Like second-hand shoppers, most investors rummage through secondary markets searching for great stock deals. These are stocks that might have been issued decades in the past or just a few moments ago, but are now being sold by their owners. It's a market that operates quite differently from a primary market, in which people can buy new investment securities right from the issuing entity. The key difference is that in a primary market investors can often buy a brand-new stock for less money than it would fetch on the secondary market. In a sense, it's like buying the latest fashion directly from the designer, instead of buying it after it has been marked up by a store.
What is a primary market?
A primary market is where new investment securities are first issued to the market on an exchange. These securities, which can be stocks, bonds, or any other type of debt or equity instrument, are issued by companies, governments, and public sector institutions in order to raise capital. The initial sale is handled by investment banks or a finance syndicate of securities dealers, which set the beginning price for the given security and facilitate its sale to public market investors.
The most commonly known primary market is an initial public stock offering, or IPO. Private companies use an IPO to issue stock to the public to raise money to fund operations or expansion. Investors in an IPO are the first to own the stock and often can buy shares at a discount to what the market is willing to pay once trading begins on secondary markets.
Facebook IPO: The primary market in action
One of the most memorable recent IPOs was that of Facebook (NASDAQ:FB) in 2012. This was one of the most highly anticipated IPOs in years, and it ultimately became one of the biggest IPOs in tech and the biggest IPO of an Internet company. What made it so highly anticipated was that many investors saw the primary market opportunity as too good to pass up. This was based on the view that Facebook's stock would soar once it hit the secondary market, given the history of first-day surges from popular tech and Internet IPOs.
Because of the high primary market demand, the underwriters handling the initial public offering settled on a price of $38 per share, which was at the top of the expected target range. Furthermore, just before the IPO, Facebook boosted the size of its stock offering by 25%, to 421 million shares. This resulted in a stock valuation of $104 billion, which is still the largest ever valuation of a newly public company.
Facebook raised $16 billion through the primary market via its IPO, which certainly accomplished its main goal of raising as much cash as it could to fund growth. Unfortunately, the initial results for primary market investors were less than expected as the stock failed to soar on the first day. In fact, the stock closed at just $38.23 after 460 million shares switched hands on the first day of trading, suggesting turnover of more than 100% on that day. All that being said, the primary market served its purpose: Facebook was able to raise cash while investors had the chance to pick up shares at what was thought to be a discount before the stock could be bid up by the secondary market.
The main purpose of the primary market is to enable companies and governments to raise cash to fund operations. However, investors see the primary market as the place they can buy a stock before it gets bid up by the secondary market. The hope is that in buying directly from the company investors can obtain the stock at a better price than they could if they bought it from other investors on secondary markets.
Matt DiLallo owns shares of Facebook, which he actually bought on the secondary market at a nice discount to its IPO price as sometimes it does pay to wait. The Motley Fool recommends Facebook. The Motley Fool owns shares of Facebook. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.