A stock in a company, commonly known as a ‘share,’ is a financial instrument representing a fractional share of ownership in a company. When you purchase a company’s stock, you become a shareholder. Investors buy stocks in the hope that the company will succeed. When the company performs well, its stock owners also share the success. The main benefit of an equity investment is the possibility of getting returns on the initial investment. These returns may be in capital gain, dividends, or both.
At the end of the course, you will be able to understand the following:
- What is a Stock?
- Types of Stocks.
- Stock Returns.
- Stock Trading.
- Stock Orders.
What is a Stock?
A stock is an investment. Investors purchase stocks in companies in anticipation that the stock value may go up in the future. If that happens, an investor may sell the stock to book profit or continue holding it for longer.
When you own stock in a company, you are called a shareholder. As a shareholder, you are entitled to share a company’s profits. A shareholder would also have to bear the loss in case of loss. However, the bearing of loss is limited to the maximum of the face value of a share.
Reasons to Invest in Stocks
It means a rise or increase in the value of the stocks in both book value and market value. When stocks are held over a more extended period, say 5 to 10 years, they may provide a consistent price rise. Sometimes over a shorter period, like in one or two years, there could be capital appreciation, but often it’s not sustainable. Historically, stocks have appreciated over a more extended period only.
This is a payment by a company to its shareholders in the form of a return on investment. When a company generates profit and intends to share it with shareholders, it declares a dividend. A dividend could be in the form of a cash dividend or even a stock dividend. A dividend is usually declared by companies that have been showing consistent profitable performance over time and have a dividend distribution policy.
An ordinary shareholder gets a right to vote in company matters. Such voting rights entitle a shareholder to vote on important issues related to a company like; dividend declaration, selection of directors, company policy on capital expenditures, etc.
Types of Stocks
There are two types of stocks that a company issues to its shareholders. These are:-
- Common stock,
- Preferred stock.
Common stock entitles its holders to vote in a shareholders’ meeting and receive dividends.
Preferred stock does not give voting rights, but its holders are entitled to receive dividend payments before common stockholders. In addition, if the company goes bankrupt and its assets are liquidated, shareholders of preferred shares get priority compared to common stock shareholders.
Every share has a par value. This is an amount determined by the company that issues the shares. Par value is usually a small amount, say Rs 10/- or Rs 100/- per share.
Par value also indicates the maximum amount of personal liability that a shareholder has in the case of the liquidation of a company. Par value is also termed Face value.
Face Value vs. Market Value
The face value is not the market value of a share. Market value is the current share price at which it could be traded at an exchange. It is based on the company’s performance. The market value of a share is determined based on the company’s performance and the demand for its shares. The face value doesn’t change, whereas the market value may fluctuate.
Shareholders who own common stock are the residual owners of the company. Being the residual owners of the company means that in case of liquidation, they will receive money only after all other creditors have been paid in full. As a result of their ownership of common stock, shareholders participate in the leadership and management of the company.
Rights of Common Stockholders
Right to Vote
There are different methods used for voting, but almost all owners of ordinary shares have the right to vote at the annual shareholders’ meeting. While votes are taken on various corporate issues (such as mergers), the most significant vote is the election of a Board of Directors to oversee the company management on behalf of the shareholders. Shareholders are also able to give their vote through proxies.
Right to Receive Dividends
If common dividends are declared, ordinary dividends may or may not be paid in a given year. However, if declared, all common shareholders have the right to receive dividends. Though shareholders are not guaranteed dividends, the right to receive dividends is one of the rights of a shareholder.
Right to Buy Shares of a New Issue
If provided in a company’s bylaws, this preemptive right allows the shareholders to purchase newly issued shares in the same percentage they currently own. This right prevents the ownership share of a shareholder from being automatically diluted because of the issuance of new shares.
Right to Share in the Distribution of Residual Assets
As previously mentioned, if the company is liquidated, common shareholders will receive a distribution of whatever assets are left after all creditors have been paid in full.
Ownership of equity shares involves a certain amount of risk for the shareholders. However, the owners of shares are in a position to benefit more from the company’s success than a bondholder because there is no limit to the dividends or capital gains that shareholders may receive.
Risk of Investing in Common Stock
Owners of common stock have no guarantee of profit. They invest in shares and assume high risk in exchange for potential returns. This possible return from shares is usually much higher than returns from safer investments like bank fixed deposits or company bonds. However, it should be noted that a common stock could be very volatile and is generally considered a high-risk investment.
