The stock market refers to public demands for issuing, buying, and selling stocks traded on a stock exchange or over the counter. Stocks, also known as equities, represent fractional ownership in a company, and a stock market is a place where investors can buy and sell ownership of such investible assets.
At the end of this course, you will be able to understand the following:-
- Equity Shares.
- Preference Shares.
- Need of Issue of Shares.
- Reasons to invest in Shares.
- Primary and Secondary Market.
- Stock Price and Factors affecting it.
- Share Trading.
- Stock Market Returns.
What is a Share?
Shares are precisely what the name implies; they are the shares in the ownership of the business. A shareholder is a part-owner of the company and can expect to share its profits but should also be prepared to share its losses.
A company usually issues two types of shares: ordinary and preference.
When investors buy shares in a company, the company uses that money to make and sell its products, fund its operations, and expand. If the company earns a profit, the stockholders (owners of shares of stock in the company) make a return, or gain, on their investment. People buy and sell stocks for one reason: They want more significant returns than they can get from conservative investments, such as savings accounts or government bonds.
What is a Share Capital?
Capital refers to the amount invested in the company so that the latter can carry on its activities. In a company, capital refers to ‘share capital.’ The capital clause in the Memorandum of Association must state the amount of capital with which the company is registered and give details of the number of shares and the type of shares.
A company cannot issue share capital over the limit specified in the capital clause without altering the capital clause of the Memorandum of Association.
The following are the different terms used to denote aspects of share capital:
- Authorized capital.
- Issued capital.
- Subscribed capital.
- Called-up capital.
- Paid-up capital.
Authorized capital means the sum mentioned in the capital clause of the Memorandum of Association. It is the maximum amount that the company raises by issuing the shares and on which the registration fee is paid. This limit cannot be exceeded unless the Memorandum of Association is altered.
Issued capital means that part of the authorized capital has been offered for subscription to members and includes shares allotted to members for consideration.
Subscribed capital means that part of the issued capital, at nominal or face value, has been subscribed or taken up by the purchaser of shares in the company and allotted.
Called-up capital means the total amount of called-up capital on the shares issued and subscribed by the shareholders on the capital account, that is, if the face value of a share is Rs.10/- but the company requires only Rs.2/- at present, it may call only Rs 2/- now and the balance Rs 8/- at a later date. Rs 2/- is the called-up share capital, and Rs.8/- is the uncalled share capital.
Paid-up capital means the total amount of called-up share capital, which is paid to the company by the members.
Types of Shares
There are two types of shares:-
Equity Shares mean that part of the company’s share capital is not for preference shares.
Preference Share means the share which fulfills the following two conditions:-
- It carries preferential rights in respect of dividends at a fixed amount or a fixed rate; that is, the dividend is payable at a fixed rate or percent, and this dividend must be paid before the holders of the equity shares can be paid dividends.
- It also carries preferential rights regarding payment of capital on winding up or otherwise. The amount paid on preference shares must be paid back to preference shareholders before anything is paid to the equity shareholders. In other words, preference share capital has priority in the payment of dividends and the repayment of capital.
Therefore, a share that does not fulfill both of these conditions is an equity share.
Issuance of Shares
Why do companies issue equity shares?
Companies issue equity shares, also called common stock, to raise money to start their businesses and help pay for ongoing activities—a private company or a closely held company that issues stock to a small group of people. A private company’s stocks are not traded openly in stock markets. On the other hand, a public company sells its shares in stock markets, where anyone can buy them. Some large companies, such as TCS, Reliance, WIPRO, etc., have thousands or millions of stockholders.
A unique feature of share capital is that a company need not repay the money of a stockholder. Hence it can use that money to fund its ongoing activities. Instead, a stockholder generates a return on the shares in the form of dividends, capital gain, or even both. A share price is set according to how much the buyer is willing to pay, and a company’s share price goes up or down as per the demand and supply. Other factors that affect the share price are; news on expected sales revenues, earnings, company expansions, mergers with other companies, etc.
The company’s management decides whether any profits will be paid to stockholders as dividends.
Why Investors Purchase Shares?
Most investors purchase shares to make money in three ways: They profit when they receive dividends, when the value of their stock price appreciates, and when the stock splits and increases in value.
Income from Dividends
A company’s management decides whether or not to pay dividends. Companies that grow fast might pay low or no dividends. They may choose to use profits to expand the company. In contrast, companies that have already reached a stage of maturity and have an average growth rate may decide to pay dividends consistently, e.g., consumer goods and pharma companies.
