Stocks – Lesson 1

hat better time to talk of shares than now with the Sensex hitting all time high and the bulls are having fun at the Dalal Street.
This is how most of the articles begin when they want to educate people on stocks and shares and eventually those who came to read will feel that it is not for them and flee from the place. So I thought I would do it a bit different and see if that helps. If you are one who had always wanted to know what stock market is and what they sell there or if you have as a kid (even as an adult) wondered what went high in Sensex and what the hell if it dropped few points, jump in. I will try to take you on a tour to the world of stocks and shares..
Mr. Rohit is a small textile owner. He gets the cloth materials and with the help of a few tailors working under him, he converts them to beautiful dresses and puts them up for sale. He has a good profit, enough to make a living in his rather small city. But he is not content with just being that. He wants to be a big business man. He dreams of it and one day decides to take the risk. So he approaches a bank and gets a loan of 1 Lakh and with some of his wife jewellery he opens a big shop at the heart of the town, employs 10 more tailors and gives his shop the name “Rohit Garments”. After two years, things are getting better, he settles his loan and still makes a profit of 2 Lakhs per year. People identify his brand and rush to his shop. Though the town is small, still many of his customers have to travel 20 kms to reach his shop. So he decides to open three more branches. But this time, he is not going for a loan in the bank. Instead he decides to make his company ‘Public’. This means instead of having 100% ownership on his firm he decides to share it with the public in return for some amount which he can use to open branches, buy tailoring machines and employ more tailors. He contacts a firm specialized in doing this and they sit and decide what is to be done.
They finally come up to a conclusion that Rohit will have 60% of ownership with him and the remaining 40% will go public. They put a valuation for the shop ‘Rohit Garments’ considering its machinery, furnitures, number of people employed, their abilities, the profit making capability etc. Let us say that they arrive at 5 Lakhs by valuation. Then they take 40% of that, which is (40 * 500000)/100 giving 2 Lakhs. Now this 2 Lakhs will be converted to units called shares. If they fix the face value of a share as Rs 10 then there will be 200000/10 = 20 thousand shares. If they fix the face value of the share as Rs 100 then there will be 200000/100 = 2 thousand shares. Let us say they decide that the face value will be Rs 10 (it really does not matter). Now we have 20 thousand shares of “Rohit Garments” ready to be sold to the public. But that is not all. The firm will further advice on the actual price for the Rs 10 unit (something like cost price and selling price). Let us say they decide it as Rs 25. This means the unit which is actually worth Rs 10 will be sold each for Rs 25 to the general public (whoever interested). And by this route, without any loan, Rohit can raise 20000 * 25 = 5 Lakhs for further expanding his business.
Now you might ask “Who the hell will give Rs 25 for something worth Rs 10?” But you will be surprised to know that many will and in fact that is how it works. People buy it hoping it will get better. Don’t confuse with it now, we will discuss that later. One fine day you will find in newspapers and in news (NDTV, CNBC, etc) that “Rohit Garments” have come up with an IPO (Initial Public Offering) of 20 thousand shares of face value Rs 10 at Rs 25 each. If you decide to buy say 100 shares of “Rohit Garments”, you can fill up a form and along with the required DD (100 * 25 = Rs 2500) send it. You will receive the certificate stating that you have been granted 100 shares at Rs 25 each (with face value Rs 10). What you have done unknowingly is to buy shares in the “Primary Stock Market” i.e IPOs.
Now what?? You can keep the shares with you. Whenever “Rohit Garments” did a great job, posted a very good profit and decide to give some to the shareholders they will announce “Dividend”. So if they decide to part with say 1 Lakh as dividend, it will be divided by 20 thousand (remember that initially there were 20 thousand shares issued) giving Rs 5 for each share held. And without doing any work you will get Rs 5 * 100 shares that you have = Rs 500. You will receive a cheque for the amount of Rs 500. Voila!! you made a profit in Stock Market. But that is not all.
Once the IPO is over the shares can get into the “Secondary Market” where they are bought and sold. Since “Rohit Garments” went public it will be given a symbol say “ROHG” and a place in the BSE (Bombay Stock Exchange). This means with the help of this symbol you can see what price it is being currently sold and bought in BSE. The BSE is a place (Secondary Market) to buy and sell shares. You happen to look into the daily newspaper and see that ROHG is now worth Rs 75. This means there are people out there that are willing to give Rs 75 for each share that you will sell them. Now you have 100 shares which you got for Rs 25 each. So if you sell them then 100 * (75-25) = 5000 Rs. Excellent!!! You get Rs 5000 for no work at all, just a buy and a sell. Wow!!!. But you need not sell it. It is upto you. You decide that you will see if the price goes above Rs 75 (So that your profit also becomes higher). After two months one day you check the prices, you find that the price of ROHG is now at Rs 150. You just can’t believe it. That means 100 * (150-25) = Rs12500. Your heart starts beating faster. I will wait you finally decide and then you forget all about it. After a few months one fine day, you check the prices. You are shocked?!? ROHG is quoted at Rs 4. “My God” You shout. That means 100 * (4 – 25) = Loss of Rs 2100. Though the profit and loss was in papers still it is the truth at the given time. So what does it take to get the profits only. Can I buy any other shares in Secondary market. To know the answers wait for Stocks – Lesson no 2.