How the Stock Market Works? And How You Can Profit.

If you are here, you come with an aspiration of being able to make a thousands and lacs of rupees in the stock markets. There is nothing wrong in that .. and yes, it can be done. In this article, I will take you through the basics of how a stock market works, how to start your investment journey and which books will help you get the right knowledge & techniques to excel.

Investing in the stock market is a fearful adventure.

The fear is towards loss of capital while the adventure is being able to double or triple your money in a matter of days. 

With fear, also come perceptions.

Many think of the stock market as a guzzler of your money. Like an abyss made of traders, brokers and institutions which eats away the average Indian’s hard earned money. 

The truth is far from that. 

The average person has an equal (and sometimes better) opportunity to make a lot of money in the stock markets. The secret is to have the necessary knowledge that will make you research companies better and make a few less beginner’s mistakes.

With this said, let’s move onto the basics.

What is a Share?

A share or a stock represents a part ownership in a company. In other words – if you own a stock (or a bunch of it) in a company, you own an equivalent proportion of the company.

Let’s understand this with a simple example.

You (A) and your partner (B) decide to float a small business on a 65:35 partnership with a capital of ₹1,00,000.

To keep things simple, you allotted a total of 1,000 shares of ₹100 each to represent the capital. And per the partnership terms, you allot yourself 650 shares while your partner gets 350 shares.

650 shares out of 1,000 shares means you own 65% of the business.

So the shareholding structure of this business is:

Name of PartnerCapital brought inPrice per Share when allottedShares AllottedValue of Shares% of Ownership
A₹65,000₹100650₹65,00065%
B₹35,000₹100350₹35,00035%
TOTAL₹100,000
1,000₹100,000100%

Now, say a third partner (C) is invited into the company. Partner C wants to bring in ₹100,000 of capital. This will push the capital brought in by all three partners to ₹200,000

How much stock will be issued to partner C?

If you are thinking 50% because ₹100,000 divided by ₹2,00,000 – then it’s not that simple.

Over the last few months, your business has done very well. Moreso, a share in your business is now valued at ₹200 as per a chartered accountant who estimated your business’s value using discounted cash flow models.

C too agrees to this valuations which means he is OK to pay ₹200 per share.

At a capital brought in of ₹100,000, C is entitled for 500 shares in the business.

Thus the new shareholding is as follows:

Name of PartnerCapital brought inPrice per Share when allottedShares AllottedValue of Shares% of Ownership
A₹65,000₹100650₹130,00043.3%
B₹35,000₹100350₹70,00023.3%
C₹100,000₹200500₹100,00033.3%
TOTAL₹200,000
1,500₹300,000100%

Hence partner C, in spite of putting a capital equivalent to what A & B had put in, gets one-third of the business’s ownership.

This is the basic framework of how ownership in stocks works.

Companies listed in stock exchanges around the world have millions of shares. 

The Shareholding of Reliance Industries Limited

Let’s take an example to drive home the point.

As on 31st December 2019, Reliance Industries quarterly disclosures had 6,19,23,12,760 fully paid-up equity shares. In his individual capacity, Mukesh Ambani, the Chairman & Managing Director of Reliance Industries holds 72,31,692 shares. This gives him an ownership of 0.12% in the company.

The share price of Reliance Industries, at the time of writing this article, was around ₹1,000. This means if you want to buy one share of Reliance Industries, you need to fork out ₹1,000.

However Mukesh Ambani did not purchase shares at ₹1,000.

He might have some but as an old timer in the company, he would have purchased shares at much lower prices.

To sum up, when you have equity or shares in a company it means that you own a portion of that company. As the value of the company increases, so will your stock price.

Equity and Preference Shares

The share capital of a company can be broadly divided into two parts:

  1. Equity Shares
  2. Preference Shares

Equity Shares or Common Stock

Equity shares represent the ownership shares in a company. This is the kind of stocks that people invest in. So when anyone says shares or stocks, it is the equity bit that they are talking about.

Claim to Profits

Like any owner, you have a claim to the profits of the company. These profits come to you in the form of dividends.

Let’s understand with our earlier example.

