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This article is a COMPLETE guide to the basics of making money in the stock market! If you are considering investing in the stock market, you MUST read this article! We have explained all the concepts and talked about all the "myths" that people have about the stock market!
What are stocks? Definition:
Plain and simple, a “stock” is a share in the ownership of a company. A stock represents a claim on the company's assets and earnings. As you acquire more stocks, your ownership stake in the company becomes greater. Note: Some times different words like shares, equity, stocks etc. are used. All these words mean the same thing.
So what does ownership of a company give you?
Holding a company's stock means that you are one of the many owners (shareholders) of a company and, as such, you have a claim to everything the company owns. This means that technically you own a tiny little piece of all the furniture, every trademark, and every contract of the company. As an owner, you are entitled to your share of the company's earnings as well. These earnings will be given to you. These earnings are called “dividends” and are given to the shareholders from time to time. A stock is represented by a "stock certificate". This is a piece of paper that is proof of your ownership. However, now-a-days you could also have a “demat” account. This means that there will be no “stock certificates”. Everything will be done though the computer electronically. Selling and buying stocks can be done just by a few clicks. Being a shareholder of a public company does not mean you have a say in the day-to-day running of the business. Instead, “one vote per share” to elect the board of directors of the company at annual meetings is all you can do. For instance, being a Microsoft shareholder doesn't mean you can call up Bill Gates and tell him how you think the company should be run. The management of the company is supposed to increase the value of the firm for
shareholders. If this doesn't happen, the shareholders can vote to have the management removed. In reality, individual investors like you and I don't own enough shares to have a material influence on the company. It's really the big boys like large institutional investors and billionaire entrepreneurs who make the decisions. For ordinary shareholders, not being able to manage the company isn't such a big deal. After all, the idea is that you don't want to have to work to make money, right? The importance of being a shareholder is that you are entitled to a portion of the company’s profits and have a claim on assets. Profits are sometimes paid out in the form of dividends as mentioned earlier. The more shares you own, the larger the portion of the profits you get. Your claim on assets is only relevant if a company goes bankrupt. In case of liquidation, you'll receive what's left after all the creditors have been paid. Another extremely important feature of stock is "limited liability", which means that, as an owner of a stock, you are "not personally liable" if the company is not able to pay its debts. In other legal structures such as partnerships, if the partnership firm goes bankrupt the creditors can come after the partners “personally” and sell off their house, car, furniture, etc. To understand all this in more detail you could read our “How to incorporate?” article. Owning stock means that, no matter what happens to the company, the maximum value you can lose is the value of your stocks. Even if a company of which you are a shareholder goes bankrupt, you can never lose your personal assets. Why would the founders share the profits with thousands of people when they could keep profits to themselves? This is the obvious question that comes up next. This what the next section is all about!
Why does a company issue stocks?
Why would the founders share the profits with thousands of people when they could keep profits to themselves? The reason is that at some point every company needs to "raise money". To do this, companies can either borrow it from somebody or raise it by selling part of the company, which is known as issuing stock. A company can borrow by taking a loan from a bank or by issuing bonds. Both methods come under "debt financing". On the other hand, issuing stock is called “equity financing”. Issuing stock is advantageous for the company because it does not require the company to pay back the money or make interest payments along the way. All that the shareholders get in return for their money is the hope that the shares will
someday be worth more than what they paid for them. The first sale of a stock, which is issued by the private company itself, is called the initial public offering (IPO). It is important that you understand the distinction between a company financing through debt and financing through equity. When you buy a debt investment such as a bond, you are guaranteed the return of your money (the principal) along with promised interest payments. This isn't the case with an equity investment. By becoming an owner, you assume the risk of the company not being successful - just as a small business owner isn't guaranteed a return, neither is a shareholder. Shareholders earn a lot if a company is successful, but they also stand to lose their entire investment if the company isn't successful.
It’s a tricky game!
Note that: There are no guarantees when it comes to individual stocks. Some companies pay out dividends, but many others do not. And there is no obligation to pay out dividends. Without dividends, an investor can make money on a stock only through its appreciation of the stock price in the open market. On the downside, any stock may go bankrupt, in which case your investment is worth nothing. Having understood this, we now want to know what makes stock prices rise and fall? If we know this, we will know which stocks to buy. In the next section we will try to understand what makes stock prices go up and down.
