How Does The Stock Market Work? – Part 1

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This is going to be a series of articles for the ones who are keen to understand how the stock market works.


As the legendary investor Warren Buffett has always told to consider stock as a part of business, not as a piece of paper. What he means by that is whenever you buy a stock, consider yourself a part owner of that business. Stocks are nothing but parts of businesses. If you’ve understood this point, then you can consider yourself to be on your path to becoming a good investor.


Let us take the example of two friends Billu and Tillu, who decide to start a business “B&T Private Limited”. Now, Billu and Tillu become the promoters of this business (A promoter is one who has started this business. Though sometimes the promoter is someone who is other than the ones who have started the business. Eg. Walmart is now the promoter of Flipkart.) This is a retail store business similar to DMart, Big Bazaar, Reliance Retail etc. They both put in ₹5 lakh each in the business. This ₹10 lakh goes into the business as equity capital. As this is a private company, they have to create shares (or stocks) for this company. They decide the face value at ₹1,000 per share. (Face value is the initial price of one share when the company is being set up). So, based on this face value, both of them are having 500 shares each (₹5 lakh / ₹1000).


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After one full year, their business is running beautifully, and their profit for the year is ₹1 lakh deducting the taxes. That’s quite a good start. B&T Private Limited keeps on growing and after five full years of operations, they are having an annual profit of ₹5 lakh, and this is from the one store which they had established. Billu and Tillu decide that now it’s time to expand their business. So, they approach an investor to invest ₹20 lakh into the business. The investor along with Billu and Tillu, after a long discussion came to the conclusion that this transaction of ₹20 lakh will be done for the exchange of 20% of the company, putting the valuation of the company at ₹1 crore (₹20 lakh / 20%).


Now there are two options to give 20% to the investor, either the promoters sell their own shares, or they issue new shares. As in our case, the promoters want to use the money for expansion of the business, the additional funds must go to the company, and not to the promoters. This means the company must create additional shares, and allocate 20% of the total shares (existing + additional) to the investor and the promoters will have the remaining 80%. Using simple math, the company will need to create 250 additional shares and allocate those to the investor (80% of the promoters have 1000 existing shares, so the remaining 20% will be 250 shares). Total shares now will be 1250 (existing 1000 + newly issued 250). 


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Let’s do a small exercise to find out at what price the new shares were allocated to the investors. Since the investor paid ₹20 lakh for getting 250 shares, he will be getting one share at the price of ₹8000. That is a huge premium as compared to the face value. Remember, the new shares will be issued at ₹1000 (face value) only. Equity capital will become 1250 x ₹1000 = ₹12.5 lakh. Equity capital has increased by only ₹2.5 lakh, whereas the investor has invested ₹20 lakh.


So where does the remaining ₹17.5 lakh go? Also where does all the profit which the company has earned during the first five years go? I’ll leave this to you to find out, until the next part.

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