The partnership of A & B turned out a profit of ₹20,000 in the first year of operations. Now, the partners decided to keep ₹15,000 in the business for buying additional machinery to grow their revenue.

Now, the remaining ₹5,000 was to be divided between the partners. Since ownership is at 65:35 ratio, A gets 65% of ₹5,000 or ₹3,250. And partner B gets 35% or ₹1,750.

Voting Rights

Further, equity shares also give voting rights to the holder of the share.

Investors in a company often (not always) get one vote for every share owned. The more the shares, the more the votes. And more votes helps these investors elect board members who oversee major decisions, governance and management compensation. 

I used the word “not always” in the earlier paragraph. 

Is one share not equal to one vote then?

No, it is not. Alphabet Inc. is one notable example of a company that has multiple classes of shares. At Alphabet Inc.:

  • Class A shares have 1 vote per share
  • Class B shares have 10 votes per share (these do not trade in the public market)
  • And there is Class C shares which have no voting rights

We go back to our example. 

When partner C entered the fray, he came with ₹100,000 in capital, was issued 500 shares and got an ownership of 33.3%. However voting rights are a very different issue. The promoter partners (A & B) issued Class B shares to Mr. C. Class B shares had 0.5 votes per share. 

As a result, we find:

Name of PartnerShares AllottedVotes per shareVoting Shares% of Voting Rights
A650165052.0%
B350135028.0%
C5000.525020.0%
TOTAL1,500
1,250100%

Preference Shares

Preference shares are that type of shares that have preferential rights over equity shares. These rights pertain to early claiming of dividends and repayment of principal upon liquidation.

Holders of preference shares are entitled to a fixed percentage of dividend before any is paid to the equity shareholders.

In construct, a preference share is a hybrid between an equity share and debenture/bond of the company. In fact, preference shares are the preferred route of venture capitalists when investing in startups.

Difference between equity shares and preference shares

The below table captures the differences between equity shares and preference shares.

CriteriaPreference SharesEquity Shares
Voting RightsGenerally no; available only in special circumstances[1]Yes
Refund of CapitalGet preference on liquidation proceeds before equity sharesPaid from proceeds only after winding up of the company
Right to Participate in ManagementNoYes
RedemptionShares redeem on the due date[2]No; however company may choose to buy-back equity shares
Right to DividendPreference share dividends are paid before equity share dividendsDividends are optional but will be paid post preference shareholders are paid
Rate of DividendThe rate is fixed[3]The rate varies often
Compulsory to IssueNoYes
ConvertibilityCan get converted into equity sharesCannot get converted to preference shares
TradeableNot tradeableBuy and sell via the stock exchanges

1. Section 47(2) of the Indian Companies Act, 2013 lists out some situations where preference shares will have voting rights. One such scenario is where dividend has not been paid for a period of 2 years or more, then such class of preference shareholders shall have a right to vote

2. Preference shares are of two types – 1. Redeemable and 2. Irredeemable preference shares. Redeemable preference shares are paid back to the shareholders at the end of a specific time.

3. Preference shares are issued with a coupon rate or a dividend rate. However, owning preference shares does not guarantee dividend payment.

Why do Companies Sell Shares in the Stock Market?

Why does anyone sell anything?

Very simple. To raise money.

But then you might say, “hey, what is the company really selling here?”

It’s a fair point. The money you pay today is for the right to participate in the company’s profits for an indefinite period of time.

Let me illustrate with an example.

You are a young 30 year old executive earning ₹10,00,000. You are talented and expect to increase your compensation by 10% each year until you retire at 60.

I offer you a choice. You can take ₹5,00,00,000 from me now and in exchange give me just 10% of your compensation each year.

In other words, your cash flow will look like the table below:

YearMoney receivedMoney paid out
Year 0₹3,00,00,000
Year 1
₹1,00,000
Year 2
₹1,10,000
Year 3
₹1,21,000
Year 4
…. …. …..

Will you take it?

Let’s say you take the deal. On the face of it, it might sound like getting ₹3,00,00,000 now is better than losing out on 10% each year. But this 10% really adds up.