Preferred stock is a hybrid financial instrument, i.e., it has features found in common stock and a bond.
Features Similar to a Bond
- Preferred stockholders usually do not vote in an annual meeting,
- Preferred stockholders generally receive dividends before common stockholders.
- Preferred stock usually pays or earns annual dividends at a constant rate. Therefore, preferred dividends are mentioned as a percentage of the par value.
- Preferred shareholders receive preference over common shareholders in the case of asset distribution in liquidation. But preferred shareholders have a lower priority than bondholders in the distribution of assets.
- Often, preferred stocks are issued with bond-like features, such as convertibility.
Features Similar to Common Stock
- If a company decides not to pay dividends on preferred shares due to financial difficulty or other reasons, it does not result in bankruptcy proceedings. However, nonpayment of interest to bondholders may lead to bankruptcy.
- Preferred dividends are paid after interest and taxes. Therefore, they are not tax-deductible for the company.
- In the event of asset distribution in liquidation, preferred shareholders are paid after bondholders and other creditors. However, they are paid in preference to common shareholders.
Ownership of common and preferred shares provides a return through dividends. A dividend could also be expressed as the portion of a company’s earnings paid to shareholders. A dividend yield is an annual dividend expressed as a percentage of the current market price of a share.
For example, if the market value of a share is Rs 100 and the annual dividend is Rs 5, the dividend yield would be 5% (Rs 5/ Rs 100).
Most of the common stocks and preferred stocks pay dividends. However, the amount and timing of dividend payments are at the discretion of the company’s board of directors. No law states that a company must pay a dividend on its common shares, even if it is profitable. Therefore, the board of directors can increase or decrease the dividend rate and even decide not to declare dividends. However, companies try to maintain a relatively even flow of dividends and increase the dividend when the company enjoys growth in net earnings.
The expected receipt of dividends is sometimes just enough for investing in shares, particularly if the yield on the investment exceeds the return from fixed deposits. Shares that pay out a reasonably generous dividend are known as income stocks. While dividends are essential to many, most investors hope to gain an additional return in the form of capital gains.
When an investor buys a share, such an investor hopes the share’s market value will increase. This increase in the market value of a share is termed a capital gain. This allows an investor to sell the share later at a higher price and book a profit.
Shares of companies expected to grow over time are known as growth stocks. Investors buy such stocks in anticipation that their per-share value will increase over time. As the company prospers, the share price of the company will also increase. Most of the time, investors purchase shares only for capital gains. However, it is also possible that the price of a few stocks may not increase. This could be due to many reasons. One reason could be that such companies have a policy of distributing regular dividends. It has been seen that when companies pay high and regular dividends, shares of such companies do not rise much in value. These are termed income stocks.
Stocks are bought for investment purposes. Most investors usually have investment portfolios with a mix of income and growth stocks. Some investors could do this by investing in schemes of a mutual fund. This could be a growth equity scheme, balanced equity scheme, or other schemes.
Buying and Selling of Shares
Shares in a company could be bought at the stock exchange. An investor needs to use a stock broker to buy or sell shares at the stock exchange.
A stock broker acts as an intermediary between investors and the company. The stock broker, therefore, provides investors with a kind of system that facilitates the transaction of shares. For each transaction, a stock broker charges a fee that is commonly called a ‘brokerage fee’ or ‘brokerage.’
Buying and selling of shares are done at the exchange through stock brokers. However, there is a process of buying, selling, and settling transactions. Brokers are connected to exchanges through electronic mediums, and all transactions related to buying and selling are done electronically without buyers and sellers knowing each other. Therefore, transactions done at an exchange are guaranteed for settlement by the exchange.
On Buying Shares
When shares are purchased, then the buyer needs to pay for the purchased shares within two business days after the day of the purchase. Delivery of shares is done in the buyer’s Demat account on T+2 days (that is, two days after the transaction for the purchase of shares is made).
On Selling Shares
When shares are sold, the exchange transfers money to the seller’s bank account after two business days from the day of the trade.
Bid Price and Ask Price
Like any marketplace, there are two sides to every trade, i.e., a buyer and a seller. A buyer submits a bid price, the highest price they’re willing to pay for a share, while a seller offers an asking price, the lowest price they’re ready to accept.
