Ultimately, companies seek to raise capital in the lowest-cost way they can, so they elect to sell stocks or bonds based on what the finance folks and investment bankers tell them is the best option. For example, if the stock market is booming and new stock can sell at a premium price, companies opt to sell more stock. Also, some companies prefer to avoid debt because they don’t like carrying it.
Taking a company public: Understanding IPOs
Suppose that The Capitalist Company (TCC) wants to issue stock for the first time, which is called an initial public offering (IPO). If TCC decides to go public, the company’s management team works with investment bankers, who help companies decide when and at what price to sell stock and then help sell (distribute) the new shares to investors willing to purchase them.
Now suppose that based upon their analysis of the value of TCC, the investment bankers believe that TCC can raise $100 million by issuing stock that represents a particular portion of the company. When a company issues stock, the price per share that the stock is sold for is somewhat arbitrary. The amount that a prospective investor will pay for a particular portion of the company’s stock should depend on the company’s profits and future growth prospects. Companies that produce higher levels of profits and grow faster can generally command a higher sales price for a given portion of the company.
Consider the following ways that investment bankers can structure the IPO for TCC:
| Price of Stock | Number of Shares Issued |
|---|---|
| $5 | 20 million shares |
| $10 | 10 million shares |
| $20 | 5 million shares |
In fact, TCC can raise $100 million in an infinite number of ways, thanks to varying stock prices. If the company wants to issue the stock at a higher price, the company sells fewer shares.
In the case of TCC, suppose that its stock is currently valued in the marketplace at $30 per share and that it earned $2 per share in the past year, which produces a price-earnings ratio of 15. Here is the formula: $30 per share divided by $2 per share equals a price-earnings ratio of 15.
Understanding Financial Markets and Economics
Tens of thousands of books, millions of articles, and enough PhD dissertations to pack a major landfill explore the topics of how the financial markets and economy will perform in the years ahead. You can spend the rest of your life reading all this stuff, and you still won’t get through it. The following sections explain what you need to know about how the factors that influence the financial markets and economy work so you can make informed investing decisions.
Driving stock prices through earnings
The goal of most companies is to make money or earnings (also called profits). Earnings result from the difference between what a company takes in (revenue) and what it spends (costs). We say most companies because some organizations’ primary purpose is not to maximize profits. Nonprofit organizations, such as colleges and universities, are a good example. But even nonprofits can’t thrive without a steady money flow.
Companies that trade publicly on the stock exchanges seek to maximize their profit — that’s what their shareholders want. Higher profits generally make stock prices rise. Most private companies seek to maximize their profits as well, but they retain much more latitude to pursue other goals.
Developing new and better products and services: Some companies develop or promote an invention or innovation that better meets customer needs. We have smartphones, 3D printers, electric cars, online investing through low-cost mutual funds, fast casual restaurants that can serve up healthy food at a decent price in just minutes — the list goes on and on.
Opening new markets to their products: Many successful U.S.-based companies, for example, have been stampeding into foreign countries to sell their products. Although some product adaptation is usually required to sell overseas, selling an already proven and developed product or service to new markets generally increases a company’s chances of success.
Expanding into related businesses: Consider the hugely successful Walt Disney Company, which was started in the 1920s as a small studio that made cartoons. Over the years, it expanded into many new but related businesses, such as theme parks and resorts, movie studios, radio and television programs, toys and children’s books, and video games.
Building a brand name: In blind taste tests, popular sodas and many well-known beers rate comparably to many generic colas and beers that are far cheaper. Yet some consumers fork over more of their hard-earned loot because of the name and packaging. Companies build brand names largely through advertising and other promotions. (For Dummies is a brand name, but For Dummies books cost about the same as lower-quality and smaller books on similar subjects!)
Managing costs and prices: Smart companies control costs. Lowering the cost of manufacturing their products or providing their services allows companies to offer their products and services more cheaply. Managing costs may help fatten the bottom line (profit). Sometimes, though, companies try to cut too many corners, and their cost-cutting ways come back to haunt them in the form of dissatisfied customers — or even lawsuits based on a faulty or dangerous product.
Watching the competition: Successful companies usually don’t follow the herd, but they do keep an eye on what the competition is up to. If lots of competitors target one part of the market, some companies target a less-pursued segment that, if they can capture it, may produce higher profits thanks to reduced competition.
Weighing whether markets are efficient
Companies generally seek to maximize profits and maintain a healthy financial condition. Ultimately, the financial