What makes stock prices go "up" and "down"?
Stock prices change every day because of market forces. By this we mean that stock prices change because of “supply and demand”. If more people want to buy a stock (demand) than sell it (supply), then the price moves up! Conversely, if more people wanted to sell a stock than buy it, there would be greater supply than demand, and the price would fall. (Basics of economics!) Understanding supply and demand is easy. What is difficult to understand is what makes people like a particular stock and dislike another stock. If you understand this, you will know what people are buying and what people are selling. If you know this you will know what prices go up and what prices go down! To figure out the likes and dislikes of people, you have to figure out what news is
positive for a company and what news is negative and how any news about a company will be interpreted by the people. The most important factor that affects the value of a company is its earnings. Earnings are the profit a company makes, and in the long run no company can survive without them. It makes sense when you think about it. If a company never makes money, it isn't going to stay in business. Public companies are required to report their earnings four times a year (once each quarter). Dalal Street watches with great attention at these times, which are referred to as earnings seasons. The reason behind this is that analysts base their future value of a company on their earnings projection. If a company's results are better than expected, the price jumps up. If a company's results disappoint and are worse than expected, then the price will fall. Of course, it's not just earnings that can change the feeling people have about a stock. It would be a rather simple world if this were the case! During the “dotcom bubble”, for example, the stock price of dozens of internet companies rose without ever making even the smallest profit. As we all know, these high stock prices did not hold, and most internet companies saw their values shrink to a fraction of their highs. Still, this fact demonstrates that there are factors other than current earnings that influence stocks. So, what are "all the factors" that affect the stocks price? The best answer is that nobody really knows for sure. Some believe that it isn't possible to predict how stock prices will change, while others think that by drawing charts and looking at past price movements, you can determine when to buy and sell. The only thing we do know is that stocks are volatile and can change in price very very rapidly. Just remember this: At the most fundamental level, supply and demand in the market determines stock price. There are many types of techniques and methods that investors use to figure out whether a stock price will go up or down! We will try to give you an introduction to these techniques in this article. But before we go into the concepts of stocks picking, and the techiques of analysis, let us understand one last basic thing....
What are the Sensex & the Nifty?
The Sensex is an "index". What is an index? An index is basically an indicator. It gives you a general idea about whether most of the stocks have gone up or most of the stocks have gone down. The Sensex is an indicator of all the major companies of the BSE. The Nifty is an indicator of all the major companies of the NSE. If the Sensex goes up, it means that the prices of the stocks of most of the major companies on the BSE have gone up. If the Sensex goes down, this tells you that the stock price of most of the major stocks on the BSE have gone down. Just like the Sensex represents the top stocks of the BSE, the Nifty represents the top stocks of the NSE. Just in case you are confused, the BSE, is the Bombay Stock Exchange and the NSE is the National Stock Exchange. The BSE is situated at Bombay and the NSE is situated at Delhi. These are the major stock exchanges in the country. There are other stock exchanges like the Calcutta Stock Exchange etc. but they are not as popular as the BSE and the NSE.Most of the stock trading in the country is done though the BSE & the NSE. Besides Sensex and the Nifty there are many other indexes. There is an index that gives you an idea about whether the mid-cap stocks go up and down. This is called the “BSE Mid-cap Index”. There are many other types of indexes. There is an index for the metal stocks. There is an index for the FMCG stocks. There is an index for the automobile stocks etc. If you are interested in knowing how the SENSEX is actually calculated...you must check-out our "How to calculate BSE SENSEX?" article! But, before we go ahead and try to understand "How to make money in the stock market?" you MUST read the next page....
3 important things you must know and follow as an new investor!
