Stock Market Multiplier Effect
With the marvelous performance of the US stock market (written in 2006), I wanted to understand the fundamentals of how it creates wealth. How did they companies become so valuable?
A very simple little example is shown here.
- Consider a company that has 100 shares outstanding at a current price of $10. The market capitalization of that company is $1000 (100 * $10).
- I want to buy a share in that company and I'm willing to pay $11 for that share. Now the market capitalization of that company is $1100 (100 * $11).
- The value of all the shares has increased by $100 although I added only $1.
- The stock market has a multiplier equal to the number of shares outstanding!
- Most companies have more than a million shares outstanding and a good number have more than a billion shares outstanding.
- It still stuns me - if I'm willing to pay $1 more for a share, all the other stockholders feel that the value of each of their stocks have gone up by $1.
This multiplier effect has an element of a pyramid scheme. That worries me, but it has been in operation for years - although it suffers from booms and busts.
This effect is reminiscent of the economic fallacy of composition.