This guide explains what the primary market and secondary market are. We will look at the purpose of these markets, the participants in them, and how they function. Here are some key takeaways about the primary and secondary markets.
This guide will go into detail about what the primary and secondary markets are as well as the purpose of these markets. Before we get into that, it’s important to be able to quickly distinguish between these two markets. Here is an infographic to help with this:
The infographic above explains the difference between these two markets. The primary market is where corporations raise capital through the initial offering of debt and equity securities (stocks and bonds). The secondary market is where the existing securities that were generated in the primary market are traded between market investors.
To understand the primary market, you need to understand the capital raising process. When corporations need money to grow, but don’t have the ability to fund that growth out of organic cash flow, they will look to raise outside capital.
There are two sources of outside funding: debt and equity.
If the business looks to raise capital through the primary market, they will issue stock. If they look to raise capital through debt, they will issue bonds. The choice to use either debt or equity is highly discretionary in a healthy business, however it may make more sense to choose one route over the other. To learn more about how businesses are financed, we recommend our guide: Capital Stack Quick Guide.
In order to raise capital through the primary market, corporations go through investment banks. These investment banks offer underwriting services to the corporations that help them facilitate these deals. To learn more about investment banking and the underwriting process, we recommend our guide: Investment Banking. Here is an infographic illustrating the capital raising (underwriting) process:
When a business issues new securities to the public for the first time, it is called an initial public offering (or IPO for short). When a business decides to issue additional securities for sale it is called a follow-on offering (sometimes called a further public offering or FPO).
So, if a business wants to raise capital through equity and decides to offer 100,000 shares of common stock to the public, this would be their initial public offering. If they then decided to go back and issue another 100,000 shares of stock this would be called a follow-on offering. The important thing to understand here is that in both cases, the company is issuing new shares for the first time. Both of these transactions occur in the primary market.
Through IPO’s and follow-on offerings companies raise capital from the investors who buy them at a certain price. The investment banks are compensated through fees and commissions.
In addition to these public offerings, rights issues and preferential allotments also occur in the primary market. A rights issue is when a company wants to issue additional shares to existing shareholders but may choose to offer them at a discounted price compared to the new market price of the shares. Preferential allotments are when a company decides to issue new shares to a few individuals that are, again, potentially offered at a discounted price compared to the market price. The key here is to understand that the new securities (stocks and bonds) are issued for the first time here in the primary market.
Now that we understand what the primary market is and its purpose in the capital raising process, we’ll move onto the secondary market.
So, in the example above we saw a corporation raise capital through an both an IPO and a follow-on offering (facilitated by an investment bank) by selling 100,000 shares of their company’s stock to investors. This was done in the primary market.
The company issued those shares because it wanted capital to grow business operations. The investors bought the shares—meaning they invested in the company—because they wanted a return on their investment.
So, what happens if those investors want to sell their shares?
The shares in the example above are publicly traded, so they can be traded through the stock market. Stock markets, like the New York Stock Exchange (NYSE) are secondary markets.
The secondary market is where investors can trade securities between themselves. Here is an infographic to illustrate this:
In the infographic above we can see how the fund managers looking to sell and the fund managers that are looking to buy are brought together in the stock market.
When securities are offered to the public for the first time, through an IPO (primary market), they are listed on the secondary market so those investors can trade them again in the future. This makes their investment substantially more liquid.
In the example we used earlier the company raised capital by issuing 100,000 shares of stock. The investors that bought those shares would have had great difficulty selling them again if they were not publicly traded (on the secondary market). Publicly traded shares of stock can be bought or sold on the open market on any trading day. Comparatively it’s significantly harder to sell shares of a privately held business. The secondary market provides the liquidity for the shares of stock.
It’s important to note that the company that issued these shares in the primary market is not compensated for their purchase or sale on transactions made in the secondary market. It’s the investors that buy and sell at the prevailing market prices that earn or lose money on these transactions.
Secondary markets also play a role in the valuation of businesses. We can get a valuation of a publicly traded company on any trading day. If we take the total number of shares outstanding and multiply it by that company’s current stock price, we get the market cap. This is the total value of that company’s stock based on that moment’s trading price.
Additionally, we can use the secondary market in the valuation of privately held businesses as well.
Normally, private company valuation presents some challenges because they don’t publish detailed financial information that we can just look up like we can find a company’s stock price. One method of private company valuation is called comparable company analysis. Here we look for comparable companies to the private company we’re trying to value that trade on public markets. We can reference the publicly traded company’s stock price and see what it trades at above earnings (or use other metrics). We can then argue in a negotiation that since open market trading supports this price, then we can justify that multiple above earnings for this private company as well.
There is an important point to note here regarding liquidity. We looked at how the secondary market provides liquidity to investors and how it is much easier to sell shares of a public company than a private company. Investors obviously prefer a higher liquidity position in their investments, all other things remaining equal. To account for this, if we were using the secondary market to value a private company, we need to assume that these publicly traded shares carry a liquidity premium and we need to discount our valuation to account for this.