In this blog post we will see what is stock market and how to invest in stocks.
The way it is easy to make money in stock market, it is even easier to ‘lose’ money in stocks. But losing money in stock market can be avoided only if one can gather more and more information about it.
Investing in stocks is risky. Hence good knowledge and right guidance is essential to invest profitably in stocks.
But one must take me wrong. I do not intend to say that only people with special skills and knowledge in stocks. In fact stock investing can be practiced profitable by anybody. The only limitation is, gathering right information.
So lets begin our information gathering process with following basic questions.
#1. What is Stock Market?
Stock market is a place where we can buy and sell stocks. Buying and selling of stocks are not done directly by us.
Only authorized stockbrokers can buy and sell stocks in market. Hence we need to first hire a stockbroker to enable buying and selling of stocks.
In olden days only rich people used to trade in stocks. Stockbrokers were rare & costly. Only rich could afford such stockbrokers.
Accessibility of common man to stock market was also very limited. Back then, stockbrokers used to practice ‘heavy outcry system’ to buy and sell stocks. But with advent of internet, outcry system was replaced by online stock trading platforms.
This also gave birth to new, cost-effective stockbrokers. Some well-known stockbrokers in India today are HDFC Securities, ICICI Direct, Axis Direct, Geojit, etc.
#2. What are Stocks?
Before explaining what are stocks we shall know why & how company borrows money.
Companies can borrow money very easily from banks in form of loans.
Companies can also borrow money from common man by issuing bonds.
Both in bank loans and bonds company is obliged to pay interest.
Companies can also issue stocks and borrow money from public. Borrowing money by issuing stocks does not oblige company pay interest to stockholders.
Then why people buy stocks?
Each stocks represent proportional ownership of a company. Suppose a machine shop is worth $10million. If the machine shop owner wants capital to expand its capacity, it can issue stocks.
Suppose he issues one million number stocks. Then each stock of the machine shop will be worth $10million/1million = $10.
An investor who owns 100nos stocks of this machine shop has 0.01% proportional ownership in the machine shop.
If in next 1 years, the machine shop makes a profit of $1million, then this shareholder will be eligible for profit share by 0.01%.
Proportion claim of 0.1% on $1 million means $100. So one of the reason why people buy stocks is to claim a share in companies profits.
This profit sharing is done by company in form of dividends. Stock market is a place where people can buy proportional ownership in any listed company.
By becoming proportional owners they earn dividend income. Warren Buffett is known to earn million of dollars in dividend alone.
Stocks not only earn dividends but it also benefits shareholders by capital appreciation.
When companies’ profits grows, its market price of stocks also rise. When people sell their stock holding at price more than its purchased price it is called as capital appreciation.
#3. Why people like stocks so much?
If objective is to beat inflation, stocks are the best investment option.
Generally people get attracted to stocks when they hear hypothetical profit-stories of others. But this should not be the reason why one should start stock investment.
There are more valid reasons to invest in stocks.
One big motivating factor is, the ability of stocks to beat inflation in long term.
Inflation decreases our purchasing power. Suppose you have Rs 5,000 in your pocket today. Due to inflation (@5%/year), after 25 years, this Rs 5,000 will be equivalent to Rs 1,400.
Hence must must take actions to prevent devaluation of ones money (due to inflation). In order to protect the ‘erosion of purchasing power’, stocks are the best investment tool.
For any investment strategy, it is important to first ensure protection of capital from wrath of inflation. Once we assure this, then we can think of capital gains.
Stock is one investment option that gives us both, capital protection and capital gain.
#4. How to Invest in Stock Market?
Buying and selling of stocks can be done easily using online trading accounts.
But difficulty of stock investment is not in opening trading accounts. The difficulty of stock investment is, selection of good stocks.
Out of all stocks available in stock market, more than 90% are not good of buying. Some stocks are bad because they trade at expensive price levels. Some stocks are bad because their ‘underlying business’ has weak fundamentals.
A good stock is one which has strong fundamentals and are also available at a right price.
One must buy those stocks that can make money for us. Money making can happen either in form of dividends or capital appreciation.
But in order to make money, stock analysis is a must. The extent of success in stock investing is dependent on how well one can analyze stocks.
Not many can analyze stocks like Warren Buffett. This is for sure, but to make decent profits, only minor checking is enough.
We do not need to learn rocket science to make money in stocks.
A long term stock investor must learn to read financial statements of companies.
Financial statements of companies highlight which company is fundamentally strong. Idea is to buy stocks of only fundamentally stronger companies.
Stock analysis is an art. One can learn it will only small practice.
Stock analysis starts with company profits. Investors would like to buy stocks of profitable companies. Higher will be the profit, higher will be the profit sharing (dividends).
Companies has their own unique ways to share companies’ profits with its shareholders. They can directly share profits by distributing dividends. They can also ‘retain’ profits instead of distributing dividends.
The retained earnings is used to expand and modernize companies facilities. This further increases companies’ profits and profitability in long term.
The enhanced profit and profitability will improve companies market price of stocks.
Higher retained earnings means company becomes more independent. Dependency on outside debt to finance its operations is reduced.
This further increase companies profitability and profits. Higher profits has direct impact on market price of stocks.
Next time when you see a stock price rising in stock market, make sure to check its historical EPS (profits). EPS growth over a period of time (say 5 years) improves market price of stocks.
Small companies do not generally pay dividends to its shareholders. They prefer to retain companies’ profits.
Large and matured companies do not have much scope of fast profit growth. Hence, Large companies prefer to share profits among shareholders in form of dividends. Dividend sharing by large companies keeps shareholders interested in their stocks.
A stock investor must understand that overvalued stocks are not good. Do not buy stocks of companies whose market price is overvalued, no matter how strong are its fundamentals.
To understand if a stock is overvalued or not, the easiest tool is Price Earnings Ratio (PE). PE ratio of stock is calculated by dividing market price of stock with its EPS.
If market price is Rs100 and its EPS is 5, then PE ratio will be 20. As a rule of thumb, a stock whose PE ratio is more than 15 is said to be overvalued.
But investors must not only rely on PE. Other indicator that can be used is PEG Ratio & dividend yield. PEG and dividend yield are my personal favorites.
I like to buy stocks that yields consistently high dividend. Generally large matured companies show high dividend yields.
You can also check our stock analysis worksheet that can be used to learn the process of stock analysis.