What are share market investments all about?
Shares are nothing but ownership of companies divided into several finite numbers. Each number represent a partial ownership of a company. Suppose a company has 100 shares outstanding in the market it means that if a person buys 51 shares of that company then he is the majority share holder of the company (or in simple words he is the big boss).
Why actually company breaks down the ownership of the company in finite shares?
Hundred percent ownership of the company is broken down into finite shares. Generally business owners retain some portion (say 25%) of shares in their own hand and release the balance 75% as public offerings. This breakdown of ownership is done for the purpose of generating funds for companies growth. How? Let us see a simple example. Suppose you are an owner of a small grocery shop, one day you decided that it is high time to expand your business. But the funds that you need for expansion (from small grocery shop to a mid size retail shop) cannot be organized by you. Neither you your credit rating is so good that bank will give you a sizable loan. In this case you can think of raising funds by ‘shares’. Assuming that the location of your grocery store is excellent and its size perfect for running a profitable retail store. In this case your existing business has prospects to raise funds for its growth by itself. You can do marketing of your profitable future business growth prospects and people will come rushing to buy your shares. Suppose you have divided the ownership of your grocery store into 1 million shares of book value $1. By issuing 75% of shares to public and assuming each share was sold at average price of $2.5, it means you have accumulated $1.8 million for expansion of your grocery shop.
In this way how you have been benefited:
1) You have generated sufficient funds for expansion of your business
2) In case you business shows good results after expansion then the market value of share will go up further. It means the worth of your business in growing. One day you may decide to sell off your total business (at a very lucrative rates) and lead a financially independent life.
3) The investors will benefit by investing in your business in the form of dividends and value appreciation of market price of shares.
The dividend is equally distributed among shareholder. Suppose your grocery shop did a net profit of $1 million last year. Out of $1 million you decided that $0.2 million you will distribute among share holders (75% of 1 million equals to 0.75 millions). It means that each share will earn (Earning per share EPS) $0.2/0.75 = $0.27/ share. It means if a share holder has one share in hand (which he bought at $2.5 each) he will earn a dividend of $0.27 giving him a dividend yield of 11%. This is fantastic.
By distributing $0.2 milion among share holders the balance earning will be $0.8 millions. As the owner has 25% holding in the business then he is entitled for 25% of $0.8 million = $0.2 million as his personal earnings. From balance $0.6 million, the business man may decide to keep $0.3 million as retained earning (which will increase the book value of share & hence its market price of share) and balance $0.3 million can be used to further modernize the retail shop.
In nutshell you can imagine that not only shares have allowed you to expand your existing grocery shop but it will also allow you to modernize your business year after year. Such modernization work is very critical and important for maintaining the competitive advantage of a business. The higher the competitive advantage the higher will be your net profits.
What is the best way to know the right price of shares?
Though I have started this discussion but let me tell you that valuing shares is one of the most difficult activity in the field of share market investment. But I will give you some easy to use tips that will help you to at least generate an estimated value of share.
There are several business performance parameters which directly dictates the market price of shares. We will discuss here those parameters for better understanding:
The liquidation value of company is of the deciding factors the effects the market price of stocks. In case when the company goes bankrupt and situation of liquidation is reached in that case what money can be recovered back by selling the assets. The most useful at time of liquidation are the retained earnings/ cash reserves. When the companies goes bankrupt its sells its assets to pay-back the shareholders their dues. In the above example we have discussed about a retail shop. The liquidated value of that retail shop will be (1) retained earnings in bank, (2) Inventories, (3) Fixed Assets like buildings, furniture’s etc called as net gross block (4) Account receivables , (5) Investments, (6) minus account payable (like debts etc.).
Suppose the liquidated value of the retail shop comes out to be $3.5 million. Number of share outstanding is 1 million. It means liquidated value of retail shop is $3.5 / shares. It means each share holder will get $3.5 for every share they have in hand. If the present market price of share is $2.5 and its liquidated value is $3.5 it means that the share is highly undervalued and investors must buy this share for sure.
The above example is used to calculate the value of business assuming a worst possible circumstances (liquidation) for a business. But taking a little optimistic view. Lets assume that the company will do at least reasonable business for next five years time and only after that it may go bankrupt. For these five years the parameters that will decide the value of share are (1) Liquidation Value, (2) Dividend Earnings & (3) Value Appreciation of market price of stock.
|Liquidation Value||Dividend Earned||Market Price|
|Year 0||$ 3.5 / share||$ 0.00/ share||$ 2.50/ share|
|Year 1||$ 3.6 / share||$ 0.27/ share||$ 4.00/ share|
|Year 2||$ 3.7 / share||$ 0.28/ share||$ 4.25/ share|
|Year 3||$3.8 / share||$ 0.29/ share||$ 5.25/ share|
|Year 4||$4.0 / share||$ 0.31/ share||$ 5.30/ share|
|Year 5||$3.8 / share||$ 0.29/ share||$ 5.85/ share|
|Income by end of Fifth Year (shares sold out just before liquidation)||$ 1.44/ share||$ 5.85/ share|
|Total Income||$ 7.29 / share|
|Invested Value||$ 2.5/ share|
|Profit||$ 4.79/ share|
|Return||@ 24% per annum|
Considering an average rate of inflation as 8% per annum and risk free interest available in the market as 7.5%, a return of 24% per annum in shares is a fantastic gain.