of the long-run potential growth of the corporation, but rather because he expects the share price to rise in the near future. The speculator does not seek out sound companies to invest in, but rather looks for underpriced stocks to turn a quick profit.⁴ In the eyes of many, stock investing is a perfectly respectable and indeed crucial feature of a market economy, whereas stock speculation is deemed unethical and harmful.

This popular condemnation of stock speculation fails to appreciate the genuine contribution of this activity. In Advanced Lesson 13, we learned that the successful entrepreneur buys resources at a low price and transforms them into finished goods and services that fetch a higher price. The greater the profits an entrepreneur reaps, the bigger this gap or mismatch between resource and consumer goods prices must have been. The entrepreneur thus serves a vital social role in channeling scarce resources into those activities where (loosely speaking) the most market value can be added.

The stock speculator is just a particular type of entrepreneur. After all, the motto of the speculator is to “buy low, sell high.” The astute speculator identifies stocks that are mispriced before others notice the problem, and benefits accordingly, if and when other investors begin to see things as the speculator. For example, suppose Acme’s stock is selling for $40 per share but Sam the speculator believes this is far too low, and that the price will rise to $45 by the end of the week when a new report comes out. (The report will have favorable news that will cause many investors to revise their expectations about the future earnings of Acme. These changed expectations will lead investors to bid more right now for Acme stock, because these shares represent partial ownership claims on Acme’s future earnings.) In anticipation of this appreciation, Sam buys 10,000 shares of Acme. If his hunch is correct and the report causes the stock price to rise to $45, Sam can then sell his shares and pocket the $50,000 gain from his speculation. Of course, if Sam had been wrong and Acme shares fell to $35, he would be down $50,000 if he sold his holdings at the end of the week.

Many observers liken stock speculation to pure gambling, but there is an essential difference: When someone bets $1,000 on red at the roulette wheel, this action doesn’t influence the movement of the wheel—at least not in an honest casino! However, when Sam the speculator buys 10,000 shares of Acme because he believes its price of $40 is too low, his very action tends to push up the price of Acme stock. After all, the demand for Acme shares has suddenly increased while the supply of shares is the same, and so (other things equal) the price of Acme stock will rise. So we see that when speculators believe that a stock will rise in the future, their attempt to profit from their prediction causes the underpriced stock to rise in value.

On the other hand, if speculators believe a certain stock is overpriced, then their actions will tend to push down the price. For example, suppose an Acme shareholder believes his stock is overpriced at $40. He can sell off 10,000 shares, and then buy them back if and when the price falls to $38. He ends up with the same number of Acme shares in his possession, but he also has an additional $20,000 because of his speculative move.⁵ In this case too, the speculator’s efforts to gain personal profit end up moving the stock price in the correct direction, because (other things equal) his selling at $40 would tend to push down the price of Acme shares.

To summarize, successful stock speculators identify and correct mis-priced stocks. Although their motivation is presumably personal financial gain, nonetheless their activities are socially useful for several reasons. First and most obvious, speculators—if they are successful—actually reduce the volatility of stock prices. After all, their actions pull up prices when they are too low, and they push down prices when they are too high. Speculators keep stock prices from straying too far from where they “ought” to be, and in that sense reduce the day-to-day movements in stock prices. The presence of speculators makes the stock market as a whole more orderly and safer for average investors, who don’t need to worry as much about a particular stock dropping 30% after a “surprise” announcement—the speculators will usually have sniffed out the story weeks in advance and already moved prices accordingly.

More fundamentally, it’s important for stocks to be accurately priced because they represent something real—they are partial ownership claims on corporations, which in turn possess scarce physical assets and produce goods and services for their customers. Recall that the relatively high market price of gold acts as a signal telling entrepreneurs, “Only use me in very important projects where the customer is willing to pay much more for the use of gold.” In a similar fashion, a very valuable corporation needs to have a very high market price (i.e., share price times the number of total shares) to ensure that it ends up in the hands of serious owners who will make good decisions affecting the fate of the corporation.