I did the math and figured that the final corpus that you give up is ₹5,23,48,207

This is exactly what the company is selling when it sells stock – it is putting potential future profits into your pocket against a larger money at the present moment

The modern stock market mostly bases the perceived value of the company on it’s potential future earnings. This allows even small companies to raise millions and billions if investors think that there is a lot more money to be made in the future if the company succeeds.

Case Study in Potential Future Earnings

Let’s take the example of Uber Technologies

Uber Technologies started trading in May 2019 at $45 per share after it offered 1.72 billion shares to the public at large. This is a starting market capitalization of $77.4 billion.

This was inspite of the company having lost money every quarter. Infact, even now the market capitalization of the company is $37 billion with the drop owing more to coronavirus than a clear understanding of the company fundamentals. 

Uber Technologies has been making losses every quarter and yet has a valuation of $35 billion. This shows that stock market investors are chasing future profit potential and not current status of earnings.
Uber Technologies has been making losses every quarter and yet has a valuation of $35 billion. This shows that stock market investors are chasing future profit potential and not current status of earnings.

The sheer investor apathy to valuations is appalling. Or perhaps it is heavy unshakeable faith in this company’s ability to growth with huge potential future profits 

Further, this ability of selling some of its ownership to raise massive amounts of operating capital is very important. I say so because this money comes without essentially taking any extra effort or introducing some new product or capability.

The Stock Market is the Place to Sell Shares

So you are ready to part with some ownership to raise some money.

Enter the stock market.

Or should I say the stock exchange.

The stock exchange is the place you go to sell shares in your company. A stock exchange is an institution where one can buy and sell stocks in multiple companies.

If yours is a fresh company i.e. never traded on the stock exchange, then you offer shares through an Initial Public Offering or IPO

What is an IPO?

An IPO or Initial Public Offering is when a company is going public for the first time. This essentially changes the status of the company from privately held business to a publicly traded corporation.

The IPO is a great way for founders of the company to cash out their stake or allow the company to raise money. 

Now once a company’s stocks are listed, the public can buy or sell them as they please. This buying & selling activity leads to fluctuations in stock prices every second for when the exchange is open. A lot of this buying and selling is on account of trends and news rather than the earnings and business value.

It is common to see large swings in prices over the short term which is where casual investors get scared and fear sets in. Look at this recent period (5 days) when the coronavirus has created havoc around the world.

The Sensex between 11th Mar 2020 and 18th Mar 2020 went through a phase of massive volatility. This was the period when the coronavirus was spreading all around the globe
The Sensex between 11th Mar 2020 and 18th Mar 2020 went through a phase of massive volatility. This was the period when the coronavirus was spreading all around the globe

In these 5 days, the Sensex dropped from 35,697 on 11th March to 32,778 on 12th March – a drop of 8% in just 1 day!

Then, the next day (12th) the Sensex went even lower to 29,687 in the first few hours only to bounce back up to 32,778 by the end of that day.

Why do share prices fluctuate?

The up and down movement of shares is a congregation of opinions. 

Whose opinion?

Mine. Yours. And millions of other investors & traders who feel about companies in different manners. 

Some people feel this company is a great long-term prospect, others look at the same company as a dud. Some traders look at a company as a buy-low-sell-high prospect which can be done within a day (called intraday trading).

I believe the phrase we are taught in school holds true here. “Beauty is in the eye of the beholder”

There are times where there are only buyers of a stock. This shows high demand which pushes up the price of share.

Recently this was the case of only buyers with India Cement, a small cap stock but which counts the Chennai Super Kings Cricket Limited as it’s subsidiary. This stock found only buyers on 25th Feb 2020 and 26th Feb 2020.

There were only buyers in India Cement on 25th and 26th Feb 2020 in the stock market
There were only buyers in India Cement on 25th and 26th Feb 2020 in the stock market

And there are times where there are only sellers of a stock which generally means everyone is trying to offload the stock.

The buying price and selling price is a classical case of demand and supply in the stock exchanges. 

The demand and supply part is fairly easy to understand. If more people want more of something then the stock is going to be expensive. And if more people want less of something then the market forces will pull down the price of that stock.

