A stock is a type of security that signifies ownership in a corporation and represents a claim on part of the corporation's assets and earnings.
When businesses are looking to expand, execute a large project, pay off expenses or raise funds for any reason but find themselves short on cash, they can turn to the market to raise money. One of the ways private businesses can obtain funds is by going public and selling shares of their company through an initial public offering (IPO). By going public, companies collect money from selling their own shares to investors and using the proceeds as needed for their business. Once the IPO is completed, shares trade freely among investors on a stock exchange.
Generally, if investors believe a certain company will perform well, there will be a demand to buy their shares and less supply to sell, and in that case, the value of the stock will increase in value. On the other hand, if investors believe that a particular company will underperform, there will be more supply than demand for the stock since fewer people are interested in purchasing that particular investment, and the stock will decrease in value.
Let’s make it easier to understand by using an example:
Company ABC Inc. is looking to borrow $25 million to expand their business across North America. ABC is not interested in taking a loan from the bank as they do not want to carry an obligation to repay a loan. After reviewing all options, ABC has decided to raise the required capital by going public and issuing shares of its company through an IPO.
Through an investment bank, ABC decides to issue 250,000 shares at $10 per share to collect the needed amount of $25 million. [$25,000,000 (capital needed) / $10 (value per share) = $250,000 shares].
Paul believes ABC will perform well in the next couple of years, so he decides to participate in the IPO and invest $5,000 in the stock which allow him to obtain 500 shares [$5,000 (amount invested) / $10 (IPO-value per share)] = 500 shares].
Five years later, ABC consistently increases their revenues and profits as Paul expected, so the value of the shares rises to $25 per share. In this scenario, Paul makes a total profit of $7,500 [$15 (profit per share) x 500 (number of shares sold)].