To take a silly example: If for some reason Microsoft shares suddenly plummeted so that with a measly $1 an investor could purchase an entire block of 1 million shares, then that would mean someone could purchase Microsoft itself if he were willing to plunk down about $9,000. Thus the fate of hundreds of millions of PC users would be at the mercy of anyone with $9,000 and an idea of “a better way to run Microsoft.” In reality, of course, the market value of Microsoft is (as of this writing) hundreds of billions of dollars. Its major shareholders may make critical mistakes when they assemble a Board of Directors and decide other issues, but the high share price ensures that the people making such decisions will take their responsibilities very seriously.⁶

Finally, recall what we learned in the previous section: One of the ways a corporation can raise new funds is to issue more stock. By improving the accuracy of stock prices, speculators help allocate the flow of new savings into corporations, so that those corporations with the best prospects will have higher stock prices and thus tend to receive more funds for expansion.

Lesson Recap...

• The stock market (located at physical exchanges but also on computer networks) brings together buyers and sellers of ownership shares of corporations. The stock market determines what group of people are the actual owners of corporations, and who therefore are ultimately responsible for how these organizations conduct business.
• When a corporation issues debt, it sells bonds in order to borrow funds from lenders. It owes a contractual amount of interest payments and the return of principal, regardless of the success of the corporation. On the other hand, when a corporation issues equity, it sells shares in order to raise funds from investors. These investors are entitled to their share of the corporation’s earnings, which are tied to the success (or failure) of the corporation.
• Stock speculators try to “buy low, sell high” (or “sell high, buy low”). Successful speculators fix “mispriced” stocks, because their actions push up stocks that are underpriced and push down stocks that are overpriced.

NEW TERMS

Stock market: A special type of market in which buyers and sellers exchange shares of corporate stock.

Corporate stock: Partial ownership claims to a corporation. If there are 100,000 total shares of stock in a corporation, someone who buys 5,000 shares owns 5% of the corporation itself.

Stock exchanges: Particular locations or venues where stocks are traded. The most famous example is the New York Stock Exchange, located on Wall Street.

Stock brokerages: Companies that help individuals buy and sell stocks. The broker will act on behalf of the client and execute his or her orders to buy and sell shares.

Sole proprietorship: A business owned by a single person.

Raise capital: The process of obtaining funds for a growing business by selling partial ownership of the business to outside investors.

Going public: Allowing the general public to buy shares of stock in a corporation, as opposed to restricting ownership to those specifically invited by the owners.

Incorporation: Transforming a business into a corporation, so that its ownership is allotted by shares of stock.

Initial public offering (IPO): The auction of shares to the general public when a corporation first decides to go public.

Issuing debt: Raising funds by selling bonds to lenders.

Issuing stock / issuing equity: Raising funds by selling stock shares to investors.

Rolling over debt: Paying off an old set of bondholders by issuing new bonds.

Refinancing (a mortgage): The situation that occurs when a homeowner gets a new mortgage from the bank (perhaps at a lower interest rate or with lower monthly payments) and uses it to pay off the current mortgage.

Callable bonds: Bonds that the issuer (borrower) has the right to pay off ahead of schedule.

Residual claimants: Refers to stockholders, who are entitled to the earnings of a corporation only after the other creditors have first been paid.

Dividend: A disbursement of a portion of a corporation’s net earnings to the stockholders.

Leverage: Enhancing the potential returns from an investment by using borrowed money.

Bankrupt: The situation that occurs when a business has liabilities greater than its assets.

Speculator: A person who buys an asset (such as a corporate stock) thinking its price will rise, or who sells an asset thinking its price will fall.

Interest rate risk: The risk bondholders face because rising interest rates will reduce the market value of their bonds.

Short sale: A transaction in which a person borrows an asset (such as a share of stock) from an existing owner, in order to sell it at the current price. The person eventually must buy back the asset to return it to the original owner.

STUDY QUESTIONS

1. If Jim owns 200 shares of a corporation, can we figure out how much of the corporation Jim owns?
2. What are the two basic options a corporation can take to raise new funds?
3. Who gets first dibs on the earnings of a corporation—the bondholders or the stockholders?
4. If a corporation is highly leveraged, will its stock be more likely to appeal to a conservative or an aggressive investor?
5. *How do successful speculators reduce the volatility of stock prices?