Stocks-explained

INTRODUCTION

The first step for anyone who aspires to invest in stocks , is to understand stocks ! The words stocks and shares mean the same thing. Share means a portion of anything. In our context, share means a portion of ownership of a company.Now,it would be better to discuss this concept with the help of an example. This will help you to get a clear idea of what a share is. Lets try to explain that with the story of a company called ‘Say-it-with-flowers’.

SCENE 1- The beginning

A group of girls decides to start a business. Since they knew floral decorations, they decide to start a flower shop. They name their business as ‘Say-it-with-flowers’. For initial expenses, they borrowed some money from the local bank and opens their shop in a small space. The business was successful.  However, they made little profit because; all the earnings were invested back into business since the customers were increasing and they had to meet the growing demand for their floral decorations.

SCENE 2- A decade after.

Ten years later, the bank loan has been paid off. Profits are over Rs 10 lakhs per year. It also has a book value of Rs 50 lakhs. (Book value is the net value of what the company owns- machinery, furniture, building less any loans). Having made their business a success, the girls now wants to expand their business. Their idea is to open two more branches at neighboring towns. After a detailed study, they find out that it’s going to cost over Rs 52 Lakhs to open two outlets. To find this 52 lakhs, they had two options- one, take out a loan from the bank. Two, sell part of their company. Since interest rates are high, they decide to take the second route. But how? What would be the cost of a share in say-it-with-flowers? Who will do the valuation? There were several questions to be answered.

SCENE 3-The big leap

To sell part of their company, the company has to be valued. The person who values a company is called an ‘underwriter’. So they approach an underwriter who checks their past records, future prospects, background of the promoters etc, The underwriter decides that the company is worth 10 times its current profits.

The current profits is 10 lakhs. So 10 times 10 lakhs is 1 crore. This one crore is actually an estimate based on various qualitative factors. Add book value to it, and you arrive at Rs 1crore and 50 Lakhs. This means, “Say-it-with-flowers” is worth Rs 150 lakhs.

40% of 150 is 60 lakhs. So, the girls decide to sell 40% of their company.A group of investors who were willing to buy the 40% shares in that company gives a check for Rs 60 lakhs. The girls still have control over the operations of the company since they still have 60% share.

SCENE 4- The benefit

Now, For the girls, 40% stake is lost but they get 60 lakhs in cash. They have the money to expand their business.As planned, they opened two new outlets for Rs 52 lakhs.The balance 8 lakhs is used for day to day operations of the three shops.

Both the new stores hit a profit of 10 lakhs a year. That means the total profit of the company Say-it-with-flowers is now Rs 30 lakhs. ( 10 lakhs x 3 shops ). The value of the business is now Rs. 450 lakhs (3 shops x 10 lakhs x 10 times + 50 lakhs x 3) and the couple’s 60% stake is worth Rs 270 lakhs.(450 x 60%)

SCENE 5 – At the stock market.

Since the investors who bought 40% of the share for 60 lakhs, is now worth 180 lakhs, the shares of say-it-with-flowers is in great demand. Since the company increased the wealth of shareholders 3 times, there are investors who are willing to purchase the shares even for an amount higher than 180 lakhs. Each day, shares of say-it-with-flowers are sold to the highest bidder. The place at which the bidding and buying process takes place is called the stock market.

SCENE 6 – You as an investor..

Let’s assume that the total shares of the company are 50,000 shares. So, 40% available to the public is 20,000 shares. The issue price was Rs 300 (60 lakhs/20000) but, now the share is worth Rs 900(180 lakhs / 20000). Since a section of the public feels that this winning streak of the company would continue, there is heavy demand for the share and due to this, the price keeps moving up.

Suppose the price is Rs 1250 now. Should you buy?

The answer is –no. Why? Because, the shares are trading above the ‘real value’ of Rs 900. This real value is also called ‘intrinsic value’.

Price drops to Rs 750. Should you buy?

Now, one day, due to some rumors, the stock market crashes, and  consequent to that, the price of the share plummets to Rs 750 per share.

Should you buy? May be, yes! Why? Because, now the share price is below the real value and some time later , you can expect the rumors to settle and that will result in  the prices moving  back to it’s original level of Rs 1250 or more.

Where should you sell?

Although the price may move back to Rs 1250, your selling point theoretically  should be at Rs 900 . Why? Because that’s the actual value point. The price rise above Rs 900 may be due to several reasons like investor sentiment which should be ignored.

CONCLUSION.

The good investor’s job is to identify companies like say-it-with-flowers that are selling below their true worth due to some illogical reason and invest in such stocks.

Hope We’ve made it clear.

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35 Responses to “Stocks-explained”

venkatraman

March 27, 2012 at 7:52 pm

excellent

Beginner

May 17, 2012 at 1:03 am

Mr. Victor, will you please elaborate that how can one justify Real value/Intrinsic value of a share at a point of time?
As this is a general but important question for all the beginners like me, hope you will guide us.

J Victor

May 17, 2012 at 7:12 am

Hi,

Intrinsic value is an opinion. At a particular point of time, no one can show an absolute figure and say that this is the intrinsic value. So, naturally,justification of intrinsic value becomes a source of debate.

