As is true in so many areas of life, there are aspects of stock market investing that may not be fully understood, even among experienced investors. When something dramatic happens in the market, for example, news accounts continue to use video or photos of dejected (or perhaps exuberant) traders on the floor of the New York Stock Exchange. But why do we even have floor traders in this day and age when most trading takes place electronically?
Perhaps we’ll get to that question in the future. In the meantime, this article is about the often-misunderstood relationship between a company, its stock, and its shareholders.
When you buy stock, who gets the money?
If you decided to purchase shares of a company’s stock — let’s say Tesla — do you envision someone down the hall from Elon Musk receiving the money and depositing it in a bank? (Or, perhaps more realistically, using it to buy more Bitcoin?) If so, you’re not alone, but you’re also probably not correct.
What actually happens is much like what happens when you buy a car. If you were to buy a new Tesla, the money would indeed go to Tesla. But if you were to buy a used Tesla, the money wouldn’t go to the company that manufactured the car but to the owner who sold it to you.
To continue the analogy, buying stock during a company’s initial public offering (IPO) is much like buying a new car. The money goes to the company (or, technically, its investment bank). It’s much more common, however, to buy stock on the “secondary market” — like buying a used car.
By the time you purchase the stock, it’s the second or third (or maybe the 50th or 100th) time the shares have changed hands. Your money isn’t going to the company; it’s going to another investor who owned shares and decided to sell. Just as Tesla wouldn’t know if you bought one of its used cars, it won’t know that you bought some of its stock from another investor.
(Where the comparison between buying stock and buying a car breaks down is that a share of stock doesn’t automatically become less valuable the more times it’s re-sold the way most cars do!)
Your broker as middleman and record-keeper
When you purchase stock, you may be notified about upcoming shareholder meetings. You may also be sent the paperwork necessary to vote at those meetings. What you won’t receive is a stock certificate with your name on it.
Today, most securities are bought and sold electronically through a broker and are held in “street name” — i.e., the name of the broker. Tesla may know how many shares of its stock Fidelity, Schwab, TD Ameritrade, and other brokers “own,” but it doesn’t know that you are the rightful owner of a portion of those shares. You do own the shares you purchased, of course, but it’s up to your broker to keep track of that.
It’s the broker’s job to provide you with the paperwork to which you’re entitled — including prospectuses for mutual funds and ETFs, tax forms, and shareholder voting materials. Further, your broker is resposible for making sure you receive any dividends owed to you.
This broker-based electronic system makes the buying and selling of stock efficient, inexpensive, and arguably safer than handling the paper stock certificates of yesteryear.
The option of Direct Registration
If the broker-as-administrator setup gives you pause, you have another option. Perhaps you’re concerned about what might happen if your broker went under. How much time and hassle would it take to be made whole? Further, how could you be certain there are proper records of what you own?
People with such concerns can use the Direct Registration System (DRS). As the name implies, utilizing the DRS means an investor’s name is directly registered on the books of the company whose securities he or she owns.
The big disadvantage to using the DRS is that it can slow the process of making trades, which prevents an investor from using specific order types, such as “market,” “limit,” or “stop-loss” orders.
Generally, with all of the regulatory scrutiny brokers are under, with SIPC insurance protecting one’s securities (and cash) up to $500,000, and with mechanisms in place to transfer holdings to another broker in a worst-case scenario, SMI doesn’t think using the DRS is necessary for most investors. Those who may benefit from it are investors holding especially large positions in a particular stock and who plan to keep that stock for a long time.
After the IPO, why should a company care about its share price?
Even though a company doesn’t receive investor money when its shares are purchased on the secondary market, there are important reasons why a company remains concerned about its stock price:
The share price likely impacts the compensation and retention of the company’s senior executives. They may have received shares (or stock options) as an incentive to join the company. Plus, because a company’s stock price reflects investor perceptions of the company’s future, bonuses may be tied to its stock’s performance.
Stock value may impact the retention of other employees who are able to purchase company shares at a favorable price. As the price goes up, so does their total compensation.
A healthy share price can help prevent a corporate take-over. Robust stock prices act as a barrier to those who may wish to gain control of a company.
A higher market cap (i.e., the number of outstanding shares times the share price) makes it easier for the company to obtain loans.
Some companies use their stock to fund acquisitions, so the higher the share price, the more ammunition a company has for such purposes.
So now you know more about the relationship between a public company, its stock, and its shareholders. It’s a bit more complicated than you may have realized.