Each buyer and seller also mentions the number of shares they are willing to purchase or sell. As a result, there is often a long list of buyers and sellers waiting to fulfill their orders at different prices.
The difference between the Bid and the Ask price is called the spread. Sometimes the spread could be broad. At other times, the difference could be significantly less, for example, a spread of just one paise. In general, those shares that are traded in higher volumes would have a narrower spread. It is always good and preferred to sell shares with a little spread. Such shares usually have depth in terms of volume and provide quick liquidity.
The number of shares available at the Bid and ask price is called size and can be found alongside the Bid and ask price in a detailed quote.
When you place a market order to buy or sell a share, you don’t specify a price, and your order gets executed immediately at the best available price.
Example of Shares Order Placement
Suppose you want to buy 1,000 shares of a company. In the Bid/Ask price section, if the best ask price is Rs 50 for 300 shares and the following best ask price is Rs 51 for 2,000 shares, then your market order would be executed for 300 shares @ Rs 50/- per share. The remaining 700 shares would be purchased @ Rs 51/- per share. Thus, the average cost would be Rs 50.70 (Rs 50*300+ Rs 51*700), plus any applicable brokerage and non-brokerage charges would be levied.
Advantage: With a market order, your order would likely be executed quickly during trading hours.
Disadvantages: When placing a market order, prices vary widely, especially in thinly traded shares. Even in heavily traded shares, sometimes price movements are fast and volatile.
The price difference is usually minimal if you’re buying or selling a heavily traded stock with a narrow spread. However, thinly traded securities with wide bid/ask spreads could result in paying or receiving a price significantly different than what you expected based on the last trade price.
REMEMBER: If you place an order when the market is closed, your order will likely be filled when trading resumes on the next business day. A lot can happen overnight, and stock may start trading at a much higher or lower price from where it closed the previous day.
When you place a market order to buy or sell a share, you don’t specify a price, and your order gets executed immediately at the best available price. In a limit order, an order is completed at a price set in the place order form. This applies to both buy and sell orders. A limit order helps to get an order executed at the desired price. It’s a type of hedging in a volatile market.
Example of Limit Order
Suppose you want to buy 1,000 shares of a company. In the Bid/Ask price section, if the best ask price is Rs 50 for 300 shares and the following best ask price is Rs 51 for 2,000 shares, then your market order would be executed for 300 shares @ Rs 50/- per share. The remaining 700 shares would be purchased @ Rs 51/- per share. Thus, the average cost would be Rs 50.70 (Rs 50*300+ Rs 51*700), plus any applicable brokerage and non-brokerage charges would be levied. Whereas, if you place a buy order @ Rs 49/- per share, your buy order would be executed only when the stock price falls to Rs 49/-. This is quite possible that during trading sessions in a day, the price of the stock mat touches the desired price.
Advantage: With a limit order, your order would likely be executed only at the desired price and not at the market price. Even in heavily traded shares, sometimes price movements are fast and volatile.
Disadvantages: When placing a limit order, it’s possible that stock doesn’t reach the desired price, and the order remains un-executed for the day unless it’s set with the feature where a future date is specified for the order execution, say good till the next ten days. In such a scenario, you may need to replace the order.
REMEMBER: If you place an order when the market is closed, your order will likely be filled when trading resumes on the next business day. A lot can happen overnight, and stock may start trading at a much higher or lower price from where it closed the previous day. A limit price order would help protect from such market volatility.
Stop Price Order
Stop-price and Stop-limit orders could be used to buy or sell stocks when they hit a predetermined price. Orders are triggered only if the price of the shares hits your chosen price. The order that’s triggered could either be a market or limit order.
Example of Stop Price Order
Suppose you own 100 shares of Company XYZ. It is trading for Rs 50, but you think the price may fall and would like to sell if it fails. So you could place a stop-limit order with a stop price of Rs 45 and a limit price of Rs 44.
If the price drops to Rs 45, the order will become a market order, and the sell order will be triggered. In this case, the stop limit order would become a limit order to sell 100 shares at Rs 44 or better price, i.e., the entire order would be executed between the price band of Rs 45-44.
Advantages: You can set a limit price near the stop price. Stop orders could be used if you cannot monitor your portfolio for a while, such as when you’re on some other important activity.
Disadvantages: If the number of available shares trading in the market is limited or the market is moving quickly, your order might not be executed.
