How Investment Bankers Know What the Stock Market will Bear

By Matt Krantz, Robert R. Johnson

Investment bankers know that as is the case with everything from ice cream cones to baseball tickets, the price of a stock hinges on the balance of supply and demand. When companies sell stock for the first time, those shares eventually need to find their way into the hands of investors willing to hold them.

The supply of stock is somewhat stable. Companies can increase the number of shares by selling stock in a follow-on offering, which is an additional sale of stock following the IPO. Conversely, companies can reduce the number of shares outstanding with stock buybacks. In a stock buyback, companies use their excess cash reserves to buy stock in the open market.

Investors have grown increasingly skeptical of the value of stock buybacks. Fans of buybacks point out companies may buy back their stock to boost their much-watched earnings per share. How? When the company’s profit, or net income, is divided by a smaller number of shares, then earnings per share rises.

Earnings per share is net income divided by the number of shares outstanding. If the number of shares outstanding falls, earnings per share rises. But critics point out that some companies routinely buy back stock when it’s expensive, a bad timing decision. Critics say that, in many cases, shareholders would’ve been better off just getting a dividend than they are when the company buys its own shares.

The supply of stock may be relatively stable, but demand for the shares is anything but. Investors, traders, and speculators crowd into the stock market and buy and sell shares of companies the same way 10-year-olds trade Skylanders figures. The process pushes the stock price up and down, causing buyers to constantly examine their financial models to decide if the stock is attractively priced or is too expensive.