What it means
An equity market has two distinct jobs that people often merge into one. The primary market raises fresh capital for businesses through flotations and follow-on issues, while the secondary market, which is what news reports mean by daily trading, simply transfers existing shares between investors without giving the company a cent.
Liquidity is what makes the whole arrangement work. Investors will buy long-term stakes in businesses largely because they know they can sell to someone else at short notice, and that willingness lowers the return companies must offer to attract capital in the first place.
For a business leader who is not in finance, the practical relevance is valuation. Your competitors' share prices and trading multiples set the benchmark against which your own business will be measured, whether you are raising money, buying a rival or selling out.
Prices move on expectations rather than on history. A company can report record profits and still see its shares fall, because what the market had already priced in was even better than what actually arrived.
Equity markets are also segmented in ways worth knowing. Large capitalisation shares tend to be liquid and heavily researched, small capitalisation shares trade thinly and swing harder, and private equity sits entirely outside public markets with far longer holding periods and no daily price.
In practice
Real-world examples.
Example
A family-owned packaging business planning a sale checks the trading multiples of three listed peers. Finding they trade at around 15 times earnings gives the owners a defensible starting point for negotiation with private buyers.
Example
A logistics firm floats 20% of its shares to fund a new distribution centre. The primary issue raises real cash for the company, while all subsequent trading in those shares moves money only between investors.
Example
A treasurer notices the company's shares fell 6% on the day it reported higher profits. Analysts had expected an even bigger increase, so the market repriced its expectations for next year rather than judging the results themselves.
Formula
Calculation
Market capitalisation = share price x number of shares in issue. Earnings per share = net profit / number of shares in issue. Price to earnings ratio = share price / earnings per share.
Take a listed components manufacturer with 25,000,000 shares trading at $18 each. Market capitalisation is 25,000,000 x $18 = $450,000,000. If the company earns a net profit of $30,000,000, earnings per share is $30,000,000 / 25,000,000 = $1.20, so the price to earnings ratio is $18 / $1.20 = 15.
Now suppose the sector re-rates and investors are willing to pay 18 times earnings instead of 15, with profit unchanged. The share price becomes $1.20 x 18 = $21.60 and market capitalisation rises to 25,000,000 x $21.60 = $540,000,000, an increase of $90,000,000 driven purely by sentiment rather than by any change in trading performance.Case study
Seen in the real world.
Tidewater Instruments is an illustrative, fictional maker of laboratory equipment used here to show how equity markets behave. It listed with 25,000,000 shares at $18, giving a market capitalisation of $450,000,000 against a net profit of $30,000,000 and a price to earnings ratio of 15.
Eighteen months later a wave of takeover activity in the sector pushed peer multiples to 18 times earnings. With profit flat at $30,000,000, Tidewater's shares drifted up to $21.60 and its market capitalisation reached $540,000,000, gaining $90,000,000 without the company selling a single extra instrument.
The board learned two things from this illustrative episode. The rise was worth nothing in cash terms because the company was not issuing shares, but it did make a share-funded acquisition materially cheaper, so they moved a long-stalled deal forward while the rating held.
Watch out
Common mistakes.
- Assuming a company receives money whenever its shares are traded. Only primary issues raise capital for the business; secondary trading moves cash between investors.
- Reading a share price on its own as a measure of size. A $200 share in a company with 1,000,000 shares is far smaller than a $5 share in a company with 500,000,000 shares.
- Expecting good results to lift the share price automatically. Markets price expectations in advance, so results that merely meet forecasts often move the price very little.
Questions
People also ask.
What is the difference between the equity market and the bond market?
Equity buyers own a slice of the business and share in its profits and losses, while bond buyers lend money and receive interest with a prior claim on repayment.
Does a rising share price help the company directly?
Not in cash, but it lowers the cost of raising new equity, makes share-funded acquisitions cheaper and improves the value of employee share plans.
Why do private companies care about listed multiples?
Because buyers and valuers benchmark private deals against comparable listed businesses, adjusted downwards for the lack of a ready market.
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