Stock Market Multiplier Effect

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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.