At this beginner stage, i think it’s ok to understand that intrinsic value is actual value of a company, but not necessarily the company’s current market value.

venkatraman

September 17, 2012 at 8:19 pm

this topic is really excellent. But can you kindly clarify why the book value is multiplied by 3 times in this case 50 lakhs X 3

Prahlad Mandal

October 15, 2012 at 1:33 pm

Hi Victor, the topic help me lots to know what is stocks and share. Thank you for your beautiful explanation on stocks.

J Victor

October 21, 2012 at 2:14 pm

Sorry for the late reply.
Book value is multiplied 3 times assuming the each branch has a book value of 50 lacs.

Kris

October 27, 2012 at 12:35 am

Good Article. Could you please explain what do you mean by book value?

thanks

J Victor

October 28, 2012 at 10:17 pm

Hi chris, read it here ..

http://www.sharemarketschool.com/concept-2-book-value/

Amol Ratnaparkhi

December 20, 2012 at 1:00 pm

very nice!!!!! but i have one question
is the company displays the real value of its shares?
If YES, then Where?

hemanth

January 22, 2013 at 4:08 pm

well explained Tq..!!
but i didn’t understand “where should you sell..” ..
that is are we not going to sell the share above 900..?if yes then how will we make profit..

J Victor

January 27, 2013 at 1:46 pm

we are supposed to buy the stock at 750 levels ( discounted value) and sell it off at the intrinsic value point ( Rs 900)

Mahantesh

March 8, 2013 at 11:56 pm

Very nice… Thank you very much…

Sameer Singhania

May 3, 2013 at 9:53 am

He victor I want to know about that what is the difference between Equity and commodity?

Mayur

July 31, 2013 at 1:18 am

Just out of curiosity….
Consider the above said company offers 20000 shares…
Now if the company is making huge profits more people will tend to buy its shares….
Suppose all 20000 shares are bought by various shareholders…
As the company is making huge profits the shareholders opt to hold their shares so that they can sell at a later stage when the value is even higher…
Now if a new shareholder wants to buy say 100 shares will he be allocated the 100 shares or not?
If yes then how is this possible as company has offered 20000 shares and all of the shares are currently allocated to various shareholders???

J Victor

August 5, 2013 at 7:43 am

unless somebody sells, you cant buy more shares.

m p nautiyal

August 10, 2013 at 10:26 am

Excellent explanation thanks.
I could not understand how profit is multiplied by 10.what are the basics to reach this value ( 10 )

senthil

August 31, 2013 at 10:44 am

I guess no one could explain so simple even a kid could understand.. thx.. thx a lot.. will continue reading…

karthi

October 2, 2013 at 11:08 pm

Dear Mr.Victor, explanation is very clear. by the way… thanks

Rahul

November 4, 2013 at 4:46 am

Hey Victor, you and your topic both are amazing buddy. :)

Cedric

November 18, 2013 at 5:21 pm

Hi Victor,

First of all, Great write up!!!

I have a quick question looking at the example. Who determines the total shares of the company? In our case the 50,000 shares?

J Victor

November 19, 2013 at 8:29 am

The promoters decide the ‘capital’. This when divided by the denomination of shares ( say face value of Rs 100 or Rs 10) we get the number of shares accordingly..

Sreenadh

December 15, 2013 at 11:15 pm

Hy Victor , You explained it in the most appropriate way . Thank you

Biju

January 24, 2014 at 3:51 pm

Good simple illustration. Very good resource for starters.

Ravi

January 25, 2014 at 10:40 am

Hello sir,
Great! explanation Thanks

Ravi

January 25, 2014 at 12:53 pm

Sir,
Suppose there is no buyer in the market and I want to sell my share then in that case company itself repurchase to all my share.( just I wanted to know the rule )
Thanks

J Victor

February 24, 2014 at 3:02 pm

no my friend. unless the company decides to buy back, you can’t give it back to the company:)

roshan

July 12, 2014 at 4:51 pm

hy victor
ty foh making this very simple!! great explanation!! thankx!!

ABHISHEK

August 10, 2014 at 10:00 am

Dear Victor,
I am going through your each article in the blog, it’s written simple and beautifully. Hope you will carry on the literature.

Narasimha

February 22, 2015 at 10:13 pm

Respected,

The information which u provided is beyond excellent.
no more words to say.
i got perfect perception on market movers mindset.
thanks
regards
Narasimha

Sakshi

July 1, 2015 at 10:03 am

Sir
Why can’t we sell share at profitable rate which is 1250 ? Instead of selling it at actual value 900

sasha

July 3, 2015 at 10:59 pm

very helpful…thank u for sharing your knowledge..!

Sachin

July 9, 2016 at 3:33 am

Sir
This all point and principles are so interesting ,knowledgeable and easy to understand that i genuinely became a huge fan for ur good stuf thanku for the great affort u pored for it .atlest now I know what is share market and how it work .

ANILKUMAR

July 9, 2016 at 1:02 pm

Superb article…

NIVEDITHA J

August 14, 2016 at 5:09 pm

your articles are all awesome, simple and easily explains the concept. Thanking you especially for your beautiful explanations for derivatives and stocks.

Ashok Kumar

November 5, 2016 at 9:44 pm

Nicely explained; easily understandable. Thank you

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