It has often been observed that capital is the mother's milk of business. The story of American prosperity is also the story of the world's deepest and most liquid capital markets. Today we look in particular at the market for equity capital (stocks).

Stock markets serve two critical objectives: to raise funds from outside investors, and to provide liquidity to allow investors to exit an investment at will. This involves two different types of transactions: primary and secondary market activities. Here is a primer.

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Christopher A. Hopkins

Primary market transactions involve the first-time sale of stock by the current private owners to the general public. A new issue brought to market is referred to as an initial public offering or IPO, whereby interested investors may purchase stock directly from the company. The process is complex and highly regulated and begins with the hiring of an investment bank known as an underwriter (or more typically, a syndicate formed by several banks to spread the risk). The underwriter creates marketing materials including a legal document called a prospectus, and begins the selling process.

One recent IPO that debuted in April is Pinterest, a private firm that sold 75 million shares to the public at $19 per share. All of the proceeds went directly to existing private shareholders in exchange for their share of ownership. At this point, Pinterest became a publicly traded company.

Secondary market transactions, on the other hand, comprise the vast majority of capital market activity. It is here that investors buy and sell the existing shares in public companies created by the IPO. This is the part of the stock market with which most of us are acquainted from the evening news. A number of indexes summarize the performance of various sectors of the market, many of which are familiar: the Dow Jones Industrial Average and the S&P 500 for example. Transaction prices are determined by competitive bidding among buyers and sellers, one of the purest examples of an unfettered free market.

A broad secondary exchange system is crucial to the process of raising capital. For investors to be willing to risk their own capital, they must have a reasonable expectation that they will be able to dispose of their positions quickly and cost-effectively. In addition, since prices are set by competition, they help in determining a reasonable value for the companies whose stocks trade on the exchanges.

Recall our earlier example of the Pinterest IPO. The initial price of $19 was set according to financial projections as well as indications of interest from potential investors, but was still an educated guess. Since the stock began trading in the secondary market, roughly one third of the total shares have changed hands on average each day since the issue went public. The current stock price is about $28 per share, an indication that investor interest remains high and that the IPO price was probably set too low.

The size of the U.S. secondary trading is staggering. The number of shares that change hands on an average day, referred to as the daily volume, is about 6 billion. Every day.

A somewhat disturbing trend has developed in recent years. The number of publicly traded companies has fallen in half over the past 20 years as more firms raise debt to buy back their outstanding shares. This reduces efficiency of price discovery, and leaves many great companies loaded up with debt that imperil their survival. Debate continues over how and even whether to respond to this trend.

Still, the US stock market continues to play a critical role in financing the American business juggernaut.

Christopher A. Hopkins, CFA, is a vice president and portfolio manager at Barnett & Co. in Chattanooga.