You need to KNOW some “unforgettable basics” before you enter the world of investing in stocks. The stock market is a field dominated by savvy investors who know the insand-outs of the market. For people who are not “on the inside”, the stock market can be a VERY dangerous place. : Don't even consider "tips" that tell you about "hot stocks". Consider the source: There are many people in the market who put in all their time and effort in promoting certain stocks. They do this because they have their money invested in those stocks. If they can
get enough people to buy the stock and they can get the stock price to rise, they will sell the stock for a huge price, the stock price will crash and they will walk off to promote another stock. Always use your own brain: It's extremely important. You must always use your own brain. Relying on the advice of others, no matter how well intentioned it may be, is almost always a complete disaster. Make sure you dig in and really examine the "facts about the companies" before you invest. Ignore press releases which have very little substance, and rely on "hype" to tell the company's story. And finally the most important tip!!! Only invest money you can afford to lose!! Sure this is a basic point, but many many people miss it. You should only invest money that you can honestly afford to lose!! Everyone enters into investments with the idea of earning big profits, but in many cases, this never works. (Especially if you are new to investing in the stock market!) Please understand that the above tips are tips for beginners. Once you really get into the stock market you do not need to follow these rules anymore. But if you are a new investor, you MUST follow these rules. They are for your own safety. But then again, nothing comes free. Everything has a price. You will have to loose some money, make some bad decisions and then only will you really understand the market. You cannot understand the market by just looking at it from far. By following these rules, you will basically not loose too much!
Stock Picking - Which stocks to buy?
Having understood all the basics of the stock market and the risk involved, now we will go into stock picking and how to pick the right stock. Before picking the right stock you need to do some analysis. There are two major types of analysis: 1. Fundamental Analysis 2. Technical Analysis Fundamental analysis is the analysis of a stock on the basis of core financial and economic analysis to predict the movement of stocks price. On the other hand, technical analysis is the study of prices and volume, for forecasting of future stock price or financial price movements. Simply put, fundamental analysis looks at the actual company and tries to figure out what the company price is going to be like in the future. On the other hand technical analysis look at the stocks chart, peoples buying behavior etc. to try and figure out what the stock price is going to be like in the future.
In this article we will go into the basics of “fundamental analysis”. Technical analysis is a little more complicated. It is much more of an "art" than a science. It depends more on experience and involves some statistics and mathematics, so explaining technical analysis is out of the scope of this article.
The Basics of Fundamental Analysis
Fundamental Analysis Definition
Fundamental analysis is a stock valuation method that uses financial and economic analysis to predict the movement of stock prices. The fundamental information that is analyzed can include a company's financial reports, and non-financial information such as estimates of the growth of demand for products sold by the company, industry comparisons, and economy-wide changes, changes in government policies etc..
To a fundamentalist, the market price of a stock tends to move towards it's “real value” or “intrinsic value”. If the “intrinsic/real value” of a stock is above the current market price, the investor would purchase the stock because he knows that the stock price would rise and move towards its “intrinsic or real value” If the intrinsic value of a stock was below the market price, the investor would sell the stock because he knows that the stock price is going to fall and come closer to its intrinsic value. All this seems simple. Now the next obvious question is how do you find out what the intrinsic value of a company is? Once you know this, you will be able to compare this price to the market price of the company and decide whether you want to buy it (or sell it if you already own that stock). To start finding out the intrinsic value, the fundamentalist analyzer makes an examination of the current and future overall health of the economy as a whole. After you analyzed the overall economy, you have to analyze firm you are interested in. You should analyze factors that give the firm a competitive advantage in it’s sector such as management experience, history of performance, growth potential, low cost producer, brand name etc. Find out as much as possible about the company and their products. Do they have any “core competency” or “fundamental strength” that puts them ahead of all the other competing firms?
