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Know all about stocks before buying one for the first time

Published : August 31, 2019

Know all about stocks before buying one for the first time

It is a fact that investing in stocks is one of the most effective ways for an individual to accumulate capital, build wealth, and grow their income over time. Yet stocks investing remain misunderstood by the majority of us. Most of us look upon a share of the company as being some mysterious force beyond rational explanations to rise and fall without rhyme or reason. But the truth is that a well-picked collection of stocks as part of a portfolio of diversified assets can provide freedom from financial worry. Here’s what you need to know about investing in stocks.

What are stock and stocks investing all about?

Put simply, a share of a company is the legal ownership in a business. Usually, companies issue stocks as common or preferred stocks. We also call stocks securities or equities.

What everyone refers are common stocks when we talk about stocks investing. A holder of any common stock of a company gets the proportionate share in profits or losses of the company. We also call holders of stocks as stockholders or shareholders. These stockholders or shareholders, in turn, elect a Board of Directors is responsible to retain or distribute some or all of the profits back to the stockholders in the form of a cash dividend

On the other hand, shareholders of preferred stock receive a specific dividend at predetermined times. Generally, such dividends are paid first, before that of the common stockholders. Further, in case, if the company goes bankrupt, the preferred stockholders are first in terms of recouping their investment from any sales or recoveries of assets of such companies. Usually, some preferred stocks may convert into common stocks over a period of time on pre-set terms.

Why do stocks of a company exist in the first place?

Stocks of a company exist for various reasons. But the most important ones are the following – 

  1. Stocks allow companies to raise money. These monies, in turn, helps turn ideas into viable businesses. Without money and supporting capital markets, none of the corporations of the world would have thrived for long.
  2. Investing in stocks provide investors with earning satisfactory returns on their investments. Such returns might help them achieve their long term financial goals quickly.
  3. Company stocks separate ownership from management. Such separation, in general, allows those with no interest, ability, or time to run an enterprise to own the company economically through voting rights. The greatest benefits of such agreement lead to a more efficient allocation of scarce resources.
  4. Equity capital on the balance sheet of a company doesn’t have a repayment date. Also, there is no guaranteed dividend. This acts as a cushion for the company. 

How stocks and stocks investing work

To understand this, consider a hypothetical example. Imagine you plan to start a drone manufacturing. Further, after doing the math you come up with the fact that you will need INR 10,000,000 to get the business on the ground. 

For this, you divide the company worth into 1,00,000 shares each, making each share of the company INR 100 worth. Now, when you sell these shares to your family and friends, you get INR 10,000,000 (1,00,000 shares x INR 100) for the business.

Further suppose that you sold all the shares, initiated the production and make a total profit of INR 5,00,000 after paying all business taxes in the 1st year. Now each share of your company is now entitled to 1/1,00,000 of that profit. This amounts to INR 5 earning per share (or EPS, as it is known in the stock market). 

Now the question is what you will do with these earnings. There are several ways you can use these earnings for your first year of operation. You may use it to pay out dividends, repurchase back some stock, or expand the company by reinvesting for expansion.

When the business grows, it needs more money for various reasons, expansion being one of them. You could raise money through an initial public offering (IPO), allowing you to sell your stock on a stock exchange.

In fact, this is precisely what happens when you buy or sell shares of a company through a stockbroker. You are telling the stock market you are interested in acquiring or selling shares of a certain company. Stock exchanges like NSE and BSE, through stockbrokers, match you up with someone willing to take the other side of the trade. 

Understanding stocks working – a real-world example

In an actual issue of shares by corporations raise millions, or even billions, for their expansion. To provide a real-world explanation of how stocks works consider the first iron and steel manufacturing company. Yes, Tata Steel, was the first steel company of India founded by Jamsetji Tata and established by Dorabji Tata on 26 August 1907. The Tata Iron and Steel Company (now Tata Steel Limited) was registered and shares were issued to the Indian investors. Further, in 1917, five years after when it first started production, it issued 1,50,000 equity shares at par for fueling its nationwide expansion. Accordingly, the face value of Tata Steel share was INR 75 during 1917. 

To use another example, let’s talk about another of India’s among the first multinational, ITC Ltd. On 24th August 2010, the company was originally incorporated as a Private Limited Company under the name, Imperial Tobacco Co. of India Ltd. The original owners were W.D. & H.O. Wills, who was a British tobacco importer and manufacturer formed in Bristol, England. It was the first UK company to mass-produce cigarettes. 

The Company was converted into a Public Limited Company on 27th October 1954. But it was only from 1970 that the company issued 5,00,000 right shares to Indian shareholders at a premium of INR 3 per shares. Also, 32,90,000 equity shares were offered to the general public, again at a premium of INR 3 per share. The face value per share in 1970 was INR 10. Again, the proceedings from the issues were for the nationwide expansion and capacity enhancement of the business.

Thus, stocks at the hand of the company are instruments to dilute their ownership in very small pieces to collect large sums of money, enough for fuelling expansion and growth. 

The fundamental mechanism of the stock market works

The stock market is nothing more than an auction place. Individual men and women working on behalf of themselves and institutions are making decisions with their own money and their institution’s money in a real-time auction. If someone wanted to sell their shares of say, Tata Steel and there were no buyers at INR 415, the price would have had to continually fall until someone else stepped in and placed a buy order with their broker. 

Investors may think that Tata Steel was going to grow its profits faster than other companies relative to the price. So they can pay for that ownership stake. Moreover, they most likely would be willing to bid up the price of the stock. Likewise, if a large investor were to dump his or her shares on the market, the supply could temporarily overwhelm the demand and drive the stock price lower.

Now the question is why anyone would be willing to pay over and above the face value of a share. The simple reason being the anticipation that management will do a good job of increasing profits and raising dividends in the future. 

Under most probabilistic scenarios, the stock market can go in any direction in the short term. Notwithstanding, the experience you are going to have as an owner is tied to the earnings and dividend figures. Of course with some extraordinary circumstances. If the business, the actual operating company, keeps pumping out more and more cash, and sending more and more of that cash to you, whether it is undervalued or overvalued at any given price doesn’t mean a whole lot to a long-term owner except in the most extreme situations.

How to acquire stocks?

Once you’ve decided that you want to own stocks, the next step is to learn how to begin buying them. It’s best to think of stocks to acquire through a brokerage account in your demat account. 

How you actually acquire the stocks depend on the brokerage account through which you are making the acquisition. You can actually have your stockbroker buy shares of whatever company or companies you want. Obviously, the stock should be publicly and not privately held. That is, you could decide to become an owner of The Tata Steel Company by specifically depositing cash. Your broker would complete the trade using your cash.

On that note, if you decide to select your own stock holdings, how do you determine which ones make it into your portfolio? This I will be covering in the next set of blogs. 

About Author

Naresh Kumar Sharma
Naresh Kumar Sharma

Naresh is the head of Research at Raghunandan Money. When it comes to studying the markets, Naresh is someone loves decoding prices, data, trends & charts. Naresh carries an equal flair for both technical and fundamental analysis and that makes him truly one of the reliable experts in the market. Naresh writes informative articles & blogs for equity, commodity, traders and investors.

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