Business Club, IITK. Tutorial: STOCKS

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1 Business Club, IITK Tutorial: STOCKS NSE drops by 50 points, Enron prices Crash, Reliance to release shares today. Look up any newspaper and undoubtedly a complete section devoted to stocks, market prices, shares, securities, bonds will be there. We will explore each one of them systematically. The literature provided on this site is very rudimentary to give you a start. Your endeavour to learn these aspects would be unsuccessful unless you follow the links provided towards the end. Would you believe if someone told you that you can own partnership in Infosys, or even Microsoft. If you don't, then probably you know nothing about stocks. And your answer would undoubtedly change after you go through next few paragraphs. Let us start with an illustration. Suppose you want to start a business, say sell computers. But you don't have adequate finances to rent a shop and build infrastructure. But you feel that once given a start, in course of time your business would do well and you would be able to earn money over your investments. You go to your room mate and the friend next door to lend you some money, on the condition that you would pay their money back along with some extra gifts (in form of money) for lending you their money in the first place. What you have effectively done is floated stocks of your company which your friends bought, using that money you made profits on your business and paid your friends dividends proportional to the amount they lent you ( i.e. number of stocks they purchased). Similarly every company needs to raise money to run its business. It floats its stocks in the market. When the company floats stocks for the first time, it is called Initial Public Offering (You must have heard of a certain company floating IPO's. Well this is what it meant! ). People read company's plans and if feel optimistic about the future of the company, they buy certain number of stocks based on their financial potency. Now they also carry the risk of their money going down the drain if the company fails to perform and has to shutdown its business. This is where the vital difference in Loans and Share comes into picture. You could say that instead of going and selling shares to thousands of people (and this incurring lot of management and transaction cost), company would have resorted to a Bank for a loan. It could have, but then if company went bankrupt, the bank officials would sell the assets (house, cars and even wardrobe) of the company officials to get their money back. But when they raise money through shares, they also throw their risk on the people. In other words, if they went bankrupt, they would not have to sell their house and wives' jewelry to pay its shareholders their money back. In other words, they will not be legally indebted to you. So a company has floated IPO and its shares have been bought by people. Henceforth the company has no say over the shares. It is with you and me and others who bought, and we may do anything with our shares. That means that we can also sell our shares to other at a price higher than what we bought. Suppose that when IPO was made, you bought 10 shares of ABC Co. at Rs 60 per share. Your room mate smells that the company is doing well and would continue to do so in near future. He offers you to buy your share at Rs100 per share. BINGO! You have

2 eared 10*(100-60) =Rs400 from the share market. And similarly your room mate would sell them when he feels that now that company is underperforming and would soon sink. Simple eh! Not exactly! So now a very obvious question that crops up is that if you own a partnership in the company, you should have a say in the decisions of the company. Of course you do have. Every year, the company holds an annual meeting with the shareholders where they can question or suggest the decision making of the company. However if you are holding shares worth Rs10,000 in ABC Co, would you spend Rs5,000 in your travel expenses to the place of meeting plus accommodation and other costs that you would incur. And above all would you miss your prestigious MTH101 lectures for the meeting where there will be hundred of other share holders voicing their opinions. Certainly Not! You feel that management is capable enough to manage your money. By buying shares, you have delegated the responsibility of running your business (yes, YOUR business because you have a partnership proportional to your shares) about which you know nothing on the management. Now suppose Mr. X holds shares worh Rs 10, 000, 000 ABC Co. The company's policies and decision would dramatically affect Mr. X's finances and thus possesses far more influence and voting rights. Shareholders vote some members as boards of Directors who make decisions on major company policies. Board of directors may or may not hold shares of the company. They are only appointed by the share holders ( like Mr X, and not you and me) to look in to the working of the management. Generally companies raise money partly through shares and partly through debt (loans). An extremely important feature of stock is its limited liability, which means that, as an owner of a stock, you are not personally liable if the company is not able to pay its debts. Owning stock means that, no matter what, the maximum value you can lose is the value of your investment. Even if a company of which you are a shareholder goes bankrupt, creditors will not chase the share holders for their money. That's all for the basics. Time to get to enter the world of Jargons. There are two types of Stocks : Common Stocks and Preferred Stocks. Common Stocks: Most of the stocks are common stocks. Limited Voting rights (generally 1 vote per stock to elect board of directors). Dividend are paid to stock holders if company performs well, but may not be paid if it underperforms. Preferred Stocks : Fixed dividends are paid the share holders owning preferred stocks. If company goes bankrupt, it will be these share holders who will be paid after the creditors and whatever left will paid to Common Stock Holders. However here the company has the option to buy these stocks back from the share holders anytime it wishes to. Sometimes stocks are also classified as Class A and Class B stocks depending upon the voting right contained in unit stock. For example Class A stock of certain company may contain 10 votes per stock ( to elect board of directors) while class B may contain only 1 vote per stock. Now suppose you want to trade your stocks. One option is go around the city asking people to buy your stocks. A better option would be to go to stock market where the buyers are and sellers of the stocks meet. Examples of stock markets are BSE ( Bombay Stock Exchange), NSE ( National Stock Exchange). NYSE (New York