Dividends could be in the form of cash or stock. A stock dividend is paid when the company doesn’t want to use the cash reserves but intends to declare a dividend. This is done by issuing shares to existing shareholders using the non-cash reserves. It has the effect of increasing existing share capital.
Each shareholder receives an equal amount per share with a cash or stock dividend. Cash dividends are usually declared on an annual basis and sometimes half-yearly also. In addition, some companies with significant increases in earnings might declare a special cash dividend at the end of the year.
Capital gain is the increase in the price of the stock over the initial investment in it. If the market value of a stock increases, an investor may decide whether to sell it at a higher price or continue holding it. If an investor trades it, the profit is the difference between the price paid and the price received. If the stock’s value falls, the return would be less than the original investment. One of the reasons the stock price increases is when the company’s board decides to place profits back into the company in ongoing projects or new projects requiring capital expenditure.
The financing of the projects by plowing back the profits positively affects earnings per share as it provides capital to the company without raising it from the market. But, apart from it, there could be other reasons for price appreciation, like the overall economic environment, industry outlook, company management, the performance of similar companies, etc.
Types of Capital Gains
- Short-Term Capital Gain (STCG): Profit on shares sold within one year from the date of purchase is considered a Short-Term Capital Gain. Short Term Capital Gains attract tax and are taxed at 15%.
- Short-Term Capital Loss (STCL): A loss on stocks sold within one year from the purchase is considered a short-term capital loss. Short Term Capital Loss can be offset against short-term Gains during the same financial year.
- Long-Term Capital Gain (LTCG): Profit on stocks sold one year after the purchase date is considered as Long Term Capital Gain. LTCG that is more than Rs 1 Lakh will be charged at a 10% tax rate without any inflation indexation benefit. However, the gains made before 31st January 2018 will be exempted from this new rule.
- Long-Term Capital Loss (LTCL): A loss on stocks sold one year after the purchase date is considered as Long Term Capital Loss. Long Term Capital Loss cannot be offset against long-term capital gains.
Increased Value from Stock Splits
The stock price may also increase through a stock split. A stock split occurs when the shares of stock owned by existing stockholders are divided into a higher number of shares.
For example, a company doubles the number of outstanding shares in a two-for-one stock split. Suppose a company has 10,000 shares valued at Rs 50/- per share. If the company splits its shares, the value of each share decreases to Rs 25, but the number of outstanding shares increases to 20,000. If you owned 200 shares before the split, you would own 400 shares after it.
|Your value||Rs 10,000||Rs 10,000|
Reasons for Share Split
Often the management believes that the stock should be trading within an ideal price range. If the market value is much higher than this range, a stock split brings the market value back into line. The lower price of stocks after they are split often attracts more investors. As a result, the price starts to rise again. The public wants to buy because of the belief that most companies split their shares only when the company’s financial future looks very good. However, it’s important to note that a stock’s market value is not guaranteed to go up after a stock split.
Voting Rights and Control of the Company
Stockholders are also given certain rights in return for their investment. For example, a company is required by law to hold a yearly meeting at which stockholders can vote on company business. In addition, stockholders usually get one vote for each share they own.
You could buy preference shares, also termed preferred stock, in addition to, or instead of, common stock. Remember that preferred stock gives the owner the advantage of receiving dividends before common stockholders receive any dividends.
Preferred stockholders know the amount of the dividend they will receive. It is either a specific amount or a percentage of the stock’s par value. The par value is an assigned value printed on a stock certificate. For example, if a stock’s par value is Rs 100 and the dividend rate is 5 percent, then the dividend amount would be Rs 5/-per share (Rs 100 * 5% or .05 = Rs 5). Unlike the market value, the par value does not change.
Why do Companies Issue Preference Shares?
Few companies use preference shares as a way of raising money. However, for some companies, it is another method of financing that may attract more conservative investors who do not want to buy common stock. Preferred stockholders receive limited voting rights and usually vote only if the company issuing the stock is in financial trouble.
Why do Investors Buy Preference Shares?
A preference share is considered a “mezzanine investment.” The yield on preference shares is generally lesser than the yield on corporate bonds but higher than the yield on common stock. A preference share, also known as preferred stock, is considered a safer investment than common stock but not as secure as bonds. People who want a steady source of income often buy preferred stock. However, preferred stocks lack the potential for growth that common stocks offer. As a result, many investors do not consider preferred stocks a good investment.
To make preferred stocks more attractive to investors, some companies may offer cumulative preferred stock, convertible preferred stock, or a participation feature.
Cumulative Preference Share
Cumulative preferred stock is where unpaid dividends build up and must be paid before any cash dividend is paid to the common stockholders. This means that if a company decides to omit one or more dividend payments to preferred stockholders, people who hold cumulative preferred stock will still receive those dividend payments during a later payment period.
