Basics of
Stock Market
“I was watching an interview of Warren
Buffet on the news channel the other day. I had not heard about Warren Buffet
earlier but after watching his interview when I googled about him I realized he
is one of the richest man in the world and is an ace investor who made most of
his money just by investing in the Stock Market. What this Stock Market is all
about? What is that Warren Buffet could do that many others could not”, Apurva
looked very curious over the Skype on the weekly conversion that we missed over
the past few weeks.
The stock market is perceived as a money
making machine and there is tremendous amount of survivorship bias about the
stock market. Survivorship bias means to refer to people who have been
successful or survived the bad times. In stock markets there have been many
cases where people have lost their hard earned money. “Oh, is that the case? So
is it better for a common man to stay away from stock markets in that case”? ,
asked Apurva. “No. it’s definitely not that way. “, I started explaining her.
One has to make informed decision before investing in the stock markets and
understand the fact that there are no guaranteed profits on the investments you
make. “What do you mean by stocks, why do they exist, where can I buy/sell
them, how do I buy them, and which stocks should I buy so that the risk for
losing money is minimized? Apurva bombarded me with her questions.
“We will take all the questions one by one.
Let us start with what are stocks.” Stocks or Shares or Equity as different
people call it, in simplistic terms is a part of ownership in a publicly listed company. Before moving forward let us understand what a “Publicly Listed Company” is. Let us take an example. Suppose you wish to start an
Ice-cream parlor with ₹ 20,000 of savings you have. You decide to buy a
machinery of Ice-cream Vending Machines which cost ₹ 20,000. You also decide to
rent a place near you for which you need to pay ₹ 5,000 rent per month. You
also employ a man which serves ice cream to people with a salary of ₹ 3800/month.
Cost of making 1 Ice-Cream is ₹ 9 and you decide to sell at ₹ 12 which is
selling price by all the ice-cream sellers have in the market. You cannot charge more
than ₹ 12 else your customers would go to your competitor.
So in this process you make ₹ 3 as profit
per Ice cream. Two months after you started a business you realize that on an
average you sell 100 ice creams a day making ₹ 9000 as revenue. After paying
rent and salary of the employee you earn profit of ₹ 200 per month. This
continues for next few months and one year after the start of your business,
you are very happy with it and by the fact that you have made ₹ 2400 profit in
the 1st year i.e. 12% return on your initial investment of ₹ 20,000.
Your total asset base has become ₹ 22,400 (assuming no depreciation of the
machine for simplicity). Now you have become ambitious and want to start another
shop in the other part of the city. But you have only ₹ 2,400 in cash in hand. For
buying the new ice cream vending, you would have to wait for another 8 years.
You would certainly not want to wait that
long, would you? So what are the options available? You can ask your
parents/relatives for money but they refuse to invest such high amount. You can
go to bank and ask for ₹ 20,000 loan, but the bank asks for 15% interest per
year as it’s a new business and has the risk that it may or may not work which
means you have to give away ₹ 3000 per year which will be a loss making affair
for you. There is a third option which is you go to public and request for
money. Why would people give you money
for your business? Answer is simple because you are sharing ownership in
return. Which means that people who would invest in your business, will be
entitled for profits proportional to the ownership that they have. The normal
bank savings would give them 4-6% return, Fix Deposit can yield 8-9% return
where as your business is currently making 12% with potential of making even
higher return on investment. Also since the amount is distributed among many
people who would invest your business, the contribution from each can be very
small making it affordable.
In our example at the end of one year the
business is worth ₹ 22,400. You decide to convert it into 100 shares of ₹ 224
each. Value of ₹ 224 is known as Face value of the share. Since you want to raise ₹ 20,000, you should
ideally issue/create 90 more shares (20,000/224) but you would not do that.
Ideally you would hire an Investment Bank to do this on behalf of you. The
investment bank runs a process known as “Book Building Process” where it gauges
the demand for you shares. Hence the value at which the share would be sold is
different than ₹ 224 rather it is usually higher than 224. Why would people pay
more than 224 for a share which is worth 224 currently? Because the price of
share is not decided by the current prospects rather it is decided by the
future prospects the company/business has. As a company, you should come out a
document called as “Red Herring Prospectus” in which you tell the prospective
investors as to what you intend to do with the money and what are future
potentials for your business. Based on the book building process a “Price Band”
is decided for the issue of shares to which investor need to subscribe. After
the subscription is complete the investment bank then decides the final price
of Issue. Since this is the first time you decide to go to public for raising
money, this is called as “Initial Public Offer”, IPO.
Let us say in our example we issued 80
shares of ₹ 250 each to raise ₹ 20,000. Now total number of shares is 180 (100
that you own + 80 that people own). The result of IPO is dilution of ownership
of the founders or better known as promoters. In your case initially you owned
100% but after the issue you own 55% of the business (100/180). You still own
the majority stake in the business and can take the management decisions. The
people who invested in your company are called as shareholders who have voting
rights which they can exercise for important decision making which required 2/3
majority (67%). Once IPO process is over the Shares are listed on an Exchange
where the original investor can sell the share of your business to new
investors who would want to invest. In India we have BSE and NSE , which are two
popular exchanges where trading takes place. The market value of ₹ 250 changes
every day based on many micro and macro factors which we will discuss some
other day.
