How Does The Stock Market Work? – Part 3

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Till now we have grown B&T Private Limited into a ₹30 crore company, with a profit of ₹1 crore. If you have not read part 1 and part 2, do read them before proceeding further.

 

Before we begin, there are a few questions just to test what you have understood till now.

 

  1. What is this ₹30 crore? 
  2. What is the share price of B&T Private Limited?
  3. What is the EPS?
  4. What is the P/E ratio?

 

If you are able to answer this, only then proceed further, or else visit the previous two articles.

 

Let’s come back to our business, B&T Private Limited. After getting the funding from the VC firm, over the next five years the company grows multiple times. Now the annual profit is ₹50 crore. Our first investor is looking for an exit (sell his stake) because he has found another high growth, early stage company to invest in. Along with our investor, the VC firm is also looking to sell a partial stake in the business. The promoters look to tap the IPO (Initial Public Offering) market. 

 

IPO means raising money from the public by selling or issuing shares to the general public like you and me.

 

To do this, firstly, the promoters convert the company from “Private Limited” to “Public Limited”. So, the new name of the company becomes “B&T Limited”. Also they split the shares, so that they can be easily purchased by retail investors like you and me. From the existing face value of ₹1000, they announce a 1000:1 split. This means for 1 share held, the shareholder will get 1000 shares in place of the one he has held. So from the 1875 shares, the total shares now become 18.75 lakh shares. This means the face value has now become ₹1.

 

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To get the company ready for listing, they approach a well known investment bank to get all the formalities done. These formalities include informing the regulator (SEBI – Securities and Exchange Board of India), informing the stock exchanges (BSE – Bombay Stock Exchange and NSE – National Stock Exchange), issuing DRHP (Draft Red Herring Prospectus). The DRHP is the most important document which can be used to study whether or not a new IPO is worth investing. It has the details of the business, its financial statements, the reason for raising money etc.

 

You have read the DRHP of the company and have learnt all the details about the B&T Limited’s business, and have found this a good quality company to invest. Now you proceed to analyze the financial statements. 

 

The financial statements have been extremely simplified to make you understand the concepts. This is not an exercise for analysis of financial statements, but to give you a basic understanding of stock market terminologies. All amounts below are in crores.

 

The Balance Sheet

 

Assets Shareholder’s Equity & Liabilities
Property Plant & Equipment 200 Equity Capital 0.1875
Cash & Investments 50 Reserves & Surplus 199.8125
Inventories 50 Borrowings 100
Other Assets 100 Other Liabilities 100
Total Assets 400 Total Liabilities & Equity 400
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Profit & Loss Statement

Revenue 1000
Cost of Goods Sold 850
Finance Cost 15
Employee Cost 50
Depreciation 25
Taxes 10
Profit After Tax 50

 

Notice how the total assets are equal to the sum of shareholder’s equity and liabilities. This is no coincidence. All balance sheets follow this equation.

 

Now let us understand some important terms.

 

Book Value: This is the sum of Equity Capital (18.75 lakh) and Reserves (199.8125 crores). This gives us ₹200 crores. Book Value in other words is also called as Shareholder’s Equity or even the Net Worth of the company.

 

Property Plant & Equipment: This is the total physical property, land bank, buildings, machinery existing in the business.

 

Borrowing: The total debt taken by the company.

 

Inventories: This is the amount of materials (raw or finished) held by the company. As our company is a retail company, the raw material is goods which are sold to the customer. The company doesn’t produce anything.

 

Finance Cost: The interest payment made by the company on its debt.

 

Depreciation: As the company buys land and builds their store on it, the cost of these is taken directly in one year of profit and loss, even though they would be used for a longer time period. To normalise this cost over a period of time, the company takes the total cost and spreads it across multiple years. This cost is called depreciation. 

 

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Note: Depreciation is not a cash expense, as no real cash goes out of the company. It is only an accounting entry.

 

Gross Profit Margin: It is the difference between revenue and cost of goods sold as a percentage of total revenue. In our example, this will be 15% ((1000-850) / 1000)

 

Net Profit Margin: It is the ratio of net profit as a percentage of total revenue. In our example, this comes out to be 5% (50 / 1000)

 

Now that we have become familiar with a number of terms, we would have to wait to know at what price the company is offering its stock to the public, which we’ll look at in the next article.



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