Convertible Preference Share
Convertible preferred stock can be exchanged for a specific number of shares of common stock. This feature provides an investor with the safety of preferred stock and the possibility of greater returns through conversion to common stock.
Participatory Preference Share
Some companies offer a participation feature, which allows preferred stockholders to share in the corporation’s earnings with the common stockholders. For example, after a required dividend is paid to preferred stockholders and a stated dividend is paid to common stockholders, preferred and common stockholders share the remainder of earnings. However, this feature is rare.
The primary market is where companies issue new security not previously traded on any exchange. A company offers securities to the general public to raise funds to finance its long-term goals. The primary market may also be called the New Issue Market (NIM). In the primary market, securities are directly issued by companies to investors. Securities are issued either by an Initial Public Offer (IPO) or a Further Public Offer (FPO).
An IPO is a process through which a company offers investors equity and becomes publicly traded. Through an IPO, the company can raise funds, and investors can invest in a company for the first time. Similarly, an FPO is a process by which already listed companies offer fresh equity in the company. Companies use FPOs to raise additional funds from the general public.
Features of Primary Market
The companies that issue their shares are called issuers, and issuing shares to the public is known as a Public Issue. This process involves various intermediaries like Merchant Bankers, Bankers to the Issue, Underwriters, Registrars, etc.
All these intermediaries are registered with the capital market regulator like SEBI in India, SEC in the USA, etc. They are required to abide by the prescribed norms to protect the investor. The Primary Market is, hence, the market that provides a channel for issuing new securities by issuers (i.e., government companies or private sector companies) to raise capital. The securities (also termed as financial instruments) may be issued at face value or a discount/premium in various forms such as equity, debt, etc. They may be issued in the domestic or international market or even both.
Importance of Primary Market
- The securities are issued by the company directly to the investors.
- The company receives the money and issues new securities to the investors.
- Companies use the primary markets to set up new ventures/businesses or to expand or modernize the existing business.
- The primary market performs the crucial function of facilitating economic capital formation.
Definition of the Prospectus
A prospectus is a detailed document that an issuer must prepare to sell its securities to the public. It must, by regulation, provide complete, accurate, and plain disclosure of all essential facts relating to the securities being issued.
A Prospectus helps the public to access the information to make sound investment decisions.
A prospectus is invaluable as it is the starting point for making an informed decision. It gives information about a company or mutual fund, including information on products, management, financial and strategic planning, and risks. Reading a prospectus is the first step towards becoming an informed individual.
Prospectus Preparation Process
When an issuer decides to sell its securities to the public, it first prepares a preliminary prospectus and submits that document to the securities’ regulators for review. A preliminary prospectus has most of the information that will end up in the final version of the prospectus but may be missing certain necessary information, such as the price or number of securities being sold.
When the securities regulators complete their review, the issuer prepares and files a final version of the prospectus for vetting by the capital market regulator. Once the vetting has been done, the issuer can begin to offer their securities.
Content of the Prospectus
Information provided in a prospectus is listed below:-
- The history of the issuer and a description of its operations.
- We have audited financial statements for the previous three years.
- A description of the issuer’s business and investment plans.
- A description of the intended use of the money raised by selling the securities.
- A summary of the significant risk factors affecting the issuer.
- Information about the issuer’s management and its principal shareholders.
Need for Prospectus
The prospectus is required by law to contain the facts. The facts, not promotional hype or a sales pitch, should be the basis for investment decisions. In addition, a prospectus allows an individual to protect himself by giving him detailed information about the issuer and the securities being sold.
In the prospectus, an individual can find answers to many questions one is expected to ask before investing. With these facts, an individual becomes better informed to make the right decisions. One should look at the merit of the investment, the risks, and how the particular investment fits the needs and objectives.
Reviewing the prospectus can determine whether the investment has merit and whether the risk and potential return levels fit particular investment needs and objectives. Securities laws require issuers to take great care to ensure the statements made in their prospectuses are accurate, as it is illegal to file a false or misleading prospectus.
Primary Market Issues
When a company raises funds by selling (issuing) its shares (or debenture/bonds) to the public through the issue of an offer document (also termed a prospectus), it is called a Public Issue.
Initial Public Offer
When an unlisted company makes a public issue for the first time and gets its shares listed on the stock exchange, the public case is called an initial public offer (IPO).
Further Public Offer
When a listed company makes another public issue to raise capital, it is called another public or follow-on offer (FPO).