REMEMBER: When setting your stop price, remember that if you put it very close to the current price, the order could be executed with even a slight price movement. This movement in the price could be due to regular market activity rather than company-specific performance.
Note: Stop orders without a limit become market orders when triggered.
You can also place a stop order to buy stock. For example, if you think the price of a stock is going up, you could put a stop-limit order to buy the stock by setting the stop price above the current price. A limit order to buy will be triggered if the price goes up to the specified price.
Stock Selection Approach
Growth and value are two fundamental approaches, or styles, in stock and mutual fund investing. Growth investors seek companies that offer strong earnings growth, while value investors seek stocks that appear to be undervalued in the marketplace. Because the two styles complement each other, they can help add diversity to an investment portfolio when used together.
Growth stocks are associated with high-quality, successful companies whose earnings are expected to grow at an above-average rate relative to the market. Hence, growth stocks generally have high price-to-earnings (P/E) ratios and high price-to-book ratios. The P/E ratio is the market value per share divided by the current year’s earnings per share. For example, if the stock is trading at Rs 500 per share and its earnings over the last 12 months have been Rs 25 per share, its P/E ratio is 20.
Share market often places a high value on growth stocks. Therefore, investors value these stocks more and are usually willing to pay more.
Investors who purchase growth stocks receive returns in the form of capital gain. A capital gain is an increase in price over the purchase price of a stock. Such investors do not look for dividends. Although dividends are sometimes paid to shareholders of growth stocks, it has been more common for growth companies to reinvest earnings in capital projects. Due to reinvestment, companies are able to make more profit, leading to an increase in the market value of shares of these companies. As a result, the market places high value on such companies as they show the potential for earnings growth.
At times, growth stocks may be seen as expensive and overvalued, which is why some investors may prefer value stocks that are considered undervalued by the market. As a result, value stocks tend to trade at lower prices relative to their fundamentals (including dividends, earnings, and sales).
Value stocks generally have good fundamentals, but they might have fallen out of favor in the market and are currently priced lesser than their actual price. As a result, they may sell at prices below the stocks’ historic levels or be associated with new companies that investors have not entirely recognized.
Value stocks generally have low current price-to-earnings ratios and low price-to-book ratios. Investors buy these stocks in the hope that they will increase in value when the broader market recognizes their full potential, which should result in rising share prices. Thus, investors hope that if they buy these stocks at current prices and the stocks eventually increase in value, they could make more money than if they had invested in higher-priced stocks.
Growth Vs. Value Stock
Growth and value are styles of investing in stocks. None of these investment styles guarantee a gain in the stock market. Both carry investment risk. Since the market value of stocks fluctuates with changes in market conditions, their returns also vary. Shares, when sold, may be worth more or less than their original cost. Investments that provide higher rates of return also involve a greater degree of risk.
Growth and value investments tend to run in cycles. Understanding their differences may help decide which approach is appropriate to achieve investment goals.
Regardless of which type of investor you are, there may be a place for both growth and value stocks in your portfolio. This strategy may help you manage risk and potentially enhance investment returns.
Market Terminology of Various Stocks
These stocks are issued by larger companies that are market leaders because they are mostly stable and dominate their industry. The market capitalization of these well-established companies is Rs 20,000 crore and above. In addition, large-cap companies usually have an experience of functioning over decades, and they have a strong reputation in the industry because they can handle any adverse events or in times of recession.
In India, the top 100 companies in the stock market are known as large companies because of their high performance and good track record. In the USA, companies with a market capitalization above USD 10 Billion are categorized under Large-cap companies.
Blue Chip Stocks
There is no official list of Blue Chip Stocks. They are a part of Large-cap companies that have shown stable financial performance and have been in the large-cap category over a longer period. They tend to pay decent, steadily rising dividends, generate some growth, and offer safety and reliability. and are low-to-moderate risk. These stocks can form your retirement portfolio’s core holdings—a grouping of stocks you plan to hold “forever” while adding other investments to your portfolio. These stocks are known to have the capabilities to endure tough market conditions and give high returns in good market conditions.
Based on market capitalization, India’s leading blue chip companies are the state bank of India, Bharti Airtel, Tata consultancy services, Reliance Industries, Coal India, HDFC, ITC, Infosys, ICICI Bank, ONGC, GAIL, and Sun Pharma. The list keeps changing as per the prevailing market price of a company. Some examples of blue chip stocks in the USA are IBM Corp., Coca-Cola Co., and Boeing Co.