What advantage do they have over their competing firms? Do they have a strong market presence and market share? Or do they constantly have to employ a large part of their profits and resources in marketing and finding new customers and fighting for market share? After you understand the company & what they do, how they relate to the market and their customers, you will be in a much better position to decide whether the price of the companies stock is going to go up or down. Having understood the basics of fundamental analysis, let us go into some more details. When investing in the stocks, we want the price of our stock to rise. Not only do we want our stock price to rise, we want it to rise FAST! So the challenge is to figure out: which stock prices are going to rise fast? Some stocks are cheap and some are costly. Some are worth Rs.500 and some are even worth 50paise. But the price of the stock is not important. The price of the stock does not make a stock good to buy. What is important is how much the price of the stock is likely to rise. If you invest Rs.500 in one stock of Rs.500 and the price goes up to Rs.540 you will make Rs.40. However, if you invest Rs.500 in a 50paise stock, you will have 1000 stocks. If the price of the stock goes up from 50paise to Rs.1, then the Rs.500 you invested is now Rs.1000. You made a profit of Rs.500. If you understand this, you can see that the price of the stock is not important. What is important is the rise in the stock’s price. More specifically the “percentage” rise in the stock price is important. If the Rs.500 stock becomes worth Rs.540, then that is a 8% rise. This 8% rise only makes us Rs.40. On the other hand when we invest the same Rs.500 in the 50paise stock and the stock price goes up to Rs.1, it is a 100% rise as the stock price has doubled. This 100% rise makes us Rs.500. The point is that when picking a company, we are interested in a company whose stock price will rise by a large percentage. Please note: Looking at the above paragraphs, it may seem like a good idea to buy all the really cheap 50paise and Rs.1 stocks hoping that their price will rise by 100% or more. This sounds good, but it can also be really really bad some times! These really small stocks are very volatile and unless you know what you are doing, do NOT get into them. However, the point to be noted is that we are interested in stocks that will have the highest % rise in the stock price. Now the question is, how do you compare stocks. How
do you compare a stock worth Rs.500 to a stock worth 50paise and figure out which one will have a higher percentage rise. How do you compare two companies that are in different fields and different industries? How do you know which one is fundamentally strong and which one is week? If you try to compare two companies in different industries and different customers it is like comparing apples and elephants. There is no way to compare them! So fundamental analysts use different tools and ratios to compare all sorts of companies no matter what business they are in or what they do! Next let us get into the tools and ratios that tell us about the companies and their comparison....
Earnings per share (EPS) ratio & what it means!
Even comparing the earnings of one company to another really doesn’t make any sense, if you think about it. Earnings will tell you nothing about how many shares the company has. Because you do not know how many shares a company has, you do not know how many parts that companies earnings have to be divided into. If the company has more shares, the earnings will be divided into more parts. For example, companies A and B both earn Rs.100, but company A has 10 shares outstanding, so each share holder has in effect earned Rs.10. On the other hand, if company B has 50 shares outstanding and they too have earned Rs.100 then each shareholder has earned Rs.2. So you see it is important to know what is the total number of outstanding shares are as well as the earnings. Thus it makes more sense to look at earnings per share (EPS), as a comparison tool. You calculate earnings per share by taking the net earnings and divide by the outstanding shares. EPS = Net Earnings / Outstanding Shares So looking at the EPS ratio, you should go buy Company A with an EPS of 10, right? EPS is not the only basis of comparing two companies, but it is one of the methods used. Note that there are three types of EPS numbers:
Trailing EPS – last year’s numbers and the only actual EPS Current EPS – this year’s numbers, which are still projections
Forward EPS – future numbers, which are obviously projections
EPS doesn’t tell you whether it’s a good stock to buy or what the market thinks of it. For that information, we need to look at some other ratios next....
Price to earning (P/E) ratio & what it means?
If there is one number that people look at than more any other number, it is the “Price to Earning Ratio (P/E)”. The P/E is a ratio that investors throw around with confidence as if it told the complete story. Of course, it doesn’t tell the whole story (if it did, we wouldn’t need all the other numbers.) The P/E looks at the relationship between the stock price and the company’s earnings. The P/E is the most popular stock analysis ratio, although it is not the only one you should consider. You calculate the P/E by taking the share price and dividing it by the company’s EPS (Earnings Per Share that we saw above) P/E = Stock Price / EPS For example: A company with a share price of Rs.40 and an EPS of 8 would have a P/E of: (40 / 8) = 5
What does P/E tell you?
Some investors read a high P/E as an “overpriced stock”. However, it can also indicate the market has high hopes for this stock’s future and has bid up the price. Conversely, a low P/E may indicate a “vote of no confidence” by the market or it could mean that the market has just overlooked the stock. Many investors made their fortunes spotting these overlooked but fundamentally strong stocks before the rest of the market discovered their true worth. In conclusion, the P/E tells you what the market thinks of a stock. It tells you whether the market likes or dislikes the stock. If things are vague and unclear to you, do not worry. The next ratio will make everything you read till now make sense..
