In this lesson, let’s look at the fundamentals of what is equity and how does an investment in equity bring returns to you as an investor.
How equity investing really works?
Before that, there is something more fundamental and basic that one needs to understand. How does a business work and create value?
The purpose of a business is to engage in activities such as trading, manufacturing or services that will enable it to solve a need or fulfil a want of consumers and in the process, generate a profit. Profit means that the price at which it sells its products or service will be higher than the cost of that product or service.
Profit = Selling Price – Costs
Profit is the incentive of setting up an enterprise.
Now a business can sell thousands or millions or billions of units of product or service. As it generates these profits, it can use a part of such profits to grow its business, expand into new markets, serve its customers better. The other part of the profits can be shared with the owners of the business. Such a share of profits with the shareholders is known as dividends.
As you might notice, the owners of the business in a company are called shareholders. In case of an individual-run business, it is a proprietor and in case of a partnership firm, they are partners.
We will keep our discussion around a company, as it is most relevant to equity investing.
There can be several shareholders in a company, each representing its ownership through the amount of shares it holds.
Now, a company, as a legal entity, is allowed to list its shares on the stock market, subject to certain rules and regulations. The stock market is the place where the shares are bought and sold amongst investors for mutually agreed price.
OK. This was a very quick overview of some of the basics of business and the stock market.
Let’s take up an example of how a company creates value.
3 friends start a business to make and sell instant noodles. They form a company, 2Minute Noodles Limited, and invest Rs. 1 lakh. Friends 1 and 2 invest Rs. 30,000 each, while Friend 3 invests Rs. 40,000 as starting capital of the company. Thus, their respective ownership or shareholding is 30%, 30% and 40%.
They use the investment of Rs. 1 lakh to create the required setup to manufacture and sell instant noodles.
In the first year of the business, 2Minute Noodles sells 10,000 packs of noodles at Rs. 10 per pack. The total revenue of the company is Rs. 1 lakh.
The entire cost of making and selling these noodles is Rs. 90,000.
Did they make a profit or a loss? Profit, of course.
Revenue of Rs. 1 lakh ( -) Costs of Rs. 90,000 = Profit of Rs. 10,000
The 3 friends are very happy. They have made a good start. As shareholders, they decide to share the profits amongst themselves.
However, one of them suggests that they should keep some money in the business for future growth. The other two agree with the idea.
So, out of the Rs. 10,000 as profits, they retain Rs. 6,000 in the company and distribute the remaining Rs. 4,000 amongst themselves as dividends. The ratio of distribution is the same as their shareholding.
Now, let’s talk about the business itself. 2Minutes Noodles was started with a capital investment of Rs. 1 lac. The business has made profits and there is an additional Rs. 6,000 available with it to grow.
So, what is the current value of the company at the end of Year 1?
It would be Rs. 1,00,000 (+) Rs. 6,000, that is, Rs. 106,000.
As you see the value of the company has increased to Rs. 1.06 lakhs.
The three friends, as owners, have shares in the company. Suppose, the original value of every share is Rs. 100 and the total number of shares is 1,000. So the 3 friends have 300, 300 and 400 shares respectively.
What is the value of every share now?
Current value per share = Rs. 106,000 (divided by) 1,000 = Rs. 106.
Wow! From Rs. 100 per share, the value is now Rs. 106 per share. A growth of 6% in just the value. Not to mention, that there was a dividend too that was distributed.
Let’s further suppose, that next year, 2Minute Noodles sells 20,000 packs of noodles at Rs. 11 per pack. The revenue of the company is Rs. 2.2 lakhs.
The cost of making and selling are Rs. 1.8 lakhs. Hence, the profit would be Rs. 40,000 (Rs. 2.2 lakhs – Rs. 1.8 lakhs).
This time again, the 3 friends apply a similar policy. They distribute 50% of the profits as dividends to themselves and the remaining 50% is left with the company for future growth.
The 50% of Rs. 40,000 is Rs. 20,000.
What is the value of the company at the end of Year 2? Let’s do the math.
Rs. 106,000 (+) Rs. 20,000 = Rs. 126,000
What is the per share value of the company?
Rs. 126,000 (divided by) 1,000 shares = Rs. 126 per share
This is a growth of almost 19% from the last year’s value. Great!
Let’s go a year further. Something really strange happens. Mid year, a government laboratory in its regular test finds the noodles unfit for consumption. Orders are issued to the company to withdraw all its unsold stock from the market.
