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Foundations

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.

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