PEG (Price to future growth ratio!) and what it tells you!
The market is usually more concerned about the future than the present, it is always looking for some way to figure out what is going to happen in the companies future. A ratio that will help you look at future earnings growth is called the PEG ratio. You calculate the PEG by taking the P/E and dividing it by the projected growth in earnings. PEG = (P/E) / (projected growth in earnings) For example, a stock with a P/E of 30 and projected earning growth next year of 15% would have a PEG of 30 / 15 = 2.
What does the “2” mean?
Technically speaking: The lower the PEG number, the less you pay for each unit of future earnings growth. So even a stock with a high P/E, but high projected earning growth may be a good value. So, to put it very simply, we are interested in stocks with a low PEG value. Just for the sake of understanding, consider this situation, you have a stock with a low P/E. Since the stock is has a low P/E, you start do wonder why the stock has a low P/E. Is it that the stock market does not like the stock? Or is it that the stock market has overlooked a stock that is actually fundamentally very strong and of good value? To figure this out, you look at the PEG ratio. Now, if the PEG ratio is big (or close to the P/E ratio), you can understand that this is probably because the “projected growth earnings” are low. This is the kind of stock that the stock market thinks is of not much value. On the other hand, if the PEG ratio is small (or very small as compared to the P/E ratio, then you know that it is a valuable stock) you know that the projected earnings must be high. You know that this is the kind of fundamentally strong stock that the market has overlooked for some reason. Important note: You must understand that the PEG ratio relies on the projected % earnings. These earnings are not always accurate and so the PEG ratio is not always accurate.
Having understood these basic three ratios, you probably have started to understand how these ratios help you understand a stock and what is valuable and what is not. In the next section we shall look at some of the things that every investor must know about. Something that SILENTLY eats into the profits of each and every investor and how to beat it...
"Inflation" & how it eats your money silently & affects your investments!
Inflation, is an economic concept. What the cause of inflation is, is not important to us from the point of view of this article. What is important to us is the effect of inflation! The effect of inflation is the prices of everything going up over the years. A movie ticket was for a few paise in my dad’s time. Now it is worth Rs.50. My dads first salary for the month was Rs.400 and over he years it has now become Rs.75,000. This is what inflation is, the price of everything goes up. Because the price goes up, the salaries go up. If you really thing about it, inflation makes the worth of money reduce. What you could buy in my dad’s time for Rs.10, now a days you will not be able to buy for Rs.400 also. The worth of money has reduced! If this is still not clear consider this, when my father was a kid, he used to get 50paise pocket money. He used to use this money to go and watch a movie (At that time you could watch a movie for 50paise!) Now, just for the sake of understanding assume that my dad decided in his childhood to save 50paise thinking, that one day when he becomes big, he will go for a movie. Many years pass. The year now is 2006. My dad goes to the theater and asks for a ticket. He offers the ticket-booth-guy at the theater 50paise and asks for a ticket. The ticket booth guy says, “I am sorry sir, the ticket is worth Rs.50. You will not be able to even buy a “paan” with the 50paise!!” The moral of the story is that, the worth of the 50paise reduced dramatically. 50paise could buy a whole lot when my dad was a kid. Now, 50paise can buy nothing. This is inflation. This tells us two important things. Firstly: Do not keep your money stagnant. If you just save money by putting it your safe it will loose value over time. If you have Rs.1000 in your safe today and you keep it there for 10years or so, it will be worth a lot less after 10 years. If you can buy something for Rs.1000 today, you will probably require Rs.1500 to buy it 10 years from now. So do not keep money locked up in your safe. Always invest money.
If you can’t think where to invest your money, then put it in a bank. Let it grow by gaining interest. But whatever you do, do not just lock your money up in your safe and keep it stagnant. If you do this, you will be loosing money without even knowing it. The more money you keep stagnant the more money you will be loosing. Secondly: When investing, you have to make sure that the rate of return on your investment is higher than the rate of inflation.
What is the rate of inflation?