Evolution of Trading at the Stock Exchanges

A stock exchange is a facility which allows for traders and stock brokerages to buy and sell securities. These securities range from stocks, bonds, derivatives, options and other financial instruments.

Stock exchanges in India started the same way it started in most parts of the world – under a tree. The earliest stock broker meetings were held in the 1850s under the banyan trees in front of the Town Hall in Mumbai. And then the flock of brokers moved to another banyan tree, this time at the junction of Meadows Street and Esplanade Road. They found a permanent location in 1874 – a place called Dalal Street. This led to the formation of the Bombay Stock Exchange in 1875.

For the next 100 years or more, trading was done manually on the trading floor. This led to very high pricing anomalies as the flow of information was not consistent. With the advent of electronic exchanges, trading has become more efficient.

How to Invest in the Share Market?

There are just three things you require for starting to invest in the share market

  1. Capital (i.e. money to invest)
  2. Trading or Demat Account
  3. Knowledge

Let’s focus on points 2 and 3 here.

Demat Account

The word “demat” comes from the word dematerialization. In simple words, it means non-physical. 

A demat account is a virtual account that is used to hold shares and securities in the electronic format. This makes these shares very easy to trade especially in a world where almost all trades happen online. 

Demat accounts in India are provided by depositories such as the NSDL and CDSL. And through intermediaries and stock brokers like Zerodha, ICICI Direct, Angel Broking etc. These brokerage houses are also known as stock brokers or share brokers.

How to Open a Demat Account?

Opening a demat account is very easy and consists of just three steps –

  1. Find a broker. There are two types of brokers – full service and discount. A full service broker is like an ICICI Direct who will give you an account manager & send you research reports. In return, the brokerage house will seek a higher broker. A discount broker like Zerodha has no such frills but will give you a very low brokerage on trades
  2. Compare the brokerage rates. It’s always good to shop and find for yourself the best deal
  3. Complete your KYC. A stock broker would generally send his representative to your location to collect the KYC documents. There is an account opening form, two passport-size photographs, a lot of signatures and documents. The KYC documents required are –
    1. Proof of identity
      1. Pan Card
      2. Passport
      3. Voter ID
      4. Driving License
    2. Proof of address 
      1. Passport
      2. Voter ID
      3. Registered Lease or Sale Agreement
      4. Driving License
      5. Utility Bills
      6. Bank Passbook

Are demat accounts free of cost?

Always read the fine print. 

Yes, stock brokers often waive off any charges of opening a demat account. In that perspective, the opening of a demat account is free of cost. 

However, there is certainly an annual maintenance charge. This ranges from ₹300 to ₹500. Some brokers charge additional money for POA (power of attorney) and similar smaller charges for other services.

Knowledge of the Stock Market

Investing in the stock market does not require a professional academic degree. Anyone can access the stock markets and pick ownership in different companies.

Knowledge is labeled in the form of having a clear idea of what you are doing. Often, we see amateur first-time investors putting money in stocks based on loose logic like the stock dropping by 5% or close to 52 week low or reaching 200 DMA band etc. These systems have some merits but only if you understand these properly.

There are a number of books available that can help you brush up on how to invest in the stock markets including how to identify good stocks, using tax laws to up your returns, using leverage (margins) to your advantage etc.

Some books I have read which have helped me are –

Can the Share Market Make You Rich?

Oh, yes. Big YES.

Investing in the right shares is your road to riches. 

Warren Buffett has a net worth of over $80 billion. All of it from investing in listed companies or privately held companies.

But that’s not the example you are looking for.

So, let’s look at Sharad Banwadekar who bought shares of MRF in the year 1968 at a mere ₹17 rupees. The shares of MRF currently trade on the NSE at exactly ₹60,000. This represents a growth of 17% per year. 

As said earlier, investing is not hard. You have to build it around a strategy of buying good companies with pricing power, growing revenue, free cash flow and good management. These principles have stood the test of time and are the identified traits of companies which have made many investors before you really rich.

So go ahead and invest some money in the stock markets. And keep on learning.

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