PDF Summary:Why Does The Stock Market Go Up?, by Brian Feroldi

The stock market drives economic expansion and allows individuals to invest in companies, but how does it function? In Why Does The Stock Market Go Up?, Brian Feroldi demystifies the stock market's mechanisms. He explains how initial public offerings work, how companies raise capital, and the metrics used to evaluate a company's performance and worth.

Feroldi also explores the factors behind stock price fluctuations. You'll understand the roles that investor sentiment, company growth potential, and market forces play in stock price changes. Learn why market declines occur and how rebounds emerge from challenging periods.

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An IPO acts as a means by which a company can obtain capital, simultaneously diluting the ownership percentage of existing shareholders. When a company issues more shares, the proportion of the company that current shareholders own is reduced. Upon becoming a publicly traded entity, the founders of Best Coffee Company—Natalie, Ethan, and Lauren—saw their ownership stakes diminish by fifty percent as new shares were issued to incoming investors. The early backers of Starbucks experienced a dilution of their equity by 12% following the company's initial public offering in 1992. Although it may initially appear counterintuitive, shareholders generally benefit in the long run as the injected funds spur the company's growth and increase its overall value.

Practical Tips

• Engage in crowdfunding platforms as a microcosm of an IPO's capital-raising aspect. Choose a platform where you can back projects or even create a small project of your own. Observe how funds are raised through the collective effort of individual investors and draw parallels to how companies accumulate capital through share issuance.
• Consider playing an online stock market simulation game that allows you to experience the effects of issuing new shares firsthand. Many of these games provide a virtual environment where you can manage a portfolio of stocks, including making decisions about public offerings. This will help you grasp the real-world implications of dilution in a risk-free setting.
• You can protect your ownership stake by creating a shareholder's agreement that outlines anti-dilution provisions. This legal document can specify that current shareholders have the right to purchase additional shares before new ones are issued, ensuring that their percentage of ownership doesn't decrease without their consent. For example, if you start a small business with partners, include a clause in your agreement that requires any new share issuance to be offered to existing shareholders first, giving them the chance to maintain their ownership levels.
• Consider joining or forming an investment club to pool resources and knowledge with others. This collective approach allows you to invest in companies together, potentially reducing the individual risk of equity dilution as you'll have a diversified portfolio and shared decision-making.
• You can evaluate the long-term potential of your investments by researching how companies reinvest their earnings. Look into the financial statements of companies you're interested in to see how they use their retained earnings. If they're reinvesting in growth opportunities, it could be a sign that they're focused on increasing shareholder value over time.

Assessing a company's worth.

This section explores the various methods used by investors to assess the worth of a business. The book emphasizes the importance of expected earnings and introduces the price-to-earnings ratio as an essential metric for assessing the value of a business.

Evaluating a company's value through analysis of its prospective profit generation.

The worth of a company is frequently assessed by examining a crucial metric called the price-to-earnings (P/E) ratio.

Feroldi emphasizes the importance of the earnings multiple as a key indicator for evaluating the worth of a business. To determine the P/E ratio, one divides the market price per share by the earnings allocated to that share. Investors are willing to pay a certain amount for every dollar generated in earnings by a company. A high valuation of a company's stock is frequently signaled by investors' belief in its potential for growth, which is reflected in an elevated price-to-earnings (P/E) ratio, whereas a lower P/E ratio might suggest either diminished prospects or a market that has yet to fully appreciate the company's worth.

Context

• There are two types of P/E ratio—trailing P/E, which uses past earnings, and forward P/E, which uses projected future earnings. Each offers different insights into a company's valuation.
• Earnings per share is calculated by taking a company's net income and dividing it by the number of outstanding shares. This metric indicates how much money a company makes for each share of its stock.
• A low P/E ratio might indicate negative market sentiment, where investors are pessimistic about the company's future performance due to industry challenges, economic downturns, or company-specific issues.

The potential for growth significantly impacts a company's valuation.

Feroldi underscores the importance of assessing a company's growth prospects when appraising its value. Companies that consistently demonstrate an increase in earnings tend to be more highly regarded by investors, as reflected in their higher price-to-earnings ratios. To illustrate his argument, Feroldi presents a scenario involving a fictional entity he refers to as the Premier Coffee Corporation, contrasting two different outcomes: one in which the entity's earnings stay constant and another where the earnings rise year after year, underscoring that the latter situation warrants a higher market valuation despite beginning with an elevated price-to-earnings ratio.

Context

• A company's current financial health, including its debt levels and cash flow, can influence its ability to invest in growth opportunities, affecting its valuation.
• Companies with a track record of growth may attract top talent, as employees often seek stable and prosperous employers, further enhancing the company’s performance and reputation.
• When a company reports higher earnings, it can lead to an increase in its stock price if the market perceives the growth as sustainable, thus affecting the P/E ratio.
• This is the overall attitude of investors toward a particular security or financial market. Positive sentiment can drive up stock prices, while negative sentiment can have the opposite effect.

