Why Do Companies Issue Stock and Why People Invest in Them?
All businesses need money to run day to day operations like buying raw materials, equipment leasing costs, office or warehouse rentals, paying workers' wages etc. Some may even need a substantial amount of cash injection to fund expansion plans nationwide or overseas. So where does all this money come from?
For the case of private businesses, they tap the funds available from their private investors to run the day to day operations and any other expansion plans which the company may have. This is feasible up to a certain point but eventually, the company's growth will be severely hindered by it's present cash situation. The private investors of this company may decide that they are satisfied with the status quo and choose to do nothing and just continue to maintain day to day operations. In reality however, the majority of investors are motivated to maximize their profits so they will find ways and means to generate greater profits. One of the ways to achieve greater profits and grow the company is to take the company public by issuing an Initial Public Offering (IPO) and list the company in a reputable stock exchange like the NYSE or Nasdaq.
When a company goes public, the company issues out stock or shares in the company to the investing public and interested financial institutions. Read "How to Trade Stocks and Shares Online" to learn how traders and investors make money trading a company's stock. By issuing out stock, the company receives cash in return from investors which they can use in whatever way they deem fit to achieve their goal of maximizing stockholder value. The motivation for investors to pump money into the company is the belief that the company's management will do their best in running the company and making strategic decisions with the aim of maximizing shareholder returns in the form of an increase in the value of their stock investment. High profile events, namely the Enron and Worldcom debacles, however have illustrated how some company managements have instead acted to the detriment of the interest of their shareholders. Investors therefore have to carry out stringent due diligence and research into individual public companies before investing their hard earned money into the stock. Check out Free Research at optionsXpress for an example of trusted information on the stock and options markets. Another great place to get useful and tradable information on a company's stock is TheStreet.com, where former hedge fund manager, Jim Cramer shares his trading ideas before he acts. Click here for a free trial.
How Do You Price a Stock?
So how does an investor or trader "value" the price of the stock? This is where the fun begins. Theoretically, you can value a stock by using the Discounted Cash Flow (DCF) method. This can be done by projecting out into the future what the company's earnings (cash flow) will be and then discounting it to the present value. Typically, investors will include an earning's multiple, which could be based on other stocks in it's sector, to determine what is a fair price to pay. Investors should always remember that when buying a stock, you are paying a price based on what the company is going to be worth in the future, and not what it was worth last week!
In theory all this sounds good, but in reality, many other factors come into the picture, primarily the human emotional factors of "greed and fear". When you really think about it, in the financial markets it all boils down to these two basic human emotions which eventually determine how stock prices move. Investors and traders who truly understand these human emotions and can relate it to the market, will make a lot of money!