What’s the Basic Function of the Stock Market?

BY busadmin  August 3, 2009 at 10:47 AM EDT

stock board; via Flickr

Question: I would like to ask you two simple (some might say “simple-minded”) questions, which may be variants of a single question. No one has yet given me a clear, straightforward answer. Perhaps you can and will.

1) Why does it matter to a company whether the price of its stock goes up or down? If a company wishes to issue new stock, I can see why the price of its existing shares would be a concern. I also understand that shareholder happiness (or unhappiness) would influence the salaries and perks of top management. Beyond that, however, does the price of a company’s share have any relationship to that company’s present or future health, the efficacy with which it produces its widgets?

2) If I buy stock in a company, am I thereby contributing to the health of that company? To the economy in general? The common assumption would seem to be “yes”; for instance we take stocks’ ups and downs as an indicator of the economy’s health, and we speak of stock buyers as “investors.” But unless I buy the stock from the company itself, I cannot see that my purchase contributes to that company’s well-being or, really, to the economy at large. In all likelihood, I am purchasing the stock from some other individual or institution, and not a penny goes to the company itself.

Unless I am overlooking something, it would seem that the stock market serves three functions and three only:

A. It is a way for a start-up company to raise initial capital or for an existing company to increase its capital through the issuance of new stock. This function does “contribute to the economy.”

B. Beyond that, the stock market is a zero-sum game, in which “investors” simply make bets on companies’ future performance. For all “winners,” there are equal “losers;” and all income is derived from the sweat of someone else’s brow. My parents’ generation, who remembered the Great Depression quite vividly, would speak of someone “playing the stock market,” and that seems an apt metaphor.

C. The stock market does serve to distribute wealth (and, presumably, risk), and that is a matter of no small importance. (When I asked one friend how his buying of stock had contributed to the economy, his best response was, “Well, my stock made it possible for me to build a swimming pool.”)

So, what am I overlooking?

Paul Solman: You’re not overlooking anything. You’re just not giving due emphasis to what matters: the cost of capital.

If you buy a company’s stock, you contribute, in your own modest way, to that company’s ability to raise capital and grow. Say the company is Solman Enterprises and there’s just one owner: me. I have a truly terrific idea that will enable me to hire thousands, prolong life for millions, make me rich, and contribute to the U.S. economy well into the 22nd century.

The idea is The Lipo-Friction, a no-money-down sturdy home stationary bicycle for the overweight that generates electricity. It can then be fed into the electric grid for a rebate on your bill that first pays for the bike, then your electricity and eventually — if you (and/or members of your family) pedal fast enough, often enough — cash.

My ability to grow this fabulous firm depends on what? First and foremost, my ability to raise enough money to give it a fair shot. A bank isn’t likely to make me a loan based on just an idea, especially not in the current environment. So, I better round up the usual suspects: investors.

The answer to your question, I hope, is beginning to emerge. Because if you, Sam, are willing to pay me a few million dollars for, say, a tenth of my firm — meaning I give you 10 percent of the stock in return for your investment — I’ll have a boatload of capital with which to launch, thus dramatically increasing my prospects of actually creating something and hiring all sorts of people in the process, thus pumping up the economy.

Now let’s suppose the company becomes such a success that it generates (if you’ll pardon the verb) heated competition. I need more capital to expand, or I’ll be undercut and overtaken. But you’re worried and look to sell your shares, thus driving down the price. (“Major Lipo-Friction shareholder said to be looking to unload,” posts a popular market blogger.)

Suddenly, my cost of capital goes up, because my share price is going down. I can’t expand. The competition knocks me out. Or, without more advertising to keep up the public’s motivation, people simply tire of generating their own electricity, no matter how good it is for them. The economy suffers. Substitute GM, GE, AIG — any firm — and you see the importance of stock price to companies, and to the economy.