Factors that play a role in a company's sustained prosperity and influence its market valuation.

The company's repurchase of its stock.

Feroldi outlines multiple crucial factors contributing to the steady increase in corporate profits.

• As inflation drives up the prices of goods and services, companies adjust their pricing upwards to preserve their profitability, which results in a rise in their revenue.

• Technological progress, better machinery, and refined methods enhance a company's efficiency, enabling it to produce more with the same or fewer inputs, thereby elevating profit margins and resulting in a rise in its profits.

• Products and offerings that fulfill previously unmet needs can stimulate expansion in the broader market, subsequently increasing demand and elevating company profits. Feroldi exemplifies this by citing the emergence of smartphones.

• By expanding into international markets, companies have the opportunity to broaden their clientele and diversify their income streams, potentially resulting in higher sales and enhanced financial gains.

• As the global population increases, so does the demand for a variety of products and services, thereby expanding the market that businesses can serve.

• Companies often acquire other businesses to integrate new technologies, expand their market reach, or diminish competition, which can result in a boost to their financial performance and revenue. The book mentions the instance of Amazon purchasing Whole Foods.

• When corporations repurchase their shares, the number of shares in circulation diminishes, resulting in a higher earnings per share despite the overall profits remaining unchanged.

Other Perspectives

• Some companies operate under regulatory constraints or long-term contracts that limit their ability to adjust prices in response to inflation, which could hinder their ability to increase revenue.
• Increased efficiency through technology can sometimes lead to workforce reductions, which can have negative social impacts and potentially affect consumer sentiment and sales.
• Introducing new products to meet unmet needs requires significant investment in research and development, marketing, and sometimes education of the market, which can be risky and may not always result in higher profits.
• The assumption that international markets will be receptive to a company's products or services may not always hold true, as local competition and consumer preferences can vary greatly from the home market.
• While global population growth can increase demand, it does not automatically translate to increased business opportunities if the population growth occurs in areas with low purchasing power or in economies that are not integrated into the global market.
• Acquiring other businesses may not always lead to the integration of new technologies if there is a misalignment in corporate cultures or if the acquired company's technology is not compatible with the acquiring company's systems.
• The benefit of share repurchases can be unevenly distributed, favoring short-term investors over long-term shareholders, as the immediate increase in earnings per share might lead to a short-term stock price increase.

Factors contributing to fluctuations within the stock market.

This section of the story explores the different factors that affect the fluctuating prices of stocks across various periods. You'll learn about the impact of investor emotions and company earnings on stock market volatility, and you'll become familiar with concepts like periods of rising stock prices, declining market trends, price adjustments after rapid increases, and phases when stock prices remain relatively stable.

Short-term stock price fluctuations driven by investor emotions and sentiments

Investor sentiment, oscillating between hopefulness and skepticism, influences the valuation multiples, thereby altering the collective value of market shares.

Investor sentiment and emotions often drive the short-term fluctuations in the prices of stocks. News events, economic data releases, geopolitical developments, or even rumors can influence investor sentiment, thereby altering their propensity to buy or sell stocks. Investors' confidence in a company's future prospects can lead to a greater valuation of its shares, as evidenced by their readiness to endorse a more substantial valuation in comparison to the company's financial performance, thereby increasing the stock's price. Investor skepticism or the sense of increased danger typically results in a tendency to favor a lower valuation, which often precipitates a reduction in the stock's market value.

Feroldi demonstrates the impact that conjectural media coverage can have on a business like Best Coffee Company. The announcement that Starbucks intends to open new locations near Best Coffee Company leads investors to lean towards a lower price-to-earnings ratio, consequently decreasing the company's stock value. The news about the expansion of the menu by the well-known cafe chain to include donuts has been met with positive reactions, which has contributed to an increase in the company's stock value, as indicated by a greater P/E ratio and consequently, a higher share price.

Context

• This refers to the total value of a company's shares in the stock market. It can fluctuate based on investor perceptions and broader market trends, impacting a company's market capitalization.
• Unverified information or speculation about a company or the market can lead to rapid buying or selling. For instance, rumors of a potential merger or acquisition can drive up a company's stock price as investors anticipate future growth.
• Effective corporate governance practices, including transparency and accountability, can increase investor trust and confidence in a company's management and future prospects.
• Geopolitical tensions, such as trade wars or conflicts, can create uncertainty about global markets, leading investors to adopt a more conservative approach to valuations. This can result in lower stock prices as investors seek to mitigate perceived risks.
• Media coverage can trigger psychological biases such as herd behavior, where investors follow the actions of others, leading to rapid buying or selling.
• The opening of new Starbucks locations can affect local economies, potentially drawing customers away from smaller coffee shops, which can influence the financial outlook and stock performance of companies like Best Coffee Company.
• Successfully expanding a menu without significant operational disruptions can demonstrate a company's effective management and scalability, which can be attractive to investors looking for stable growth opportunities.

