What is a stock exchange?

Kristia van HeerdenLatest, OUTstanding

As we’ve discussed before, turning your money into an asset is the best way to ensure it grows ahead of inflation. Cash in the bank protects your money in the short term, while investments grow your wealth in the long run. You can invest in a physical asset, like starting a business or buying a franchise, but most of the time this type of investment requires big money upfront. Investing in paper assets like shares is also a way to become a business owner, but requires a lot less money and effort since other people manage the business.

In this article we’re going to explain how the stock market makes it possible for ordinary people to own small parts of huge companies.

Why companies sell shares

Companies often need money to grow. The bigger the company, the more money it needs. Loans are an option, but borrowed money needs to be paid back with interest.

For that reason, companies often prefer raising money by getting investors, who become part-owners (shareholders) of the company. Just like a small business owner, investors get to share in the profits (dividends) of a company when it does well and feel the pain when times are tough. A share is a digital certificate* given to part-owners of a company.

How companies get investors

The managers of a company decide how much of the company’s ownership they want to give up to raise money. Each share entitles the owner to a vote. When management makes important decisions, shareholders can use their votes to influence the outcomes. Shareholders with more shares have a bigger influence on how a company is run.

While companies can sell shares to individuals directly, it can be hard to find thousands of shareholders, manage how many shares each shareholder owns and facilitate buying and selling shares. For that reason, companies go to a marketplace where people who are looking for investments go shopping for good deals. This marketplace is called a stock exchange (or stock market).

When a company makes its shares available on the stock exchange, we say the company is listed. Remember, a listed company is a company whose shares are on the list of shares on the stock exchange.

A marketplace for shares

A stock exchange works like a farmer’s market. The company takes its shares to the exchange to be sold like a farmer takes her vegetables to the market. Brokers get the shares from the companies and sell them to the public, like stalls at a market. We investors go to brokers to buy and sell the shares that are available on the market. These brokers or stockbrokers charge a fee for their services known as a commission. An exchange like the JSE (Johannesburg Stock Exchange) only facilitates the buying and selling of shares and both these actions are done through brokers.

Both the listed company and the brokers pay for the privilege of using the exchange facility. In return, the exchange manages a register that keeps track of which individual owns which shares.

What happens when you sell a share

When you are ready to sell a share, you don’t sell it back to the company or to the exchange. You sell it to other people who think the share price will go up in the future, via the broker. The exchange matches you with a buyer who is willing to pay what you are asking for the share. Once you’ve sold the share, the name on the share certificate changes and the new owner will be the person earning dividends from that share going forward.

*These days it’s actually more like a line item in a digital logbook. Back in the days when stock markets were paper based, shareholders got share certificates.

OUTstanding Money

Being outstanding with your money doesn’t have to be hard. This series of articles will give you all the tools you need to get your house in order to start investing.

This series of articles was sponsored by OUTvest, and written by Just One Lap in 2018.  It’s timeless wisdom that needs to be out there – in public spaces where it can feed into ongoing discussions about long term financial wellness.