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Of Shares, IPOs and Stock Markets

If you’re wondering what this thing is that people call “shares” and how does it affect your life, here goes.

When companies look for money for their business, they can get it in two ways – either they borrow from a bank and pay interest (“debt”) or they ask people like you and me to invest and give us shares (“equity”). A share is a part of a business.

For instance, say I start a company named “Brouhaha Pvt. Ltd.”. A friend named Anup and I decide to split the initial investment 50-50. We need Rs. 10 lakh to start, so I put in Rs. 500,000 and so does Anup. Now this is given to us as ‘shares’. Each share has a “face value” of Rs. 10, and each of us gets 50,000 shares. Totally the company has “issued” 100,000 shares of face value of Rs. 10.

Now the company grows. We earn Rs. 10 crore in profits because of a great marketing strategy. The total number of shares remains the same at 100,000.

Then suddenly we decide that we need to expand, and we need 60 crores more money to allow us to expand faster. We can do two things – go to a bank to borrow or ask for other people to invest in the business. We decide to do the latter.

But who will have 60 crores? We can choose to find a big rich individual or company, or choose to “go public” meaning we ask a LOT of small shareholders to invest whatever they want to, and in return we will issue them shares of the company. Let’s again go with the latter option.

But will they pay the face value, or Rs. 10 per share? Obviously not – the company has grown that initial amount from 10 lakh capital to a 10 crore profit, plus there are assets in the business, so the value of the company is much higher!

The exact price is a matter of “valuation”. Typically this is a function of how well you can grow your company in the future, a factor called the P/E ratio which is a multiple of your net profits. So let us say that we expect a Price to Earnings ratio (P/E) of 15 on last twelve month earnings, a conservative value that we believe we can get. We go public with an initial public offer (IPO) valuing the company at Rs. 150 crores (10 cr. profit x 15 P/E ratio).

That means 100,000 shares are valued at Rs. 150 crore. That’s a value of Rs. 15,000 per share. But usually such huge figures are not easy to convey to a buyer. But the profits over the last few years have accumulated as “reserves” in our balance sheet, and the company has 20 cr. reserves but only 10 lakhs as capital. So let us say we issue more shares as “bonus shares”, reducing the reserves and increasing the capital. This increases the total number of current shares from 100,000 to 1 crore shares, again at a “face value” of Rs. 10. Without having to pay anything more Anup and I are now owners of 50 lakh shares each. And each share is worth Rs. 150 (150 crore total value divided by one crore shares)

To get Rs. 60 crores, we have to issue 40 lakh more shares (at a price of Rs. 150). For this we go for an IPO, which we will ask for money from anyone who wants to own a share of our business. Post IPO, we will have a total of 1.4 crore shares (1 crore earlier and 40 lakh freshly issued shares) and we will be listed in a stock market for anyone to buy and sell our shares. The shares list at Rs. 150, but because the company is expected to grow even more, the price goes up to Rs. 200 per share.

Let’s say a person named Sarath wants to buy a share of this business but the company has got all the money it needs from the IPO. So there will no further shares issued, but Sarath can buy shares from the stock exchange. He will buy shares at Rs. 200. So he will own a share of the company, but he’s willing to pay more than the IPO price because he thinks the company will do well.

The person who sold the share got it in the IPO – at Rs. 150. Now he makes a profit of Rs. 50. Later Sarath sells it to someone else at even higher values like 250 etc. The company doesn’t really get affected because it isn’t seeing the money, but the share price goes up as the company starts doing better, and as more people begin to want the shares.

Why does the share price go up? The answer is: Perceived value. I may think the company is worth 1 crore, but someone else might think it’s worth 2 crores. When my shares reach my valuation I sell, but someone else will think it’s a good deal and buy.

To organise such buying and selling, there are commercial “stock exchanges”. BSE and NSE are some of them, though there are a number of other, smaller exchanges in India. An exchange provides a common place for people to buy or sell shares, with sales happening on an auction basis – buyers bid for shares at a price they are willing to pay, and sellers “ask” for a price from buyers. Exchanges match these prices and share exchanges happen along with payments. “Brokers” facilitate these exchanges, and you pay them a fee as brokerage, part of which goes to the stock exchange as well.