Long-term stock market trends follow the growth in corporate earnings

Over time, the stock market has typically experienced an average increase of around 10% per year.

Brian Feroldi emphasizes that while the mood of investors may sway the market in the short term, it's the enduring growth of company earnings that steers the market's trajectory over an extended period. This mirrors the growth in the combined profits of the firms represented. The value of a company's shares generally increases in tandem with its profits and has a tendency to decrease when its financial performance weakens.

The author emphasizes that, historically, the S&P 500 has delivered an annual return close to 10 percent. Historically, the stock market's valuation has shown a persistent upward trajectory.

Context

• Achieving the average 10% return generally requires a long-term investment horizon, often spanning decades, to smooth out the short-term volatility and market cycles.
• Different sectors and industries experience varying rates of earnings growth, influenced by factors such as technological advancements, consumer demand, and regulatory changes.
• Efficient management of costs and expenses can enhance profit margins, positively affecting share prices. Companies that can control costs effectively are often more attractive to investors.
• The historical return includes dividends reinvested, which significantly contributes to the overall return over time.
• Over the long term, investor confidence and the tendency to invest in equities for growth can contribute to the persistent upward trend in stock market valuations.

The stock market consistently recovers following its occasional declines.

The passage delves into the catalysts for abrupt downturns in the stock market and examines the recurring trend of market rebounds.

Grasping the elements that lead to significant downturns in the stock market.

Investor anxiety and swift selling activity can trigger a drop in stock prices.

Investor anxiety and doubt, frequently triggered by specific occurrences, may cause a flurry of hasty sell-offs, precipitating a swift drop in stock prices and a significant market slump. These events can be varied and unexpected, ranging from economic recessions, geopolitical crises, natural disasters, to pandemics. The 2020 emergence of the COVID-19 pandemic serves as a modern example of such an event.

Brian Feroldi illustrates the mechanisms of a market downturn using the case of Best Coffee Company. The emergence of a pandemic leads to a decline in customer traffic, which in turn heightens investor concerns regarding potential profit decreases. Investors' growing anxiety results in increased stock disposals, consequently reducing their value and heightening panic within the investment sector.

Context

• Investor anxiety often stems from behavioral finance principles, where emotions like fear and greed can heavily influence decision-making, leading to irrational market behaviors such as panic selling.
• Certain industries, like travel, hospitality, and retail, were hit particularly hard due to reduced consumer activity, while others, such as technology and healthcare, experienced growth.
• Pandemics introduce uncertainty into the economy, affecting not just individual companies but entire sectors, leading to broader market volatility.
• Poor economic indicators, such as rising unemployment or declining GDP, can heighten investor anxiety, prompting them to sell stocks in anticipation of further declines.
• Large institutional investors, such as mutual funds and pension funds, can significantly impact stock prices. Their decisions to sell large volumes of stock can lead to sharp price declines.

The market has invariably bounced back after experiencing previous downturns.

Challenging periods necessitate creativity and streamlining, eliminating businesses that lack resilience.

Market fluctuations, including the inevitable declines, might be unsettling, yet Feroldi emphasizes the market's proven ability to recover from past obstacles and solidify with the passage of time. This resilience is attributed to several key factors:

• Advancements and improvements in processes: Challenging financial periods frequently lead companies to embrace new innovations, change their strategies, and enhance their efficiency in operations. Market selection filters out weaker companies, allowing the stronger ones to grow and thrive.

• During periods of economic instability, governments often step in to stabilize the economy through support for businesses, assistance to those without jobs, and stimulation of business and trade operations.

• Human history demonstrates a consistent pattern of surmounting obstacles and devising solutions, showcasing the enduring resilience of human creativity and business spirit. Economic downturns pave the way for the emergence of new enterprises, a surge in innovation, and the revitalization of economic dynamism.

Feroldi emphasizes that times of economic hardship, such as the severe depression of 1873 and the significant economic distress experienced during the 1930s, spurred a surge of inventive activity and technological advancements, leading to the invention of the telephone, light bulb, and a host of other groundbreaking innovations.

Other Perspectives

• Economic recoveries can sometimes be driven by artificial stimuli, such as government intervention, which may not be sustainable in the long term and could lead to future market distortions or imbalances.
• While challenging financial periods can indeed prompt innovation and strategy shifts, they can also lead to reduced investment in research and development due to budget constraints, potentially stifling innovation.
• Market downturns can sometimes indiscriminately affect both strong and weak companies, with external factors such as access to capital, market position, or geographic location playing a significant role in a company's ability to survive.
• The effectiveness of government intervention is highly dependent on the appropriateness of the measures taken, which can be difficult to gauge and implement correctly.
• The narrative of constant progress and overcoming obstacles does not account for the possibility of negative consequences of innovation, such as environmental damage, ethical concerns, or the exacerbation of social divides.
• Some economic downturns may result in a brain drain, where skilled individuals emigrate in search of better opportunities, potentially stifling innovation in their home country.