2. Primary and secondary market, and index weighting

Theory 1: How the market really works

You buy shares today in a listed company. You pay your money, you receive your shares, everything in order. And that company does not take in a single penny of what you paid.

In the previous module we saw how a company's share count changes and exactly what free float the public has access to. Now it is time to look at how that public access is born — the stock market listing — and what an index actually does with those shares.

When a company runs out of places to get money

A private company that grows enough reaches a point where it needs more money than its founders or current investors can provide. It then has several options:

• Take out a bank loan.
• Look for more private investors.
• Go public through a stock market listing, or initial public offering (IPO).

That third route takes two forms, and what separates them is who keeps the money:

• A primary offering: the company issues new shares and the cash goes into its own accounts.
• A secondary offering: what is sold are shares that already exist, belonging to the current owners, and the cash goes to them.

Either way, the company or its current owners sell a portion of the shares directly to the public for the first time. The price is set in advance, with the help of investment banks.

The money raised goes into the company's coffers when what is issued are new shares, and funds its growth: hiring people, opening factories, paying down debt. When what is sold are shares that already exist, it goes to the founders or early investors who want to cash out some of what they put in. Many listings combine the two.

Who decides the price of that first sale

Setting the offer price is far from trivial, which is why almost no company does it alone. It hires one or more investment banks as underwriters.

Those banks analyze the company's accounts. They then talk to large institutional investors to gauge what they would be willing to pay. With that information they propose a price that tries to balance two opposing interests:

• Set it too high and the offering may fail, because nobody buys.
• Set it too low and the company 'leaves money on the table': the first buyers pocket an immediate gain at the expense of what the company could have raised.

Primary market and secondary market

That moment — the direct sale of the company's new shares to the first buyers — is called the primary market.

It is important to grasp it properly, because it is the exception and not the rule. The vast majority of share transactions that happen every day are not primary market at all, but secondary market.

In the secondary market the company is no longer directly involved. These are investors who already hold shares — bought in the IPO or in an earlier purchase — selling them to other investors.

And there is the explanation for the contradiction we opened with. When you buy a share in a company that went public 20 years ago, that money does not reach the company. It goes into the pocket of the person who sold you that particular share. The company already received its money, once, in the primary market.

What a stock exchange does, and what it does not do

The stock exchange — the New York Stock Exchange, Nasdaq, the Madrid Stock Exchange — is, in essence, the organized secondary market. An infrastructure, today almost entirely electronic, that takes care of three things:

• Connecting millions of buyers and sellers.
• Guaranteeing that trades are executed and settled correctly.
• Publishing in real time the prices at which trades are being closed.

Notice what is not on that list: the exchange does not set the price. The price is set by the clash between what people are willing to pay and what other people are willing to accept to sell. We will look at that clash in detail in the next module.

The exchange simply provides the venue where it happens in an orderly way — physical in the old days, a server today — and charges a small fee for facilitating it.

What an index really is

When we say that a company 'is in the S&P 500', we are talking about an index. That is a specific, curated list of roughly the 500 largest US companies by market capitalization trading on US exchanges. The agency S&P maintains it and reviews it periodically.

The index itself is not a company and cannot be bought directly. It is a calculated number, typically weighted by the size of each company, that serves as a thermometer for the whole.

When the news says 'the S&P 500 rose 1.2% today', it is describing the weighted average move of those 500 companies. Not that all of them rose by the same amount. Not even that all of them rose.

This platform takes the S&P 500 as its reference universe precisely because it combines size — large companies, with reliable data and plenty of liquidity — with diversity, spanning eleven different sectors of the economy.

Why the index does not count all the capital

The market capitalization, or 'market cap', that determines whether a company makes it into an index is calculated simply: the current price of one share, multiplied by the total number of shares outstanding.

But the S&P 500 and most modern indices do not weight each company by its total market cap. They weight it by its free-float-adjusted market cap.

Suppose a company worth 500 billion whose founders keep half of it off the market. The index only counts as 'weight' the half that is genuinely tradable, because that is the only part an investor can actually buy.

This prevents a company with a lot of capital locked up in insiders' hands from carrying a weight in the index that no real investor could replicate by buying on the open market.

The price per share, on its own, says nothing

A company with 10 billion shares trading at $15 each has a market cap of $150 billion, whatever the 'apparent' price of each individual share.

This is key to understanding something that confuses many beginners. The fact that one share costs $15 and another costs $1,500 says absolutely nothing, on its own, about which company is bigger or 'better'.

It depends entirely on how many shares each one has issued, something we will cover in more detail when we discuss how to read a company.