Mid-cap stocks could be the large-caps of the future or probably of the past. Investing in these companies can be riskier than investing in large-cap market companies. This is because mid-caps tend to be more volatile. On the other hand, mid-cap companies also can turn into large-cap companies in the long run. These companies offer a higher growth potential than large-cap stocks; hence, more investors are attracted to investing in such companies.
In India, mid-cap companies have a market capitalization above Rs 5,000 crores but less than Rs 20,000 crores. Companies ranking from 101st to 200th are called mid-cap companies in market capitalization. In the USA, mid-cap companies have a market capitalization range of USD 2 Billion to USD 10 Billion.
Small Cap Stocks
Many small-company stocks have generated better returns over time than stocks of large companies. But there’s a risk that small-company stocks are much more volatile than shares of big companies. In addition, there are several ways of defining what constitutes a small company.
The definition of small companies varies in different countries. In India, a company with less than Rs 5,000 Crores market capitalization is defined as a small-cap company. The rule of SEBI states that companies ranked from 251 in market capitalization are called small-cap companies. In the USA, companies with a market capitalization range of 300 Million to 2 Billion USD are categorized under small-cap companies.
Cyclical stocks are shares of companies whose sales and earnings are susceptible to the ups and downs of the economy. Performances of such stocks are interlinked with the health of the economy. When the economy does well, the prices of such stocks usually remain high; when it performs poorly, the values of stocks lose a substantial value. For example, when the economy flourishes, people come out of their homes and afford to invest in buying cars, houses, shops, and travel, so the prices go up. And when an economic downturn starts, these discretionary expenses are the first ones any consumer cuts from their wallet. However, in many cases, prices of cyclical stocks increase when the economy recovers after a recession and even (many times) surpasses its older value. Many such stocks possess the bounce-back capability and often are considered favorites among many investors.
Stocks of those companies offering luxury and discretionary goods and services are often considered cyclical. For example, airlines, vehicle manufacturers, hotels, restaurants, and clothing stocks fall into this category.
Defensive stocks describe shares of companies whose goods and services sales tend to hold well even during economic downturns. Examples of industries substantially insulated from the business cycle are utilities, government contractors, and producers of essential consumer products, such as food, beverages, FMCG, and pharmaceuticals.
Income stocks distribute a high percentage of their earnings as dividends. This is because the companies that issue dividends tend to be mature and have limited opportunities for reinvesting their profits into more- attractive opportunities, for example, FMCG, Pharma companies, etc. In addition, stocks that pay significant dividends are usually less volatile because investors regularly receive cash dividends, regardless of market volatility.
Foreign stocks add valuable diversification to a purely domestic stock portfolio. That’s because domestic and global stock markets don’t always move in tandem. In addition, foreign stocks provide exposure to overseas currencies, economies, and business cycles. Overseas stocks are divided into two subsets: developed markets (such as the USA, Europe, Japan, and China) and developing and emerging economies like South Asian countries and Brazil, South Africa, etc.
Among many different types of stocks, penny stocks are usually high in demand and often catch the eyes of new investors. Penny stocks are typically issued by small companies, especially start-ups, to raise funds from investors. This type of stock is generally illiquid, trades at a low price, and is issued by companies with very low market capitalization.
In the Indian trading market, penny stocks are usually traded below the price of Rs. 10, and in western markets, such stocks are generally traded below $1 most of the time. Many also consider a stock priced under $5 as a penny stock. The benefit of investing in penny stock is that it is available at a low price and can turn a ‘small investment’ into a ‘fortune.’ For example, if you purchase 50,000 shares of a penny stock for $1 each, then even a $1 rise in the share price can lead you to earn $50,000 in a limited time. However, as people say that every good thing comes with some risk, there is another side. Penny stocks are considered risky as they come from companies with very few shareholders and disclose minimal information about their businesses. Moreover, such stocks are more prone to price manipulation and scams and do not end up making money for investors most of the time.
Conclusion: Stock Market is a Long Term Market
Stocks, whether purchased individually or through equity mutual fund schemes, offer the best opportunity in the long term. Careful research continued attention to your diversified portfolio, and consistent patience can help you achieve your investing goals.