The company has no choice but to comply with the orders.
In this year 3, it had been able to sell only 15,000 packs so far at Rs. 12 per pack. There are another 10,000 packs lying unsold. Unfortunately, they had to be called back and destroyed.
Let’s see the impact on the numbers because of the event. Revenue or sales of the company is 15,000 * Rs. 12, that is, Rs. 1.8 lakhs. The cost of all sold and unsold packs is Rs. 2 lakhs.
So, what’s the profit?
Rs. 1.8 lakhs (-) Rs. 2 lakhs = Rs. (-) 20,000.
This isn’t a profit. The business has suffered a loss of Rs. 20,000 this time.
Surely, that also means there are no dividends to distribute to the shareholders since there are no profits. And what happens to the value of the company? It changes, negatively.
Current business value = Previous value of Rs. 1.26 lakhs (-) Rs. 20,000 loss = Rs. 1.06 lakhs.
The per share value is also back to Rs. 106.
The value of the shareholding of the 3 friends also suffers because of this.
However, this was just a temporary phase. Over the years, counting the ups and downs, the business kept growing and the value of the shares also kept pace.
So, this was the story of 2Minute Noodles Limited.
I hope this example has brought in an understanding of how the business creates value and how does the value of a company and its share price change. But the share price referred to here is the book value of a share, that is, the value as indicated by the financial numbers in the books of accounts of the company.
Let’s take this a step further. Suppose this company was listed on a stock exchange, that is, anyone could buy and sell the shares of the company on the stock market.
Why would someone buy a share of the company? Because the investor believes that it’s a great business which will generate profits and cash flows in the years to come. The investor has money lying with him which by investing in this company can generate a better rate of return.
When you become a shareholder, you become a part owner of the company of which you buy the share, just like those 3 friends. As an owner you also get to take part in the profits or losses of the company. And as the value of the company grows, the value of your shareholding also grows.
You can choose to invest in several such companies and make a portfolio of good businesses by buying their stocks. When you feel you need the money, you go back to the stock market and sell your shares in return for cash.
The stock markets
When it comes buying and selling of shares in the stock market, there is a little change that one should understand.
The price at which the share of the company is being sold may not be its book value. The price in the stock market better reflects an expectation about the company’s future performance. The price is an estimate that is derived on the basis of assumptions about the future sales of the company, its costs, profits, competition, etc.
Based on these, a value or price is calculated that the investor thinks is appropriate to pay for participating in the profits of the company.
The results are not guaranteed. There is an element of risk that exists as we saw in the 2Minutes Noodles case. The investor takes this risk into account and adjusts the price accordingly.
A smart investor buys a stock if the market price is less than or equal to this price determined by him, else he looks for other opportunities.
Note: There is some arithmetic behind these calculations which we will take up some other time. It would need some study and practice.
How should you go about equity investing?
Unfortunately, the perception about the stock market is that it is a gambling casino. The only way to make money there is to punt.
The tendency to make short term profits through rise or fall in prices is a trading mentality, which sometimes can border on speculation. Speculation in stock markets is like shooting arrows in the dark hoping that some would strike the bulls eye. Unfortunately, it doesn’t work that way. You are guaranteed to lose your shirt in this process.
Too many greenhorns or inexperienced investors fall prey to this approach.
As you might have understood by now, there is a way business works and creates value. Yes, there is a huge movement in share prices on a day to day basis, but over time, the real business fundamentals of profits and cash flow catch up and get reflected in the stock prices.
You focus on the fundamentals of business value, profits and cash flows, that the business is going to deliver and take your decision to invest based on them. Everything else can be safely ignored.
If you believe that you do not have the time or inclination to understand and find out which are the right stocks to buy and at what price, you can either take help of your advisor. Alternatively, you can choose professional fund management with mutual funds.
When you invest in equity / stocks, don’t fall prey to short term performance. You cannot expect blockbuster results in a period of just a few months. The stocks that you invest in are real companies. It takes time to create value. Have patience!
Thankfully, there is a section of really smart investors like you who take investing seriously. These investors understand how businesses work and how value is created.
They are aware that wealth is created over a very long period of time. They choose companies or mutual funds which can help them deliver on this goal of long term wealth creation.
My humble request to you is to focus on this approach. You will certainly be astounded by the results.
This note is a part of the free course – Investing 101. Want to receive other lessons of Investing 101 on email?