Building Wealth One of our favorite thinkers, physicist Richard Feynman, says "if you can't explain it in simple terms, you don't understand it."
With that in mind, we have a question for you, "How does the stock market work?"
We understand that stocks represent the partial ownership of a business, but where does it come from? Who does your money go to when you buy shares? What's the value of that ownership?
The stock market is a weird sort of financial alchemy and when you try to explain it at a basic level, it can all seem very strange.
And nothing is stranger (or more misunderstood) than an initial public offering (or IPO).
Get ready for the IPOs to come hot and heavy. A wave of private companies will "go public" over the course of the next year and list their shares on the exchanges so that any investor can buy them.
Ride-sharing service Lyft (LYFT) just went public at $72 per share and a valuation around $20 billion, minting a whole new crop of millionaires amongst Lyft insiders. Shares surged to near $90 – making money for a new batch of public investors – before falling below $70.
You're going to see this story happen more often as Uber, Airbnb, WeWork, Pinterest, and dozens of other companies go public this year.
The IPO process offers opportunities. It also outlines exactly how stocks work and how investors and insiders make money from them. If you want to be able to explain an IPO at your next cocktail party, read on...
Companies Need Capital and Investors Have It
Companies need money to operate and they can do it by borrowing (taking on debt or issuing bonds) or they can sell part of their company to an outside investor. If they do this on the public market, that's an IPO. And that ownership can trade freely on the stock exchange.
Prior to an IPO, a company's ownership all belongs to the company founders and early private investors. If any of those owners wanted to sell their stake in the company for cash, they'd have to go out and find a buyer and negotiate a price.
Let's look at what Lyft did. We're going to simplify some numbers here to tell the story, but it's all close enough for conversation...
Lyft's private owners decided they wanted to sell about 10% of the company to raise money. They divided the company up into 300 million shares and squeezed their ownership into 270 million of those shares. For instance, GM owned 7.8% of Lyft prior to the IPO. It got 7.8% of those 270 million shares (18.6 million).
Next, Lyft took 10% of the company – the remaining 30 million shares – and sold it to the public. But what price do you sell it at?
It's the jobs of the investment banks handling the IPO to figure this out. Wherever they decide to price shares, that's how much money Lyft collects for going public. If the banks had priced shares at $25, Lyft would have collected $750 million. If they'd priced it at $50, Lyft would have collected $1.5 billion. A higher price is better.
But if the banks price shares too high, there aren't enough interested investors to buy all the shares.
In theory, the bank wants to figure out the maximum price that will move all the shares of Lyft. However, on Wall Street, it's considered a bad sign for an IPO to drop in price after hitting the market. For that reason, banks tend to underprice the IPO so shares pop on the first day.
The banks did a valuation of Lyft and tried to gauge the interest amongst investors. In the case of Lyft, they came up with a price of $72. That means Lyft raised a little over $2 billion and the value of the total company is around $20 billion.
The bank starts parceling out those shares at $72. It talks to other banks, brokerages, and institutions to drum up enough investors willing to pay $72 to buy shares. The brokerages will call up preferred, high-net-worth clients and offer them an "allocation" of shares at $72. Those shares get handed out to these fortunate insiders.
Next, shares start trading on the open market. Since there was a lot of excitement around Lyft's IPO – more investors wanted shares than could get an allocation – the very first trade went off around $87.
That means a lucky investor who got allocated shares bought them for $72 and sold them for $87 on the first day.
But since then, Lyft shares have drifted back down to around $70. This is considered a bad sign for investors' opinion of Lyft's long-term prospects.
What happens next?
Lyft, the company, gets $2 billion to invest in its business. Currently, Lyft loses around $900 million per year running its business. And the more it grows its revenue, the more it loses. It needs that $2 billion to keep itself afloat.
In most cases, companies that go public are profitable but need money to expand or invest in operations.
The early investors in Lyft now have a way to cash out. It is sitting on 270 million shares worth $70 each (as of Monday). Because of the rules of the IPO, Lyft can't sell shares for 180 days, but after that lockup expires, Lyft can turn its ownership stake into cash.
As for the public, we can now become owners of Lyft. The company is a long way from paying a dividend, so buying shares of Lyft would mean you expect the company to grow or for its valuation to rise. If that happens, you would be able to sell your shares to another investor in the future to earn a return.
That's Public Stocks in a Nutshell
That's why companies go public. They can sell off a percentage of their equity for capital, and then that equity will trade freely. The company doesn't collect money each time you buy shares, only at the initial offering.
There are lots of wrinkles to this story that make it more complicated. Companies can do "secondary offerings" to raise more money. The Lyft founders introduced a dual-class structure to keep voting control of the company.
But that's how IPOs and stocks work. They make millionaires (or billionaires) of the insiders. They help companies raise capital to grow and invest. And they allow any investor to earn returns from the partial ownership of businesses.
We don't know if Lyft shares will rise from here. The company loses a lot of money and doesn't seem to have a path to profitability before it burns through that $2 billion. But there will be other IPOs coming with better income statements.
The financial news loves to publish eye-popping valuations and one-day returns, but they rarely tell the whole story of what those numbers mean and who's making money from them.
Armed with the proper details, watching the IPO market can help you understand why you invest in stocks at all.
What We're Reading...
- Something different: Watch Richard Feynman explain how wood burns and releases stored sunshine.
Here's to our health, wealth, and a great retirement,
Dr. David Eifrig and the Health & Wealth Bulletin Research Team
April 3, 2019