When I started to invest in stock market, a huge array of questions bombarded my mind. The best teacher for me at that time was Internet. Though, back then, the answers were not as specific but the collective information was useful.
A beginner does not ask the same questions as an expert. The information that is generally available on internet is more relevant to semi-experts. Many beginners face this problem. They do not get the needful know-how about stock investment.
It is not useful to tell a beginner about stock analysis, till he know what is stock market. There are thousands of people who are super-interested to practice stock investment. But nobody is there to answer their FAQ’s. Hence they prefer staying away from stock investment. I know this because I went through this phase of confusion and frustration.
Today after years of learning and practice, I recall my good old days. In this backdrop, it is a pleasure to write a blog answering the FAQ’s about stock investment for beginners.
This blog is specifically for beginners and those prospective investors who want to take a plunge in stock market. Here are top 6 frequently asked questions (FAQ’s) about stock investment.
#1: What is stock market all about?
What image comes to mind with the term stock market? Beginners probably imagine stock market as a place where people gamble to buy/sell stocks. This is not wrong, in market people do buy and sell things. Similarly in stock market people buy and sell stocks.
But the weightage of the word “stock” is very big. To understand ‘stock market’ one must know the utility of stocks. Wise people invest in stocks and become millionaire. The place where stocks are bough and sold is called ‘stock market’.
People often compare stock market to casino. But in reality, stock market is more similar to ‘industries’ and ‘banks’. For financial gurus, stock market is like a place of worship.
It is essential to give the due respect to stock market. To make money in stocks, one must first have right concepts about the market itself. Stock market has capability to make tonns of money for people, only if people trade in this market in a right way.
In India there are two main stock markets (stock exchange). Bombay Stock Exchange (BSE) and National Stock Exchange (NSE). Over 5000 companies stocks are listed in BSE. Over 1600 companies are listed in NSE. Market capitalization of BSE is $1.3 Trillion. Market capitalization of NSE is $0.9 Trillion.
Stock market is a market where common people like you & me can go and buy/sell stocks. People buy stocks for sake of money-growth. Buy low and sell high. But in stock market stocks prices not always grows. Price of stocks traded in stock exchange remain volatile. No one can predict when price will go up and when it will fall.
Amidst this volatility of stock prices in market, people invest their money for growth (capital appreciation). There are people who also buy stocks for income generation (dividends).
To buy and sell stocks one need not physically visit the stock market. Opening an account with brokerage firm that provides online trading facility can do the trick. With online trading account, one can buy and sell stocks online from comfort of home.
#2: Which is better BSE or NSE?
Frankly speaking, there is no major difference. In BSE more stocks are listed hence people prefer BSE. But apart from this, there is no distinct advantage of stock investment of BSE over NSE.
Lets understand it like this? Why we invest in stocks? We do so for capital appreciation or income generation. How to ensure capital appreciation? Buy low and sell high. How to ensure high income generation? Buy dividend paying stocks at low price.
It means the whole concept of stock investment is based on market price of stocks. So what drives the market price of stocks? Whether stock that are listed in BSE grows faster than NSE stocks? Not at all. In fact stock exchange has no influence on market price of stocks.
Market price of stocks is influenced by 2 factors (1) financial performance of its underlying business & (2) demand and supply balance of stocks in stock market.
#3: What are shares & stocks?
In India we call it shares. In America people call it stocks.
A share represent a part-ownership of a company. Suppose one share of Company ABC represent 0.00000001% ownership in that company. A person who has 1 million number shares of ABC will have 1% ownership in ABC.
Companies subdivided the total value of company into several shares. Suppose valuation of company ABC is $1,000 million. One share of ABC will be worth $10.
A common man cannot dream of buying company ABC worth $1,000 million. But he can surely buy shares of ABC which trading at $10/share.
This is what makes shares trading so exciting. Here people are not just buying anything, they are actually buying part ownership in companies.
Imagine yourself possessing 100,000 number share of Google (Alphabet). In Total Google has 296 million shares in market. Possessing 100,000 shares means you have 0.034% ownership in Google Inc. Suppose Google pays $0.3/share as dividend every year. In this case you will earn $30,000/year only from dividends.
People can earn dividend income just by holding on to shares. When people sell their share-holdings thy collect money equivalent to the selling price. Ten number shares of company ABC sold at $10.5/share will collect $105 for the seller.
#4: What is the right price of shares?
What we see in the market is ‘market price’ of shares. At market price we buy and sell shares.
There is another price called ‘fair price’ of shares. Fair price decides whether a share is overvalued or undervalued. To make profitable stock investment one must buy undervalued shares. When market price of stocks is below fair price, it is called undervalued and vice versa.
The right price of stocks is that market price which is trading at below its fair price.
The challenge for a beginner is to calculate fair price of stocks. Fair price can be calculated from digging deep into financial reports of companies. Financial reports like balance sheet, profit and loss accounts, & cash flow statements helps in estimation of fair price of stocks.
Let’s take a simple example of fair value calculation. Suppose company ABC has $3300 million in asset & $2300 million in debt. Net asset of ABC will be $3300 – $2300 = $1,000 million. If ABC has 100 million number share outstanding, its fair value will be $1,000/100 = $10/share. It means the fair value of ABC is $10/share.
In order to judge if current market price of is overvalued or undervalued, one must compare market price per share with fair price per share. If current market price of ABC is $12 per share it means share is overvalued.
Warren Buffett recommends people to buy those share which trade at two-third of its fair price.
#5: Why companies float their shares in market?
Companies float their shares in stock market to generate funds. Companies sell their ownership (shares) in exchange for money. The money collected by company by issuing shares is used for expansion of business.
When companies issue share to public for the first time it is called IPO. Common men can buy IPO from primary market. There are two parts of stock market; primary market & secondary market. Day-to-day trading of shares is done in secondary market.
But why companies float their shares in market and dilute their own ownership? Why companies do not raise money from banks in form of loan?
Loan from banks beat interest expense. While funds raised by issue of shares are not liable for any compulsory interest payment. Companies only pay dividend to shareholders and that too is at their discretion. It means, funds raised vide shares are much cheaper.
Companies can also buy-back its shares from secondary market. This way they can increase their shareholding in the company.
#6: Why should common men practice stock investment?
Stock investment is very risky. This is a phrase that is also a common understanding. But what is the risk associated with stock investment?
Not many people can estimate the fair price of stocks. As a result, people keep buying and selling stocks blindly. Considering that stock prices are so volatile, the chances of losing money due to blind-investing is very high.
Lack of know how of people to estimate fair price of shares makes stock investment risky. So, its ones own inability to evaluate stocks makes stock investing risky.
Inherently stock investment is not bad, but unwise investing makes it risky for novice.
So, why should common men practice stock investment at all? The potential return that stock investment can generate for people far exceeds any other investment option. On an average, returns generated by stocks is close to 12% per annum (in India). Compare this to other investment options, which generates average return of close to 7% per annum. Moreover, long term investment is stocks is even tax free.
But how common men can invest in stocks? We cannot expect everyone to become stock analyst and then buy stocks?
Yes its true. This is why experts ask common men to buy stocks indirectly.
A very close resemblance to direct stock investing is ‘index linked ETF’. One can buy index linked ETF every time the market (Sensex or Nifty) falls by 2%-3%. This must be practiced like any other ‘good habit’.
If one wants even lesser hassle, one must start a SIP in diversified equity mutual funds.