Imagine you own a bakery. Your bakery uses a secret recipe of your late, great grandmother Mary. Business is slow at first, but customers love your cakes and muffins, and you start to expand operations. Very soon you're swamped with orders and you just can not keep up with demand. You decide to open a second bakery. Before long you've opened up a third bakery, and so on.
Even with increasing revenue, you'll probably find out that you do not have enough money to start the next bakery. It takes a lot of money to open new locations. A new bakery will not have an existing customer base, and it's questionable as to whether or not a new location will be profitable. Some businesses decided to get a loan from a traditional institution like a bank. Others decide on raising investment capital. They go into the stock market and look for money.
You schedule a consultation with an investment banker from a well-known Wall Street firm. In your consultation, the investment banker reviews your business and decisions that you have a great business going with a real competitive advantage (your great granny's recipes). The investment banker believes that you can make even more money if you start to expand. He says he is going to make a few phone calls, set up meetings with some investors, and get back with you.
It takes a couple of weeks, but the investment banker finally gets back with you. He thinks you are a great candidate for going public. He has drafted a mess of legal paper work and if you are interested in moving forward, you need to come down to his office and review them. If you sign the paperwork, your bakery will start trading on the stock market. Your initial market cap (company value) will be $ 50 million. You own some of the shares. Partners the investment banker has lined up own a portion of the shares. The reminder will be offered to the public in an initial public offering. After the IPO, the value of your company will be determined by the stock market. The millions bought in by the IPO go towards future expansion of the company.
A year has gone by and the bakery business has been really good. The stock price has more than doubled, but how and why?
The stock market can be thought of as an auction marketplace. Both buyer and seller come together on a price they each think is fair. Stock price depends on several factors: projected future growth of earnings, the track record of management, overall company earnings, the economic outlook of the industry the company operates in, the company's book value (what the assets of the company are currently worth) and more. Stocks increase in value when these factors are positive. Stocks will fall in value when these factors are negative.
Warren Buffet once said, "If a business does well, the stock event follows." This is the unique truth about the stock market. All other things being equal, companies that do well will ride their stock price up. Businesses that do poor will see their stock's price plummet. That is the basic undering foundation of the stock market.