As we said earlier, the prices of everything goes up over time and this phenomenon is called inflation. The question is: By how much do the prices go up? At what rate do the prices do up? The rate at which the prices of everything go up is called the "rate of inflation". For example, if the price of something is Rs.100 this year and next year the price becomes approximately Rs.104 then the rate of inflation is 4%. If the price of something is Rs.80 then after a year with a rate of inflation of 4% the price go up to (80 x 1.04) = 83.2 So, when you make an investment, make sure that your rate of return on the investment is higher than the rate of inflation in your country. In our county India, for the year 20052006 the rate of inflation was 4% (Which is really low and amazing!). This rate keeps changing every year. The finance minister generally gives the official statement on the inflation rate of the country for a particular year.
What is the rate of return?
The rate of return is how much you make on an investment. Suppose you invest Rs.100 in the market and over a year, you make Rs.120, then you rate of return is 20%. If you invest Rs.100 in the market today and you make money at a 3% "rate of return" in one year you will have Rs.103. But now, since the rate of inflation is at 4%, an item costing Rs.100 today will cost Rs.104 a year from now. So what you can buy with today’s Rs.100, you will only be able to buy with Rs.104 a year from now. But the Rs.100 that you invested has grown only at a 3% rate of return and so it is worth Rs.103. In effect, you are loosing money! So in conclusion, the rate of return on your investments, have to be higher than the rate of inflation. From the above paragraphs you can note how silently, inflation eats into your money. You would not even know about it an your money would sit loosing value for no fault of
yours. But inflation is not the only thing you should be considering, there are other things too that eat into you money. The first thing is “brokerage” and the second thing is “taxation”.
Investors beware of: Brokerage and taxation!
You probably know the concept that all your transactions in the stock market are done though a "stockbroker". A stockbroker earns a commission on whatever transaction you make. Suppose you make a transaction of Rs.2000, and the stockbroker charges you a 3% commission, then you have to pay the stockbroker Rs.60 (3% of Rs.2000) for the transaction. So your total investment in the transaction in “not Rs.2000”. The total investment in the transaction is Rs.2060/So after sometime, if the price of the stocks you invested in goes up to Rs.2060 then you have not made any money because the total amount you invested was Rs.2060/What is more, even when you sell the stocks, you have to pay the broker brokerage of 3%. This means that, when you sell the stocks for Rs.2060, you have to pay the broker Rs.61.6 so the profit of Rs.60 you made on the transaction is gone, in fact you actually make a loss of Rs.1.6!! So in effect even though you made a profit of Rs.60 because your stock price went up, you have actually made a loss. If combine this with the fact that inflation reduces the value of money over time, you are just loosing money if you do not invest wisely without understanding brokerage and inflation. Important note about brokerage: Brokers make money on whatever transaction you make. Whether you buy or sell, brokers will make money. Because brokers basically make money on transactions. Because of this, brokers tend to encourage you to trade. They don’t really care about whether you make a profit or loss. They just care about whether you are trading. The more money you are using for trading, the more they will make. Because of this, it would be wise to not blindly follow your brokers advise. The broker will give you “hot tips” etc. not because they are looking out for you and your profit, but because they are thinking about their own personal profit! There is even one more factor that eats into your money. Tax!!! Please note: We are not in any way encouraging you to not pay tax! We are just educating you about it. There is a “short term capital gain tax” in our country. For a short term (less than one
year) you have to pay tax on any capital gain you make though the stock market trading. How much % tax you have to pay, depends on which "tax bracket" you fall in. Just to give you an idea. If I make Rs.100 though a transaction in the stock market, since I fall in the 33% tax bracket. It have to pay Rs.33 of that to the government!! Please note: The government encourages you to be a long term-investor by having no long term capital gain tax. If you make a capital gain by investing for a period greater than one year, the you do not have to pay any tax on the money you make. Now combine this short term capital gain tax with brokerage and inflation! Think about it for some time. You will almost make nothing on a small profit gains! If you want to make money out of the stock market, you must make large profit gains. Conclusion: As a general rule, just for the sake of simplicity, your investments must grow at a minimum rate of 15% per year to stay ahead of inflation, tax and brokerage!! Remember this when making all your investments. This concludes our basics of the stock market guide. There is lot more to learn! And the best way to do it is to start investing! (Don’t invest too much in the beginning but do start!) Once you have your money in the market, you will start to understand things a whole lot better! Best of luck!
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