Offer For Sale
Institutional investors, like venture funds, private equity funds, etc., invest in an unlisted company when it is minimal or early. Subsequently, when the company becomes large, these investors sell their shares to the public through the issue of the offer document, and the company’s shares are listed on a stock exchange. This is called an offer for sale. The proceeds of this issue go to existing investors and not the company.
When a company raises funds from its existing shareholders by issuing them new shares or debentures, it is called a rights issue. The offer document for a rights issue is called the Letter of Offer, and the issue is kept open for 30-60 days. Existing shareholders are entitled to apply for new shares in proportion to the already-held shares. For example, in a rights issue of a 1:5 ratio, the investors have the right to subscribe to one (new) share of the company for every five shares held by the investor.
In a bonus issue, a company issues new shares to its existing shareholders without any proceeds.
In a bonus issue, the new shares are issued out of the company’s reserves (i.e., accumulated profits), and shareholders need not pay any money to the company for receiving the new shares. Shareholders’ net worth consists of equity capital and reserves. After a bonus issue, there is an increase in the company’s equity capital with a corresponding decrease in the reserves, while the net worth remains constant. In a bonus issue of a 5:1 ratio, an investor will receive five new company shares for each share the investor held initially.
Pricing of Public Issues
Based on pricing, issues can be classified into Book Built and Fixed Price issues.
In a book-building issue, the issuer company mentions the minimum and maximum price (i.e., price band) at which it will issue its shares. Thus the offer document (in this case, called the Red Herring Prospectus) contains only the price band instead of the price at which its shares are offered to the public. Within this price band, the investor can choose the price at which the investor is willing to buy the shares and the quantity. As this process is similar to bidding in an auction, the application form for book built issue is also known as the bid form.
At times the issuer may revise the price band (revision of price band), which a newspaper advertisement must accompany.
Bids by various investors are entered into the stock exchange system through the broker’s (also called syndicate member) terminal. The list of requests received from investors at different price bands is known as the ‘book’ and can be seen on the website(s) of the stock exchange for each investor category.
Based on the total demand in the ‘book,’ the issuer and merchant banker decide the cut-off price. The cut-off price is when the cumulative share demand equals or exceeds the offered size.
Illustratively, the cut-off price of a public issue of 1,000 shares with a price band of 100 to 120 would be arrived at as follows:-
|Number of Shares||Cumulative Number of Shares||Bid Price||Shares Allotted|
|Cut Off Price||114||Total= 1,000|
All investors who applied (bid) for shares at or above the cut-off price will be allotted shares at the cut-off price proportionately. If the investment is less than Rs 200,000 (i.e., retail investor), the investor can bid at the cut-off price by ticking the cut-off option in the application form.
After the allotment, a public advertisement is issued, giving details of the issue price and a table showing the number of securities and the amount payable by successful bidders.
A secondary market is a platform wherein the shares of companies are traded among investors. It means that investors can freely buy and sell shares without the intervention of the issuing company.
It is the marketplace where previously issued securities, such as stocks and bonds, are traded among investors. It is also the market where investors buy securities from other investors, not from the issuing organization. The sale proceeds from the secondary market go to the investor, not the issuing company. On the other hand, a primary market is where the issuing organization gives the securities for the first time, and the proceeds go to the company that issues shares.
Importance of a Secondary Market
The secondary market is essential for several reasons:
- First, the secondary market helps measure the economic condition of a country. The rise or fall in share prices indicates an economy’s boom or recession cycle.
- The secondary market provides a suitable mechanism for a fair valuation of a company.
- The secondary market helps drive the price of securities towards their genuine, fair market value through the fundamental economic forces of supply and demand.
- The secondary market promotes economic efficiency. Each sale of a security involves a seller who values the security less than the price and a buyer who appreciates the security more than the price.
- The secondary market allows for high liquidity, i.e., stocks can be easily bought and sold for cash.
Listing of Shares
Listing means the admission of securities to a stock exchange for trading. It is done through a formal agreement between the issuer and the respective stock exchange. The prime objective of listing is to provide liquidity and marketability of securities.
Listing is not compulsory under the Companies Act. However, it becomes necessary when a public limited company desires to issue shares or debentures. The company must comply with the exchange’s requirements when securities are listed on a stock exchange.
Objectives of Listing
The primary objectives of the listing are:-
- To provide marketability and liquidity of a company’s securities.
- To provide free negotiability to stocks.
- To protect shareholders’ and investors’ interests.
- To provide a mechanism for effective control and supervision of trading.
How are stock prices set?
Before a stock can be bought or sold, the buyer and seller must agree on a price. In stock exchange trading, the buyer and seller never meet. A stockbroker helps in bringing together the buyers and sellers of the stock. The stockbroker tries to find a price the buyer and seller can agree on.
