What is a stock? How does an investor stand to benefit from buying stocks? What are the risks involved and why do losses occur? These may be basic questions, but they nevertheless puzzle most potential investors.
In simple terms, a share or stock may be defined as a part of ownership in a business or a company. Funds are required to float a company and run it. There are different ways to meet this requirement and one of the most inexpensive and safest means for a company is to issue its shares to the public.
Let us try to explain this by an example.
Let us imagine that Rs 100 crore is required to execute the expansion plans of a company. Let us say that out of the required Rs 100 crore, Rs 20 crore is the promoter’s contribution and Rs 50 crore is borrowed from a bank by pledging assets. The remaining Rs 30 crore can be raised from the public by issuing shares of the company.
An undertaking is given at the time of allotting shares that the company will share a part of its future profits with the investors. This means that along with the growth of the company, the wealth of its investors will also grow.
A share of the profits
The bank does not stand to lose its money since it can always sell the pledged assets and recover its loan. But the shareholder’s investment runs huge risk because as per the undertaking, the company is not bound to repay the shareholders till the time it is in operation. This means that if the company makes losses, shareholders stand to lose the value of their investments. This is why it is always important to find good quality investment opportunities. The company should be profitable for the shareholders to earn money in the form of dividends or its share price should rise so that the investor can sell them for a profit.
In effect, if the company is profitable, the investor can recover his money by selling his shares. Else, the public’s expectation of the future profits of the company should be high so as to create enough demand for its shares now. Therefore, stocks give one an opportunity to benefit from the growth of good companies when spotted early enough.
Share sale and price
All companies cannot raise capital by issuing shares. Issuance of shares by companies to raise capital is strictly regulated and governed by a well laid out processes. Neither can a company price its shares as per its whims and fancies. Factors such as the growth potential, earnings per share, the real value per share, last three month’s performance of the company and so on are scrutinized before arriving at an offer price.
The shares of the company are issued to the public as per the conditions mentioned in its prospectus. The first public shareholding in any company happens through an initial public offering or IPO. Such companies that give the public a share of their ownerships are called public limited companies.
Such companies list their shares on the stock exchanges and these shares are then traded on the exchanges’ platforms. Since they are listed and traded, it means that one can exit by selling the shares at any given time and limit the losses. Public limited companies are bound to give its shareholders transaction rights over the shares. Public issue happens in the primary market while the buying and selling of already listed shares happens in what is referred to as the secondary market.
The Broker’s role
Though the public can buy or sell exchange listed shares as they wish, one can deal in shares only through exchange registered approved brokers. Nowadays one can find an exchange registered brokers’ branch office in any part of the country and franchisees have also come up in every nook and corner. Today, with the advent of technology, it is even possible to transact in shares online from any part of the world through one of these registered stock brokers.
One can deal in shares on the BSE or NSE through approved brokers sitting at home in even a small town in Kerala. One need not even have to visit the broker’s office since the trading and investment can be carried out from one’s home over the internet.
Face value and offer price
Price mentioned in the share certificate is the face value. It can be in the denominations of Rs one, two, three, five, ten or hundred and so on. Multiplying the total number of shares of the company by its face value gives the total paid up capital of the company.
Most of the time the shares are issued at a price higher than their face value which is called the issue price. The price differential is called the premium.
A growing company will be reinvesting its profits and making gains from it. Hence, after a few years of operations, a profitable company’s net worth will be higher than its paid up capital and the company’s share price will go up with the growth of its net worth. Therefore, offering shares that carry a higher value than the face value to the public will be being unfair to the initial investors. So, shares are sold at a premium to the face value to the new investors.
Now let us see how share transaction happens in the secondary market. Transactions that happen on a day in the market are not settled on the same day. The settlement happens on another day (T+2) in which T stands for the trading day and plus two means two days from the trading day. This means that the settlement for transactions carried out today will be done on the third day.
Suppose you sell a stock today. The proceeds of the sale will be credited into your account only on the third day from the day of sale. Similarly, if you buy a stock today, the funds will be deducted from your account on the third day. This is called rolling settlement. All business days except holidays are settlement days.
Long and short
Participants in the stock markets can buy and sell stocks on the same day. Those who want to go flat at the end of the day do so by selling what they have bought and buying what they have sold during the course of the day. For such transactions there is no need to take or give delivery since they are all squared off at the end of the day. The settlement is done at the end of the day by calculating the difference in buy price and sell price. Those who buy stocks are said to be long and those who sell them without owning them are said to have established a short position.
Dealing in the shorter time frames is highly risky and hence one has to determine in advance the maximum loss that can be suffered. This is called a stop loss. An order to square off the position at a predetermined maximum loss level is entered into the system which in other words is known as stop loss.
The participant determines in advance the maximum amount he can afford to lose and enters an order to take him out of the position once that level is breached. Thus, this entered order or the stop loss ensures that the participant’s losses are limited irrespective of the magnitude of the market movement against his or her position.
Sebi and exchanges
The Securities and Exchange Board of India or Sebi is the apex regulator of the Indian stock markets. The systems, practices and infrastructure at Sebi are modern and are one of the best in the world.
Stock exchanges are the marketplaces where shares and debentures change hands. There are two national level stock exchanges in India, namely the Bombay Stock Exchange or BSE and National Stock Exchange of India or NSE. Over the counter stock exchanges are also there at the national level for listing and trading of small and medium enterprises whose net worth is between Rs 30 lakh and Rs 10 crore.
(In arrangements with Sampadhyam)