I wrote the following article for FlyLite magazine, which is the in-flight magazine of JetLite. The post takes it’s motivation from Deepak Shenoy’s post on shares, IPOs and stock markets. The proceeds from Flylite would go to a non religous charity as soon as I get it.

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Investing in stocks is very rewarding but comes with a caveat. It is not for the faint hearted and you need to have a disciplined and informed approach to stock investing.

A friend was boasting about his Stock picks and how he has discovered a whole lot of money making stocks. To be fair to him, he had a good sense of stocks which were selling below their value in the crashes. And he helped himself with those stocks “On Sale”. But (being a friend), he also admitted that some of his stocks happened to be the “falling knife”. (Falling knife stocks look like undervalued stocks, but continue to go downhill)

The point I want to make is not to laugh at my friend but realize that becoming a self proclaimed stock guru can be easy but dangerous! And we need to beware of a lot of “noise” in the media giving out “hot tips” and “get rich quick” schemes.

That’s why learning all about shares is a good idea before you begin.

Let us take a journey around shares and understand the jargons like Earning per share (EPS), Price Earning Ratio (P/E) as we go along.

Let’s say you start a company named “ChangeTheWorld Pvt. Ltd.”. You and a friend invest Rs 500000/- each to start the company. What you can do is to issue 50000 shares to your friend and yourself and it will have a face value of Rs 10/-. Totally the company has “issued” 100,000 shares of face value of Rs. 10.

Now the company grows. You earn Rs. 1 crore in profits because of a great marketing strategy. The total number of shares remains the same at 100,000. So what is your share of face value of Rs 10/- worth now?

Common sense tells me that the profits divided by the number of shares will give me the answer. This is commonly known as Earning Per Share. For your company it will be Rs 100/-

The exact price of your share is a matter of “valuation”. Typically this is a function of how well you can grow your company in the future, a factor called the P/E ratio which is a multiple of your net profits.

The P/E Ratio that is considered to value your company takes into account the P/E Ratio of your competitors. The average P/E of the industry indicates the growth prospects in the future for that industry.
So let us say that you expect a Price to Earnings ratio (P/E) of 15 on last twelve month earnings, a conservative value that you believe we can get. You can value the company at Rs. 15 crores (1 cr. profit x 15 P/E ratio).

Then suddenly you decide that you need to expand, and need 15 crores more money to allow us to expand faster. We can do two things – go to a bank to borrow or ask for other people to invest in the business. We decide to do the latter.

But who will have 15 crores? We can choose to find a big rich individual or company, or choose to “go public” meaning we ask a LOT of small shareholders to invest whatever they want to, and in return we will issue them shares of the company. Let’s again go with the latter option.

Now you have grown the company and you have built assets for the company, so the value of the company is much higher than the face value of Rs 10/- per share. Obviously I would like to invest in your business and pay much more for the shares. How much should I pay for a share? Read on.

Right now 100,000 shares are valued at Rs. 15 crore as we saw by taking a P/E of 15. That’s a value of Rs. 1500 per share.

Now as the company grows, the profits are accumulated in the reserves in your balance sheet. And your company has 2 cr. reserves but only 10 lakhs as capital. So you can issue more shares as “bonus shares”, reducing the reserves and increasing the capital. This increases the total number of current shares from 100,000 to 1 crore shares, again at a “face value” of Rs. 10. So now you are owners of 50 lakh shares each. And each share is worth Rs. 15 (15 crore total value divided by one crore shares)

To get Rs. 15 crores, we have to issue 1 crore more shares (at a price of Rs. 15). For this you go for an IPO, which will ask for money from anyone who wants to own a share of our business. Post IPO, you will have a total of 2.0 crore shares (1 crore earlier and 1 crore freshly issued shares) and you will be listed in a stock market for anyone to buy and sell your shares. The shares list at Rs. 15, but because the company is expected to grow even more, the price goes up to Rs. 20 per share.

Let’s say another person wants to buy a share of this business but the company has got all the money it needs from the IPO. So there will no further shares issued, but anyone can buy shares from the stock exchange. He will buy shares at Rs. 20. So he will own a share of the company, but he’s willing to pay more than the IPO price because he thinks the company will do well.

The person who sold the share got it in the IPO – at Rs. 15. Now he makes a profit of Rs. 5. Later the other person who bought at Rs 20/- can sell it to someone else at even higher values like 25 etc. The company doesn’t really get affected because it isn’t seeing the money, but the share price goes up as the company starts doing better, and as more people begin to want the shares.

Why does the share price go up? The answer is: Perceived value. I may think the company is worth 15 crore, but someone else might think it’s worth 20 crores. When my shares reach my valuation I sell, but someone else will think it’s a good deal and buy.

To organize such buying and selling, there are commercial “stock exchanges”. BSE and NSE are some of them, though there are a number of other, smaller exchanges in India. An exchange provides a common place for people to buy or sell shares, with sales happening on an auction basis – buyers bid for shares at a price they are willing to pay, and sellers “ask” for a price from buyers. Exchanges match these prices and share exchanges happen along with payments. “Brokers” facilitate these exchanges, and you pay them a fee as brokerage, part of which goes to the stock exchange as well.

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I edit Personal Finance Online Resources, nurture Financial Literacy Foundation, deliver Financial Awareness Workshops and have built a desktop RupeeManager.

Invite me for a talk. Email me on ranjan@ranjanvarma.com or Call me on +919867755615