The stock market appears in the news every day. You hear about it any time it reaches a new high or a new low. Obviously, shares and the stock market are important, but many of you may find that you know very little about them. What is a share? What is a stock market? Why do we need a stock market? Here is a very basic article that introduces the concept.

Shares & Its Value

Let’s say that you want to start a business, and you decide to open a hotel. You go out and buy a building, buy all the restaurant equipment, furniture, buy your supplies and hire your waiters, cooks, servers, and other staff etc. You advertise and start your business.

Let’s say that:

You spend Rs. 50 lacs buying the building and the equipment.

In the first year, you spend Rs. 25 lacs on supplies, food and the payroll for your employees.

At the end of your first year, you add up all of the money you have received from customers and find that your total income is Rs. 30 lacs.

Since you have made Rs. 30 lacs and paid out Rs. 25 lacs for expenses, your net profit is:

Rs. 30 lacs (income) – Rs. 25 lacs (expense) = Rs.  5 lacs (profit)

At the end of the second year, you bring in Rs. 32.5 lacs and your expenses remain the same, thus making a net profit of Rs. 7.5 lacs. At this point, you decide that you want to sell the business. What is it worth?

One way to look at it is to say that the business is “worth” Rs. 50 lacs. If you close the business, you can sell the building, the equipment and everything else and get Rs. 50 lacs. This is a simplification, of course. The building probably went up in value, and the equipment went down because it is now used. For the sake of simplicity, let’s say that things balance out to Rs. 50 lacs. This is the asset value, or book value, of the business – the value of all of the business’s assets if you sold them outright today.

But what if you keep it going?

If you keep the hotel going, it will probably make at least Rs. 7.5 lacs this year – you know that from your history with the business. Therefore, you can think of the hotel as an investment that will pay out something like Rs. 7.5 lacs in interest every year. Looking at it that way, someone might be willing to pay Rs. 75 lacs for the hotel, as a Rs. 7.5 lacs return per year on a Rs. 75 lacs investment represents a 10% rate of return. Someone might even be willing to pay Rs. 1.5 crores, which represents a 5% rate of return or more if he or she thought that the hotel’s income would grow and increase earnings over time at a rate faster than the rate of inflation.

The hotel’s owner, therefore, will set the price accordingly. You might price the hotel at Rs. 1.5 crores. What if 10 people come to you and say, “Wow, I would like to buy your hotel but I don’t have Rs. 1.5 crores.” You might want to somehow divide your hotel into 10 equal pieces and sell each piece for Rs. 15 lacs each. In other words, you might sell shares in the hotel. Then, each person who bought a share would receive one-tenth of the profits at the end of the year, and each person would have one out of 10 votes in any business decisions. Or, you might divide ownership up into 1,500 shares and sell each share for Rs. 10,000 to make the price something that more people could afford. Or, you might divide ownership up into 3,000 shares, keep 1,500 for yourself, and sell the remaining shares for Rs. 5000 each. That way, you retain a majority of the shares (and therefore the votes) and remain in control of the hotel while sharing the profit with other people. In the meantime, you get to put Rs. 75 lacs in the bank when you sell the 1,500 shares to other people.

Stock, at its core, is really that simple. It represents ownership of a company’s assets and profits. A dividend on a share of stock represents that share’s portion of the company’s profits, generally dispersed yearly. If the hotel has 10 owners, each owning one share of stock and the hotel makes Rs. 7.5 lacs in profit during the year then each owner gets a dividend of Rs. 75,000. A large company like Reliance Industries has millions of shares of stock outstanding. In this case, the total profits of the company are divided by total number of shares.

One measure of the value of a company, at least as far as investors are concerned, is the product of the number of outstanding shares multiplied by the share price. This value is called the capitalisation of the company.

A Stock Exchange

If I am an individual businessman who owns a hotel, and I am selling my hotel stock to other private citizens, I might do the whole transaction by word-of-mouth, or by placing an ad in the newspaper. This makes selling the stock easy for me. However, it creates a problem down the line for investors who want to sell their stock in the hotel. The seller has to go out and find a buyer, which can be hard. A “stock market” solves this problem.

Stocks in publicly traded companies are bought and sold at a stock market (also known as a stock exchange). The Bombay Stock Exchange (BSE) is an example of a stock exchange in our country. The stock exchange is like a supermarket. The reason you go to the supermarket is that you can go to one place and buy all of the different types of food that you need in one stop – it’s a lot more convenient than visiting the fruit vendor, the grocer, the baker, etc. The BSE is the supermarket where everyone who wants to buy and sell shares of stocks can go to do their buying and selling.

The exchange makes buying and selling easy. You don’t have to actually go to the stock market to buy or sell. You can call a stockbroker who does business with the BSE, and he or she will buy or sell on your behalf. If the exchange did not exist, buying or selling stock would be a lot harder. You would have to place an advertisement in the newspaper, wait for a call and negotiate on a price whenever you wanted to sell stock. With an exchange in place, you can buy and sell shares instantly.

A company

Any business that wants to sell shares of stock to a number of different people does so by turning itself into a company. The process of turning a business into a company is called incorporation.

If you start a hotel by taking your own money to buy the building and the equipment, then what you have done is formed a sole proprietorship. You own the entire hotel yourself. You get to make all of the decisions and you keep all of the profit. If three people pool their money together and start a hotel as a team, what they have done is formed a partnership. The three people own the hotel themselves, sharing the profit and decision-making.

A company is different, and it is a pretty interesting concept. A company is an “incorporated person.” That is, a company is registered with the government, it can own property, it can go to court to sue people, it can be sued and it can make contracts in its own name. By definition, a company has shares that can be bought and sold, and all of the owners of the company hold shares in the company to represent their ownership. One incredibly interesting characteristic of this “incorporated person” is that it has an indefinite and potentially infinite life span.

There is a whole body of law that controls companies – these laws are in place to protect the shareholders and the public. These laws control a number of things about how a company operates and is organized. For example, every company has a board of directors. The shareholders in the company meet every year to vote on the people for the board. The board of directors makes the decisions for the company. It hires the employees, makes the company’s decisions and sets the company’s policies. The board of directors can be thought of as the brain of the virtual person.

Shareholders

From this description, you can see that a company has a group of owners – the shareholders. The owners elect a board of directors to make the company’s major decisions. The owners of a company become owners by buying shares in the company. The board of directors decides how many total shares there will be. For example, a company might have one million shares of stock. The company can either be privately held or publicly held. In a privately held company, the shares of stock are owned by a small number of people who probably all know one another. They buy and sell their shares amongst themselves. A publicly held company is owned by thousands of people who trade their shares on a public stock exchange.

One of the big reasons why companies exist is to create a structure for collecting lots of investment money in a business. A company is an easy way to gather large quantities of investment capital – money from investors. When a company first sells shares to the public, it does so in an IPO (Initial Public Offering).

Another reason that companies exist is to limit the liability of the owners to some extent. If the company gets sued, it is the company that pays the settlement. The company may go out of business, but that is the worst that can happen. If you are a sole proprietor who owns a hotel and the hotel gets sued, you are the one who is being sued. “You” and “the hotel” are the same thing. If you lose the suit then you, personally, can lose everything you own in the process.