Introduction
- What are share markets? Why they exist and what purpose do they serve?
- What are shares, and why do people own or trade them?
- Shares of well performing companies rise in the long run, basically people are willing to trade its shares at those higher prices. But why? What is the correlation between a company's performance and its share price on the stock trading market?
These are some of the most basic questions that naturally arise when someone begins exploring the world of investing.
Many people find the world of stocks intriguing, and a clear understanding of these fundamental questions is the first step for any aspiring investor.
This article aims to demystify the working of share markets and provide a clear understanding of how they work, their significance for both companies and investors, and the fascinating reason behind the rise and fall of share prices.
Let's break down the complex world of share markets using a very simplistic, real world example.
A Hypothetical Cement Company
i. The background
Imagine I'm the owner of a small but successful cement company. The company's assets- land, machinery, and equipment- are worth, say about, $10m. And using these assets, the company sells cement to the local construction businesses and earns a net annual profit of $1m.
Now, I want to expand my business to a new state. For this to happen effectively, I need to open another factory in the newer geography, hire more workers and buy more machinery. My team estimates this plan will cost around $15 million.
How to raise this much amount of money? There can be a few options-
- Wait till I have saved up enough money from my profits. But this may take a long time and the opportunity present now in that new state may get lost by then.
- Take a loan from the bank. But this borrowing would mean paying back interests on the loan which will eat into my profits even during crunch times. Also, banks may not be willing to lend such a large amount of money without any collateral.
- Raise the capital through investments. This means selling a part of my company to investors in exchange for money.
ii. The investment
Let's say I pooled $5m of my own money and invite five of my friends to invest the remaining $10m. For the sake of simplicity, suppose each of them invests $2m and in return they get 5% of my company each.
It is to be noted that I'm not supposed to return this money or make any interest payments to my friends. Essentially, they are investing their money into my company and not lending, in return they get partial ownership in the company.
Thus, investments are different from loans.
So now, after their investments, I only own 75% stake and my friends own 25% stake in the company. The company is no longer just mine and I cannot claim all the profits as my own.
Whenever the company is distributing the profits, called dividends, it will be distributed proportionally among the owners. So, I will get 75% of the profits and the remaining 25% will belong to my friends.
However, since I still own the majority stake, I decide how profits are allocated. I can either distribute the profits as dividends or reinvest them back into the company for expansion.
iii. The expansion
Suppose the new plant becomes operational and starts making money in 2-3 years. During this time, the profits from the previous plant has also increased and the collective profit of the company now is clocking at $3m per year.
But instead of distributing those profits among myself and my friends, I decide to reinvest the money back into the company- to modernize its machinery and equipment, open more retail outlets, and hire more workers.
Basically, I am sacrificing the present profits of the company for its growth, hoping this will bring even more profits in the future.
And I continue to do this year after year. Fast forward 10 years, the company has expanded to 5 states and is now generating a total profit of $10m per year. The assets of the company have also grown and are now worth $100m.
Yet none of my friends or myself have claimed any of those profits so far. Whatever the company earns, it gets reinvested back into the company for more growth.
Now you may ask, how long will this go on?
Well, the straightforward answer to that is, it should go on as long as there are good future prospects and growth opportunities for the company.
But then, is the investors' money stuck there till then? How are the investors going to be compensated for their investments?
Sure, each of my friend has a 5% (of the present $100m assets) stake in the company. Hence they definitely have a healthy proportion of profits and assets, but they cannot claim any part of that directly. So what is the benefit for investors in this arrangement?
This is where the concept of trading comes in.
iv. The trading
If any of my friends needs to cash out their investments, what they can do is sell all or part of their share of stake in the company to someone else. This way, they don't have to wait for the company to pay dividends to benefit from their investments.
So if their stake is worth $5m now, then they can sell it entirely to one or more persons, at least for that much. Though realistically, they would be able to sell it for a much higher price than that. Maybe 3 or 4 or even more times their present worth of $5m, especially if the company is growing well.
Why? Because my friend is not just selling their present ownership (which is worth $5m) to the buyer but also the opportunity to earn huge amount of profits of the company from that ownership in the future. The 3 or 4 times premium is attributed to that- the future growth potential of the company.
This is the core reason why shares of companies that are performing well and have a bright future often trade at higher prices in the stock market. People are willing to pay more now for a piece of those expected future profits.
The Share Market
The example above is a simplified version of how real share markets work. Here, instead of inviting my friends, I will be inviting the general public to invest in my company. The company will be divided (on paper) into an arbitrary number of divisions as appropriated by its management. These divisions are called shares.
At first, the company offers its shares to the public through a process called an IPO (Initial Public Offering). The company raises money from the people who are the first or initial buyers of these shares in the IPO. Afterwards, the company gets listed on a stock exchange and its shares can then be traded on that exchange.
Thus, share markets are essentially platforms where shares of publicly traded companies are bought and sold.
It is important to note here that you do not buy (or sell) shares directly from a stock exchange. You only trade through their medium. If you are buying say, 100 shares of a company, then there must be one or more sellers selling 100 or more shares of the same company at nearly that same time. Otherwise your order will be left pending at the exchange until it matches.
Conclusion
Share markets play a vital role in the economy. They provide companies with a way to raise large capital so that they can grow, innovate, and create jobs. At the same time, they give investors (like you and me) opportunities to invest in these companies and potentially grow our wealth over time.
When you buy shares of a company, you buy partial ownership of that company proportional to the amount of shares. A shareholder gets benefit out of this ownership in a couple of ways-
- The company distributes its profits in the form of dividends or share buybacks. It may not be now but in the future.
- A claim on the company's assets in the event of liquidation (after the company has paid its debt)
- By selling their shares to someone else at a higher price (capital appreciation)
An important point here to acknowledge is that, it is because of points 1 and 2, that the 3rd one exists. If a company performs well and has a healthy growth potential, then more number of investors would want to tap into those future profits. As such many of them won't mind offering premiums to the present shareholders of the company to acquire their stakes. This is the sole basis of capital appreciation.
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