IPO stands for initial public offering. This financial procedure is often misunderstood. This article explains what an initial public offering is, and how investors and companies alike can profit from it.

The equities market is a flexible beast that can generate profits in a variety of ways. It can also be a pool of cash growing companies can “dip into” when they need resources to continue growing.

This is how it works. A company will divide its assets into shares and hire the services of a brokerage firm, which will buy the entire stock of the company, and sell it for a profit. The commission charged by a typical brokerage firm is around 10% of the sale price.

To illustrate imagine you own a small business in the Bookbinding industry. You need cash in order to continue growing. Maybe you need a new press or a larger workshop. You have $10,000 in assets and $5,000 in debt. Your company is worth $5,000. If you sell 100 shares of your company each one would be worth $50. Once you have sold these shares to investors their price will rise or drop depending on how well or how badly your business does.

This is where the most common misconception of the IPO system occurs. Many people think companies profit every time one of their shares is bought or sold. This is not true. The company only profits from the initial sale of stock options. It is then individual investors that go on to buy and sell the shares that profit or lose money depending on their skill and the behavior of the market.

If a company consistently increases its profits over the years its stock price will grow. Why does this happen? This is a natural result of the most important law of economics, that of supply and demand. When a company goes public and sells a limited number of shares, also called a float, the price is set by the perceived value of the firm. If the firm does well the demand for shares in that company will also grow. However, the supply of shares is limited, so the demand grows increasing the price.

This is why the stock market and the price of shares is so sensitive to financial news like the slightest variation in the interest rate. The economy is a very fluid system that moves through trends, waves and ripples. Successful investors will buy stocks when a company’s performance is promising and sell when financial woes are in the horizon.

Knowing when a company will do well or when the writing is on the wall for their fall is determined by economic news that provides investors and analysts with clues on where the economy is going and at what speed. Needless to say, this is a risky and difficult game to play. Regardless, the IPO system is one of the best gifts of Capitalism to the economy, because it provides companies with a tool to expand and create wealth in the future.