The simple answer is that a stock market is a public market where shares of stock can be bought and sold, but this doesn't do enough to answer the question, "What is a stock market?" Moving the definition a little further along, a stock market is also an important part of the financial system as companies can issue new stock to fund their operations or retire stock to reduce the number of shares outstanding. Thus, a better definition of a stock market is a public market where shares of stock can be issued, bought, sold, or retired.
The most recognizable example of a stock market is the New York Stock Exchange (NYSE) where an auction market exists to match buyers and sellers in individual stocks. Without grinding through the details, an auction market has an 'auctioneer' known as a specialist who is responsible for maintaining an orderly market in a particular stock. The specialist's job is to match buyers and sellers through an order book where orders for buys and sells are maintained. While most of this happens through computers, large orders continue to be taken care of by the specialist and it is estimated this accounts for up to 18% of order flows at the NYSE.
The NASDAQ (National Association of Securities Dealers Automated Quotation) is the top example of an over-the-counter market. This type of stock market functions differently than an exchange. In processing buy and sell orders, a number of 'market makers' continuously buy and sell for their own accounts and post prices at which investors can buy and sell. In any single stock, there can be several market makers competing for order flow and offering various prices. This is quite different than on an exchange, as a specialist does not buy and sell from its own inventory as market makers do in the over-the-counter market.
New Issues - The Primary Market
If you're a private company like Facebook, you can raise a tremendous amount of capital by 'going public' which means issuing new stock to be traded on an exchange or over-the-counter. The process for this is rather convoluted, but the basic setup is a company will contract with an investment bank and they will value the shares. At that point, the investment bank will underwrite the initial public offering meaning that if not all of the shares sell to the public, the bank will purchase the remaining shares at the agreed upon price. After the shares have been issued, the company (Facebook, for example) would receive the cash and the stock would begin trading either on an exchange or over-the-counter. The process of issuing new stock and the proceeds of the sale going to the issuing company is said to take place in the primary market.
Buying and Selling - The Secondary Market
After new shares have been issued, they trade on the secondary market where the company receives no further compensation, but investors can buy and sell shares, moving the price of the stock up and down over time. While the company doesn't receive any direct dollars from the stock, the secondary market continues to serve an important function for investors and the company. For investors, the secondary market offers liquidity where shares can be sold and converted into cash. For companies, the continuous trading of shares offers a valuation for the stock which can help them assess what could be gained by issuing additional shares (called a secondary offering).
The act of retiring shares may seem a bit silly at first blush, as there doesn't seem to be much to gain. If you pay good money for shares, it seems foolish to cancel the shares. Of course, that's from the perspective of an investor. The company could have a number of motivations for retiring stock which could include bumping up earnings (fewer shares outstanding means a higher earnings per share), taking the company private, or boosting ownership stakes of insiders (fewer shares held by others increases the percentage ownership of major shareholders). Regardless of the reason, to retire shares, a company purchases the stock in the secondary market and then cancels the shares through a formal process outlined by the Securities Exchange Commission (SEC). Once retired, the company cannot re-issue without going through a process not unlike when shares are newly issued.
In this article, you should have learned that a stock market is more than just a place to buy and sell stock. It also makes the issuance of new shares possible whose proceeds can be used by the issuing company to fund its business. In addition, retiring shares changes ownership percentages and can assist companies by increasing earnings per share - a key ratio in the world of stock investing.
- When a company issues new shares, what does the company gain? What does the company lose?
- On the New York Stock Exchange, if a stock has massive numbers of investors selling (like financial stocks after Lehman Brothers collapsed in September of 2008) and only a few willing to buy, how quickly can the share price fall? Conversely, when a stock has enormous buying demand and few sellers (like Google after its initial public offering), how fast will the stock price rise? Hint: lookup price charts of Citibank from September 1st through the 30th of 2008 and Google from August 19, 2004 through December 31st of the same year.
- Earnings per share (EPS) is defined mathematically as [Net Earnings divided by # of Shares Outstanding], if a company with net earnings of $100 has 100 shares outstanding, EPS would equal $1 per share. What if the company retires 10 shares? How are net earnings, share outstanding, and EPS affected?