Stocks-explainedby J Victor on August 2nd, 2010
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.
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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