Let me spare you the pain of having to take a 4 year economics degree.
Now, this is a really brief summary and is intended to be simplistic.
Firstly you need to know that markets are generally accepted to be an efficient means of matching buyers and sellers through the mechanism of prices.
Supply and demand for any good or service should always tend to be in equilibrium so that those who wish to buy pay a price which matches those who wish to sell. This is true of markets in general and not just the stockmarket.
If you just accept that this works you can save yourself a lot of pain and suffering. If you don't believe me, the stockmarket will educate you but it has a habit of handing out large tuition bills.
(For those of you who want to argue that markets are not fully efficient, I agree that there are some inefficiencies and that other steps (eg regulation, laws etc) are required to ensure an orderly market. However, there is no evidence that a fund manager can identify these inefficiencies in advance and with sufficient regularity to pay for the additional costs of active fund mangement and consequently it is virtually impossible to profit from the inefficiencies)
So, in a nutshell capitalism is the means by which those with capital, lets call them capitalists, allocate their capital to achieve an expected return.
This expected return is a function of the risks being taken.
If I deposit my capital with the post office I have a lot of security - but my expected return is low. Capitalism assumes that I will not be satisifed with this safe return, mainly because over time, my capital will not maintain its real value allowing for inflation. I will see everyone else doing better than me (call it growth or progress) and so I will want to join the party.
A bank is less safe than the post office, as we are seeing in spades right now. So, I expect a higher return. I expect to be rewarded for taking the additional risk.
Government bonds are typically safer than corporate bonds (ie loans to governments are more likely to be paid back than loans to companies)
The interest rate reflects the underlying risks of repayment. So, loans to Argentina or Iceland should pay a higher interest rate than loans to Switzerland.
Finally, taking a share in a business offers a higher expected return than anything else (including property*)
So, the logic of the efficient market is that capital will tend to gravitate into investments in companies as over time this offers the highest expected return.
As I said capitalism is called capitalism because everything is based on the return on capital employed.
"a small company has a higher cost of capital than a big company".
This just means that a small company is more risky than a big company. Would you rather invest in IBM or Greggs the Baker (a real company listed in the UK)
Think like a bank - I'd rather lend my money to IBM anyday. So the cost of capital for the baker is higher. They have to pay more for capital. So, the expected return on my investment is higher. Ie as an investor, I require a higher return on my investment to compensate me for the higher risk.
Watch Dragons Den on the BBC! These people are there mainly because the Banks have already decided that most of the ideas are as mad as a box of hot frogs. If you want me to invest in your company, I want half of it!
Risk and return living together in perfect harmony.
3) And how can people find out the "value of a company " in relation to Book to market value ?
This is a more tricky subject. I'll come back to this one.
4) And last but not least equity investments :
"generally refers to the buying and holding of shares of
stock on a
stock market by individuals and funds in anticipation of income from
dividends and
capital gain as the value of the stock rises." would the above be a good description?
Yep that is the bulk of it. There are other issues to consider like where you stand in line in the event of a company going bankrupt - which is again really relevant right now.
First in line are the banks then senior debt bond holders, then subordinate bondholders then preference shareholders then common stock holders.
Equity investment almost always means common stock holders. Again last in line, greatest risk, highest expected return.
Hope that helps.
*Property has a lower expected return than equity. Why?
Because if I am in business I can rent a property to conduct my business - whatever it might be. I expect to make a profit after costs (including the rent).
So, it is logical that if the expected return on property was higher than on equity, all companies with a property would simply shut down and rent out their buildings. This simply does not happen. Why? Because the process of added value from being in business creates wealth.
