An Introduction To The Stock Market : Part 2

“I never attempt to make money on the stock market. I buy on the assumption that they could close the market the next day and not reopen it for five years.” –Warren Buffet

The blog, today, will more or less hover around the investment strategies that the Stock market virtuoso’s have assumed ever since this crazy place for fanatics found its way going. More than four centuries have passed by since the first ever Stock Exchange in Amsterdam commenced its operations. But, then who cares about this factual trivia when the topic we are addressing is all about Money..?? Few more jargons will roll out of the Pandora’s Box and some superficial affairs along with it shall make a perfect recipe for today’s blog. .!!

Let’s get an insight of the ingredients of a company’s stock and various other operations undertaken by a company to remain reliable amongst investors.

Market Capitalization:

Current market value of a stock multiplied by the total number of outstanding shares is the current market capitalization of the company. Stock trading at 100 per share with 1 million outstanding shares has a market cap of 10 crores.

Face Value:

It is the original cost of the stock shown on the certificate.

The face value of a share of stock is also known as its par value, which is the legal capital of each share of stock. A business must retain this legal capital in its business and may not pay it out as dividends to shareholders.

Suppose ‘X’ has a face value of 10rs and 1, 00,000 equity shares. Then its reserves must never go down than 10, 00,000 rs… This provides a cushion for company’s creditors.

Usual face values: 1, 2,5,10,100.

The dividend may also get paid to the equity holders as the percentage of the face value.

E.g. ‘X’ declares 250% dividend per equity share. Now if the face value of ‘X’ is 10 then it will pay 25rs per every share you are holding as dividend.

Not to forget, Market value is completely different than the face value.

Dividend:

It is a distribution of a portion of a company’s earnings, decided by the board of directors, to a class of its shareholders.

Most secure and stable companies offer dividends to their stockholders. Their share prices might not move much, but the dividend attempts to make up for this.
High-growth companies rarely offer dividends because all of their profits are reinvested to help sustain higher-than-average growth.

Bonus:

Free shares of stock given to current shareholders, based upon the number of shares that a shareholder owns. While this stock action increases the number of shares owned, it does not increase the total value.

Suppose you own 50 shares of ‘X’, which is trading at 1000 per share in the market. Company decides to give 1 on 1 (1:1) bonus to the shareholders, so your 50 shares will increase up to 100. But the stock price will get adjusted somewhere around half the value it was being traded before bonus. In this case it will settle somewhere around 500. So your net worth will remain unaltered.

Bonus shares are issued by cashing in on the free reserves of the company.

A company builds up its reserves by retaining part of its profit over the years (the part that is not paid out as dividend). After a while, these free reserves increase, and the company wanting to issue bonus shares converts part of the reserves into capital.

So you do not pay; and the company’s profits are not impacted.

A bonus issue adds to the total number of shares in the market.

Say a company had 10 million shares. Now, with a bonus issue of 2:1, there will be 20 million shares issues. So now, there will be 30 million shares.

This is referred to as a dilution in equity.

A bonus issue is a signal that the company is in a position to service its larger equity. What it means is that the management would not have given these shares if it was not confident of being able to increase its profits and distribute dividends on all these shares in the future.

A bonus issue is taken as a sign of the good health of the company.

When a bonus issue is announced, the company also announces a record date for the issue. The record date is the date on which the bonus takes effect, and shareholders on that date are entitled to the bonus.

Split:

All publicly-traded companies have a set number of shares that are outstanding on the stock market. A stock split is a decision by the company’s board of directors to increase the number of shares that are outstanding by issuing more shares to current shareholders.

For example, in a 2-for-1 stock split, every shareholder with one stock is given an additional share. So, if a company had 10 million shares outstanding before the split, it will have 20 million shares outstanding after a 2-for-1 stock split. The face value of the stock changes after every split. A stock’s price is also affected by a stock split. After a split, the stock price will be reduced since the number of shares outstanding has increased. In the example of a 2-for-1 split, the share price will be halved. Thus, although the number of outstanding shares and the stock price change, the market cap remains same.

Think for an example of a company having a face value of 100 and 1 million outstanding shares. Company decides to split the face value from 100 to 10(10-for-1 split). So now it will have 10 million outstanding shares.

A stock split is used primarily by companies that have seen their share prices increase substantially . As a result, stock splits help make shares more affordable to small investors.

A bonus is usually a gift to the investors and imposes additional burden to the company’s reserves, whereas stock split is merely an adjustment of the stock prices by the company.

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As I presume, Primary market is no longer an obscure term for us now. However, the power of investment in Primary market is highly undervalued and the privileges it provide, mostly unexplored.

So let’s get some facts in to understand how a rightly thought-out decision to invest in Primary market via Initial Public Offering (IPO) can turn your fortunes around.

A company named ‘X’ came up with an IPO in the year 1993 with an offer price of 95 rs per equity share and a face value of 10 per share.. Suppose you had 10000 rs to invest at that time (And also a belief in that company) and you filled up the IPO form to apply to own the equity shares of that company. Now such was the time back then in the Indian Economy that investing in equity market was reckoned to be highly speculative and risky. Not to ignore the fact that Economy was still in early stages of revival and the wound of Harshad Mehta scam still pretty much fresh.

The IPO was undersubscribed eventually. And as a reason of which, you would have been awarded 105 shares of ‘X’. (When an IPO is undersubscribed, every applicant gets full worth of his money converted in equity/shares)

Now just have a look at what followed afterwards:

1:1 bonus in 1994 – Your 105 shares now become 210.

1:1 bonus in 1997 – Your 210 shares now become 420.

1:1 bonus in 1999- You now have 840 shares of ‘X’.

Face value split from 10 to 5 in 2000- You now own 1680 shares of ‘X’.

3:1 bonus in 2004 – 1680 shares now become 6720.

And finally 1:1 bonus in 2006- You now have a staggering 13440 shares of ‘X’.

Company was sincere enough to roll out regular dividends to you which amount to a whopping 47, 51,565 rs..!!

Currently ‘X’ is trading at 3215 per share.

So your net worth today is 4,32,09,600 rs + 47,51,565 rs which is 4,79,61,165 rs..!

Company we are talking about here is none other than the IT giant –Infosys.

 

How is that for an investment..!!?

 

You can also read Introduction To The Stock Market : Part 1.

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About the author:

nishant shah 1

This is Nishant Shah from Ahmedabad. I completed my B.Tech in Mechanical Engineering from NIT, Surat. I would be joining IIM Ahmedabad in June for a Post Graduate Programme in Management. I have interned at ONGC and Inductotherm, and dabbled in Financial Markets at Sharekhan. I have spent two months at IIM Ahmedabad under Prof. Vijaya Sherry Chand, working for the Education Innovations Bank. I am passionate about analysing Cricket and find solace in reading literature. You can find me at financefink.

 

Comments

3 comments

Mohit Gupta

After reading first half of the post(specifically Rs10000 and year 1993) I desperately scrolled down to search for Infosys because I got the feeling that example quoted is of Infosys.

I am an avid reader of ET so no new knowledge addition as such but nice to read.

Nicely written blog !!!