3 Stock Exchange) and Nasdaq are two most important stock market of America. Two other important financial hubs are London, Home of London Stock Exchange and Honkong, Home of Hongkong Stock Exchange. Some Definitions : Direct Market: Where IPO's are made. Indirect Market: Where the other stocks (not IPO's) are bought and sold. Thus the companies whose stocks are being traded has no say in the indirect market. Generally we refer to this kind of market when we talk about stock markets. Most of the people like you and me do not have the know how of trading stocks and what price to bid for. Neither we want to get involved in the yelling nor pushing and bumping that goes on stock markets. So we appoint an agent called Broker who does the job for us. For if you want to buy a stock of particular companies, call a broker and he will intimate you with current prices and future prospects of various stocks. Then based on your decision, he on your behalf would go and purchase the stocks you request for. Obviously you pay the broker for sharing his experience and services. Broker, What a friend to have! Wrong, not most of the times. Remember Harshad Mehta Scam. Earlier the brokers use to be quite expenses and generally not in the reach of a common man. With the advent of internet, most of these services became available cheap and online. Today you can buy the stocks at the press of the key while sitting in your rooms. Another way to buy shares is Dividend Reinvestment plan ( DRP). Sometimes Companies offer the share holders more share in place of dividends. Generally DRP is a good option because of two reasons. Since company is offering dividends means it is performing well in the market. So it makes sense to invest more in that company. Secondly when shares are offered at a lower price when done through DRP By now you might have realized that astronomical amount of money involved share markets. And also the potential for cheating, fraud or scam. Company officials may sell stocks worth millions to innocent people like you and me and abscond away to Switzerland for a long & expensive vacation. And no way will you and me be able to get our hard earned cash back. Enters SEBI Security and Exchange Board of India. Government organization that frames a set of rules and regulation for the stock markets for companies, brokers and even share holders. For example every company has to list itself with SEBI and get its approval before making an IPO or floating new stocks in the market. Similarly all the brokers have to register themselves to SEBI. You may like to take a look at SEBI website ( We will cover the details of SEBI later when we learn about IPO's. We have dealt with the question of how to buy stocks. But the more important is still unanswered? When to buy and sell stocks. Because this would determine the fate of your fiscal gains. Prices of the stocks rise when people realize that company's future is bright. Note that it is not sufficient for only you to have this realization, but market as a hole. Hence there will be people chasing you for your shares bidding high prices. Thus value of a stock depends on its future valuation by the public.

4 A value of the company is its Market Capitalization. It is the product of the total number of stocks in the market and the cost per share. Thus a company with 100 stocks at Rs1000/share is more worth than company with 200 stocks at Rs250/share. Number of mathematical expressions are used as indicators for valuating company's future prospects. Market Capitalization is just on of them. Some others are P/E ratio (Price Earning Ratio), EPS (Earning per share), PEG (Price Earning to Growth) etc. They are briefly explained below. * P/E Ratio : It is the ratio of price per share and the earning per share. A high value is suggestive of future growth. * EPS : It is the profit allocated to the each out standing common share. EPS = (Net Income - Dividends on preferred stocks)/total no. of outstanding stocks It is the most commonly used indicator variable. EPS indicates the profitability of the company. So just compare EPS or P/E ratio or other indices of various companies, and the one that gives the best value is the most prizes stock present. Simple eh! WRONG! These variables are only suggestive and lot of decisions on stock markets depend on political, international and social scenario, companys future plans and strategies, its reputation in public and very much on the mystery word called intuition". A lot of experience and market knowledge underlies the successful investment in stock markets. We will consider this aspect after we are through our basics on stock markets. That was all as far as basics are concerned. Hopefully after going through these pages, all those nitty gritty headlines in newspapers would make sense. Before concluding, we will take a look at few more jargons we frequently come across when talking about stock markets. BULLS : When the economy is prospering, GDP is shooting up, Stock prices are rising and future prospects look good, the environment is termed is market for bulls. People buy without putting much thought in bulls market. This attitude is termed as bullish attitude. BEWARE : You can fall to rumbles if you don't discern the approach of the maxima of bulls market, because after certain point, prices begin to fall. BEARS : Bears are just opposite to the bulls. When economy is in recession, stock prices are falling and national income is going down, it is said to be the market for bears. People are reluctant to buy stocks in a bear market. However if you can spot the the end of a bear market using logic or sixth sense or any other means, you can be a millionaire in days as after the end of bear market, the prices of the stocks are bound to go up. Chickens and Pigs : Chicken are the people who are extremely pessimistic about stock prices and very reluctant to invest. They are afraid to loose anything and have a very low appetite for risk. They generally invest only in securities with low but fixed return with certainity.pigs are the ones who are very emotional impatient to grow rich in stock markets as such such sell and buy stock in a matter of hours without putting much thought and wisdom over them.

5 It is often said, Bulls make money, bears make money, but pigs just get slaughtered!. Phew!! You just now had a very heavy dose on ABC of the stock markets'. Go and chill out In canteen, for stock markets can make life very hot. But make sure you follow up the following the useful links to have a more detailed picture of Stocks.