So that was about shares and stock exchanges and such. Now you still have to figure out how to buy shares, which companies to buy, and when. More on that later.

  • hari says:

    >Hi Deepak,

    I have a doubt deepak. As you have mentioned in the article
    1)Does each company increases the number of shares/capital by utilizing its reserves

    2) Also Can you tell me if capital is the initial investment i.e no of shares * price of each share.

    3) If a company issues a bonus will it have any impact on the face value?


  • Anonymous says:

    >Hi Deepak,

    Just the kind of post I was looking out for to explain how these “shares” come into existence. Thanks a lot for putting it through in a simple manner.
    A few doubts remain still though:

    1) When you initially pool in money of 5 lakh each, do you actually get shares (as in which can be bought / sold) or shares come into picture only once you go public and list on an exchange. Do the initial lot of shares have to be at face value 10 only or it can be some other face value also?

    2) The concept of bonus shares. You had 1 lakh shares initially and then from the reserves of 20 crores, you moved 10 crores to capital column by issuing bonus shares of face value 10 again. How does this concept work? My understanding is that each share represents some capital (money) involved in the business and hence you are moving from reserves (which are income saved over a period of time) and converting it into shares (hence moved to capital). In case of your example, if I understand correctly, is it to say that as per some calculation, your company issued a bonus of 99:1 by moving 10 crores from reserve to capital? (Taking figures from your example)
    In one of your earlier posts you had said that “Technically, a bonus is nothing but moving a liability (profit or reserve) over to capital. So it doesn’t affect the balance sheet at all on the assets side, only minor moves on the liabilities side.
    Could you elaborate on this also a bit please, why would cash reserve be termed as a liability, should it not an asset?

    3) Again, at time of IPO, to raise 60 crores (50 crores as initial requirement plus additional 10 which were moved to reserve), you issue 40 lakh shares @ 150 / share. These are in addition to the initial 1 crore shares. From what I understand, they be looked at as a receipt for having invested 150 rupees per share in your company. Does this imply that at any point of time, if a company (already listed on exchange) wants to get more money for its business, it can float another PO (public offer) and get more money by issuing more shares. This funda of shares coming into existence from nowhere is interesting and I guess SEBI would have some rules for it.

    I ask some very basic (and maybe stupid) questions but then I could not get answers to these from anyone and your post came at the right time so am raising them here. Had you added that post on books to read to your sticky investment fundas maybe I would have had the answers ;-).

    As always, keep up the good work.

    PS1: One request, is it possible to add a “new” link in your investment fundas sticky post to make it easier to spot the new entry. At times it becomes a bit tough to spot the new one.
    PS2: Still waiting for that post on identifying / analysing good stocks early on, maybe with SRF as example (in case you are still interested in it).

  • Deepak Shenoy says:

    1) increasing shares by “capitalization of reserves” is what is a bonus issue. Only existing shareholders get shares,and prorated to their shareholding.

    2) Capital = no. of shares x face value per share.

    3) No, bonus shares don’t change the face value. Only “splits” change the face value.

  • Deepak Shenoy says:

    1) Shares exist in every limited company, public or private. Face value can be anything I think but it has to be a round figure. (no 1.25 and such).

    2) This is a very good question but the funda of accounting is: Share capital is a liability and so are reserves. Effectively, reserves are that part of teh company that is actually owned by the shareholders so it’s a liability (i.e. it’s a shareholder’s asset and teh company’s liability) Even share capital is a liability. effectively, when you issue bonus shares, you move money from one head (“reserves”) to anohter “capital”. Since they are both on the liability side of the balance sheet, nothing changes.

    Cash reserve has nothing to do with “reserve” here. Reserves are an accounting term used to place accrued profits and so on.

    3) Cash raised is 60 crore. It is not 50 cr. + 10 fromreserves. I think that was a typo that I now fixed (thanks for the heads up!)

    And of course companies can go for more IPOs! The concept of rights issues, FCCBs, Follow on public offers, and even ESOPs are all concepts of issuing new shares against money received.

    I like the idea of “new posts” in the sticky. I have a list of recent posts in the left side bar (near the top) which may help too!

    Analysing good stocks wise: I am preparing the set of posts for chooseing stocks of which this is the first post 🙂

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