A computer network links stockbrokers together. Using this network, stockbrokers try to reach a fair deal on the price on behalf of their investors. The process is complicated because there are usually several investors trying to buy and sell stock in a company at the same time. It is something like a big computerized auction.
Why do stock prices change?
Once a stock is bought or sold, the price is posted on the exchange, so everyone knows the latest price. Stock prices can change quickly. The stocks of many companies are bought and sold daily at prices that vary throughout the day. When more people want to buy a stock than those who want to sell it, the stock’s price will rise.
Usually, more people want to buy a company’s stock if they believe that the price of the stock will rise or if the company’s profits or dividends will rise more strongly than expected. Conversely, if more people want to sell a company’s stock than the buyers, the stock’s price will likely fall.
Stocks owned by many people are easier to buy and sell and provide liquidity. For this reason, the stock price may not change as much as that of a stock that is not traded as often.
Factors Affecting Share Price
Supply and demand are the main factors determining whether a share price moves up or down. If more people want to buy a share than sell it, the price will rise because the share is more sought-after (the ‘demand’ outstrips the ‘supply’). On the other hand, if supply exceeds demand, the price will fall.
How do supply and demand affect share prices?
Supply and demand affect the appeal and, ultimately, the price of shares. While there might be other factors, such as the health of the economy and company earnings, these are just supply and demand drivers.
This means that even if you think a stock is over or undervalued, the market decides its worth. For example, if more buyers move into the market, the demand grows, and share prices go up, especially if there is a limited supply. On the other hand, if supply and demand are just about equal, the share price will likely move around in a narrow range for a while until one of the factors outweighs the other.
Supply Factors that affect Share Price
Supply factors that affect share prices include company share issues, share buybacks, and sellers. It’s important to note that share prices will decrease when supply exceeds demand and more investors start to sell.
A share issue is when a company releases new shares to the public. In other words, when it offers shares for purchase. There is always a limited number of shares in circulation for any given company, so if lots of investors want to buy a share and the supply is low, the share price will increase.
A share buyback is when a company buys back its shares from investors to reduce supply. Once this happens, the shares are either canceled or kept for redistribution in the future. A share buyback reduces the total number of shares in circulation, which could increase the share price and the company’s earnings per share (EPS).
Sellers are the investors responsible for pushing shares back into the market and increasing the supply. They usually sell to make a profit when they expect a reversal or when they think the share is losing too much value. The price will go down if demand doesn’t match the increased supply. Conversely, the price will rise if there are more buyers than sellers.
Demand Factors that affect Share Price
Demand factors affecting share prices include company news and performance, economic factors, industry trends, market sentiment, and unexpected events such as natural disasters. Demand gives shares value. If there is no demand for a company’s shares, they will have no value.
Expected and Unexpected Company News
Any news surrounding a company, expected or unexpected, can cause movement in its share price. For example, an earnings report that reveals significant profit, a new product launch, missed targets, or the death or departure of a critical figure could all lead to swings in demand and share prices. Even natural disasters can cause business disruption and increase a company’s debt, meaning less demand.
Economic factors affected prices, including interest rate changes, financial outlook, and inflation. For example, if the interest rate and inflation go up, and the economic outlook is poor, demand will usually decrease, and the share price will likely come down.
Industry trends often determine the price of shares because companies in the same industry often perform similarly and are subject to the same pressures. So, when an industry is booming, share demand in that specific sector will often increase, pushing share prices up. Conversely, it’s also possible for the need for one company’s shares to increase if a competitor is doing poorly.
Market sentiment refers to the overall feeling that traders have about an asset. Understanding market sentiment can be a powerful tool for an investor. However, it can often be purely psychological, as investors are influenced by the market mood instead of concrete news or figures. It can also be entirely subjective and assumptive but can be used to inform fundamental and technical analysis to estimate changes in share prices.
Conclusion: Stock Market Could be Risky Yet Rewarding
When one talks about equity, the immediate relative word that comes to mind is a risk. Historical data suggests that equities provide the best returns over long periods compared to other investment asset classes. Owing equity means becoming a part owner of the company.
The dearth of attractive alternative investment avenues also provides a strong case for investment in equities. Investors can always park their money in bank fixed deposits, bonds, and other safe investments, yielding fixed rates of return. Considering inflation, such returns are dismal and do not provide capital appreciation. Equity investment provides dividends and an opportunity for capital appreciation.
Investing in equity is a case of risk and reward. Investment in equity gets exposed to high volatility in the short term, which tends to even out in the long term.